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What Most People Don't Understand About Startup Valuation

     

Startups are a bit obsessive when it comes to valuation. Everyone wants to be the next elusive unicorn, especially since fundraising has become increasingly difficult. Although valuation is no doubt a crucial figure in the fundraising process, it is not the end all and be all. Granted, it is hard not to get caught up on valuation because it can establish the direction a new company will take as it goes forward.

 

However, what people often overlook in their quest for the highest valuation possible is the fact that too high of a valuation can make that direction point due south. That's right, higher valuation does not translate to inevitable success. In fact, a high valuation early on has its fair share of shortcomings, and here is why:

Higher Expectations

If a company manages to snag an impressive valuation at the outset, they are usually expected to soar to success in record time. In general, a high valuation will entail some hefty investments, and anytime substantial sums of money are on the line, some pretty high expectations go along with that. Unfortunately, such high expectations may be the impediment to a startup's ability to succeed. With so much pressure to deliver, companies often try to do too much too soon. Clearly, there is a belief that the monetary resources will support such efforts, but a lack of structure, skills, and know-how often prove problematic.

Rather than impose stressful expectations from the beginning, conservative goals and measures should be put into place. Then, if a company does extremely well, they are exceeding expectations instead of falling short or barely meeting them, which is far more likely to occur with a high valuation in the early stage.

Less Flexibility

In addition to the imposition of high expectations that may be difficult to meet, large investments associated with a high valuation often correspond with other conditions and restrictions. Although investor mandates are usually meant to mitigate risk and protect invested capital, these restrictions can make it harder for company founders to act in a strategic manner that would eventually behoove the company.

After all, it is a lot easier to engage in risky maneuvers when someone else's money is at stake, but a lot harder to justify and deal with the potential fallout. Thus, a higher valuation may seem like more dollars to work with but it generally results in a lot less flexibility.

Potential Down Rounds and Dilution

In some cases, high valuations actually end up damaging a company when unforeseen circumstances arise and subsequent fundraising rounds are needed. In the event that things do not proceed as planned, companies may be forced to engage in a down round, undermining the company's value and essentially negating the high valuation given in the first place. And, down rounds ultimately mean dilution for the original investors, who may balk and bail as soon as possible, further damaging the company. Companies have to proceed with realistic valuations or risk having all of their hard work be for naught.

Irresponsible Spending

An infusion of cash certainly creates a lot of opportunities for budding entrepreneurs, but there is something to be said for creating something big out of something rather small. More and more companies would likely attest to the benefits of bootstrapping and those who did not take that route and ultimately floundered would probably recommend giving it a try.

The ability to grow and problem solve on a frugal budget could bode very well for a company’s future. And, if taking that path, any subsequent need for funding to further accelerate that growth trajectory will actually help to justify a decent valuation, without having to worry about the external hindrances and obstacles that a high initial valuation may have presented.

Even entrepreneurs who understand that valuation is just one of many important facets to a deal probably have to fight the urge to seek the highest number possible. In some cases, bigger simply is not always better, especially right at the beginning, and ascending to that peak must occur via a more natural progression.

 

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