70. High valuations can demotivate employees and derail investment

Founders constantly strive to grow their company and maximize their valuation. Most startup advice is about maximizing that value.

I will make a controversial claim: In many cases, a high valuation can hurt your company.

I am not talking about high valuations for companies with high growth and strong product/market fit. I am considering valuations for early-stage startups that are way out of line with the rest of the market.

Inappropriately high valuations can hurt you in two ways. It can demotivate your employees and cause problems closing your next round of investment. Let's unpack why that happens for each case.

Having an unrealistically high valuation can hurt you in two ways. First, it can demotivate your employees, and second, it can cause problems with the next fundraising round. So I want to unpack precisely how that works in both cases.

This article is part of our series on startup fundraising.

Demotivated Employees

In early-stage companies, you don't usually pay employees market wages (if you pay them at all). Most of their compensation comes from stock options.

Your team counts on an exit payout to reward them for the work they are doing now.

So let's consider two scenarios:

Suppose that your company takes investment at an incredible $20 million valuation. At the same time, a comparable company, in a similar industry, at the same stage raised money at a $5 million valuation. You're feeling good. You convinced an investor to invest at this stratospheric value.

You Raise at $20m

What does this $20m valuation mean for your next hire?

You will grant them options with a strike price based on this new $20 million valuation.

For simplicity, let's assume the employee deserves $100,000 worth of options, and the strike price is $1 per share. For complicated reasons people commonly value an option equal to its strike price. Therefore, you issue this new hire 100,000 options at the $1 strike price.

Competitor raises at $5m

Now suppose this person's friend went to work for your competitor that also just raised money, but at a $5 million valuation. In this simplified example, that means the strike price would be just $0.25.

If they also deserve $100,000 worth of options, that company will issue 400,000 at the $0.25 strike price.

Outcome

What happens to these two employees a few years later at an exit? Let's assume that both companies have done reasonably well and are acquired for $100 million. I will completely neglect dilution from additional rounds and options pools to keep the math simple.

Your company was worth $1 per share when the valuation was $20 million, so at $100 million, the stock price is $5 per share. At the exit, your employee can exercise their options worth $4 each ($5 share price - $1 strike price). They will receive $400,000, which is nothing to sneeze at.

However, consider their friend at your competitor. That company also has a $5 share price. The friend has 400,000 options worth $4.75 each ($5 share price - $0.25 strike price). That comes to $1.9 million, nearly five times what your employee made. They may well feel like they got screwed.

A savvy employee will see this coming. If they could choose to work for either company, they would take the one with the lower valuation.

Fundraising Troubles

The other problem with having an unrealistically high valuation is its impact on future funding rounds. Let's continue to consider the case of the $20 million valuation, where $5 million would have been more appropriate.

If things go spectacularly well and your next round comes in at $30, $50, or $100 million, nothing goes wrong, and everyone's happy.

But, suppose over the next year or two, your company doubles in size, but you're not able to find another sucker investor to pay an inflated valuation. Your next round valuation comes in at $10 million. This is where the problem happens.

Your previous investor will feel pretty unhappy about this. They invested at a $20 million valuation, you have doubled in size, and the subsequent investors are getting in at half the price.

If they negotiated anti-dilution provisions, they could receive the same deal as the new investors at the cost of significant dilution for everyone else. I talked in detail about that and many other causes of dilution in this article.

Even without those provisions, your previous investor may have substantial leverage to renegotiate their deal retroactively. In most cases, at least in the United States, the investor received preferred stock. Each funding round typically receives its own series of preferred stock. The seed investors get Series Seed Preferred; the A-Round investors receive Series A Preferred, and so on. Each series may have negotiated different rights and protections. Some may have secured the right to vote as a block on issuing any new shares.

If the previous investors have that ability, they can hold your new funding round hostage by refusing to authorize the new shares. They will block the round unless you agree to compensate them by effectively giving them the same deal the new investors have. Alternatively, they will force you to keep looking for a better deal that may never arrive.

If you need the funding immediately, they have you over a barrel.

Even if you capitulate, this could still cause problems for your round. The new investor assumed that they would be paying $X for Y% of the company. Compensating the earlier investor could alter this equation, making the investment less attractive. Additionally, they might worry that substantial dilution of the founders might demotivate them. As a result, they might walk away from the deal altogether.

Best Practice

Research a reasonable range of valuations for your company. Ensure your investment round falls within that range.

Talk to your advisors, and investors who are not in this round, and look at venture capital databases to get a clear picture.

You will try to negotiate for something at the high end, and the investor might push in the other direction. But, you will know if the valuation is way out of line in either direction. If it is too high, you might choose to negotiate down or take other steps to protect yourself against the possible problems this would create. If the offer is too low, you know when you should simply refuse the deal.

Many founders see other companies getting absurd valuations and ask, "why not me?"

I won't deny that there are some seemingly crazy deals out there, but they are relatively rare. In many cases, facts that might not be apparent support the valuation. Perhaps the team is all rock stars, or they have signed deals that will create explosive growth. Focus instead on the mainstream of startups. What is typical, not what is possible in extreme cases.

Please leave a comment below letting me know your experiences with valuations and negotiating with investors.

If you like to listen to your content, the podcast is below. You can get it through your service of choice here.

Also, connect with other founders in our community, the Feel the Boot Founders Alliance.

The High Growth Handbook has a similar analysis on over-optimized valuations.

Chris Barbin makes similar points in The Hidden Risks of Overvaluing Valuation.

Until next time, Ciao!

Next you might want to read about how to calculate valuations for early-stage startups.