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One lesson that Silicon Valley’s wild venture financing environment has clearly learned over the past few years is that bigger valuations are not always better.
“I think we’ve all seen the negative impact of having a valuation that’s too high for the last, let’s call it, three years,” Elizabeth Yin, co-founder of Hustle Fund, said onstage at TechCrunch Disrupt last week. When the venture capital market is on the rise and startups are able to easily raise a lot of money before they have a real, demonstrable business, they have set themselves up for tough times.
Because “the bar is higher for the next round,” she said. A general rule of thumb is that in each early round, business growth should justify double or perhaps triple the previous valuation, she said.
So, early reviews “shouldn’t be a really crazy thing where you don’t think you can realistically grow with traction, because it always catches up with you,” she said.
If the company fails to grow to a high valuation, it could end up burning out its most important employees, said VC Renata Quintini, co-founder of Renegade Partners.
Most startups give stock to employees, or sometimes grant stock options — which the employee is required to buy. Most startups offer this stock as a significant portion of their employees’ salaries. People join startups because they believe that if they help build the company, their equity will pay off. Therefore, it is clearly not a good idea for employee shares to become less valuable over time.
“If you don’t close that gap, you’re actually demotivating the people who joined you early,” Quintini warns.
VC Corinne Riley, a partner at Greylock, said on stage that the best way to raise money is to “create a solid process,” by setting reasonable valuation expectations from the beginning. “You don’t want to be hanging around and have a multi-month run. You’re wasting your own time. You’re wasting the VC’s time,” she said. “You want to know exactly how much you want to raise.”
Quintini advises founders to keep ranges in mind for both amount and valuation. To do this, she says, a founder must spend more time in the information-gathering phase than in the actual pitch phase.
They should ask the venture capitalists in their network what they think about their valuation. They should know what type of market they are in and what revenue multiples or other pricing metrics are popular for their area at the moment. They should carefully consider how much dilution they are willing to take – that is, how much of their company they are willing to sell and how much of the stake they will retain after the round.
If the founder wants to sell a smaller stake — 10% versus the usual 20% — the founder must find out which companies might be receptive to that idea. Many companies will not be interested in small stakes, because that reduces their chances of making a large return.
Walking into a pitch meeting wanting too much for too little means “you better have a great business and a weird company backing it; otherwise you’re actually turning off VCs,” Quintini says.
If a venture capitalist comes with a term sheet that significantly outperforms all others in valuation, founders must consider the finer details. Has the venture capitalist hoarded a term sheet in order to give his company too much power? This may also mean that the company will not be able to convince other VC firms to invest in later rounds.
Startup accelerator Y Combinator distributes A sample terminology explaining what most venture capital firms consider standard terminology. It covers everything from voting rights to board seats.
“I’ve definitely seen a number of founders, especially global companies, getting all kinds of term sheets with all kinds of terms that I would consider non-standard,” Yin described, such as “strange board configurations” like a venture capitalist wanting to get Multi-seat boards of directors, or preferences for “liquidation of all kinds.” Anything higher than a “1x” liquidation preference means the investor gets more money, first, in the event the company is sold and not a standard order.
In addition to being prepared to negotiate the dollar amount, valuation, and stake size, founders must be prepared to negotiate the composition of the board and items such as who can choose independent directors. Whatever you decide on the terms that give venture capitalists power could impact your company and its future valuations forever.
“I encourage our founders to say no to non-standard things. Then there are some others who are on the borderline. And maybe you take it because you don’t have any other options, but once you’re done with it, it’s really hard to relax,” Yin says.
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