I recently met a company that I really liked; an innovative online financial services product. It hit a lot of my criteria for investment; it had a working product, it paralleled existing offline behavior, and it had achieved some early success in gaining distribution. And it had done all this on just $1.5m of angel money.
However, although I really liked the company, I didn’t seriously pursue an investment. The reason is that the $1.5m was raised at a $30m valuation. The company was still very early stage, with very limited usage and an unproven revenue model. Any sort of investment that we we would have made would have been at a much lower valuation than $30m.
The company is still pursuing financing, but it is currently focusing its efforts on raising more angel money.
This made me think about the asymmetric risk that an entrepreneur faces when pricing a round.
An example of asymmetric risk is catching a plane. If you arrive early, you waste some time sitting in the airport. This is unfortunate, but it’s tolerable. If you arrive late, you miss the plane altogether. This can be expensive and very inconvenient.
The same situation exists when an entrepreneur determines at what valuation she can raise money. So if she raises at a valuation that is too low, she suffers more dilution than she needed to. This is not desirable, but the negative consequences are linear in that they are roughly in proportion to the degree that the valuation was cheap. [Disclaimer: As a venture capitalist, I benefit from investing at lower valuations.]
On the other hand, if she raises at a valuation that is too high, she runs the risk of a future “down round“, or even worse, being unable to raise more money at all. Valuation is always based on some combination of past performance and future potential. When valuations creep up and are based more on future potential than past performance, more pressure is put on the company to hit its potential and justify its valuation. If things don’t go to plan, when the company next needs to raise money it may not be able to justify its past valuation at all.
The American Bar association has a good article describing some of the likely consequences of a down round. In this case, the negative consequences are not linear, but look more like a cliff. A downround can be highly disruptive and cause significant damage not just to ownership stakes, but to overall company morale and the relationship between investors and founders
Marc Andreessen recently posted about fundraising for a startup and answered the question “So how much money should I raise?” as follows:
In general, as much as you can.
Without giving away control of your company, and without being insane.
Entrepreneurs who try to play it too aggressive and hold back on raising money when they can because they think they can raise it later occasionally do very well, but are gambling their whole company on that strategy in addition to all the normal startup risks.
Suppose you raise a lot of money and you do really well. You’ll be really happy and make a lot of money, even if you don’t make quite as much money as if you had rolled the dice and raised less money up front.
Suppose you don’t raise a lot of money when you can and it backfires. You lose your company, and you’ll be really, really sad.
His rationale is the same as the one for thinking about valuation – asymmetric risk.
Today’s startup funding environment is buoyant, much like it was in the late ’90s. It’s a good time to be an entrepreneur. However, entrepreneurs should also be careful not to repeat some of the mistakes of the ’90s. Inc magazine has a case study of one company that raised money at too high a valuation that is worth reading as a lesson in the dangers of asymmetric risk.