It’s a story often told. The entrepreneur thinks investors are trying to artificially tamp valuation down. The investors see risk and don’t want to overpay.
In our experience, it’s usually the entrepreneur who sets the bar too aggressively. There’s a consequence, and we’re starting to see some real life examples—Facebook, Groupon and LinkedIn.
Here’s what can happen when valuations are too high.
- Everyone holding options celebrates. Those who calculate the difference between the exercise price on their options and the suggested value of the company’s shares based on the recent round, really celebrate.
- The bootstrapping disciplines that helped the company make it through the so-called Valley of Death erode a bit. There’s more cash. The burn rate increases. Employees take business trips when they could have Skyped. The shared office space becomes a little too cramped. Key developers get to upgrade to higher resolution displays.
- The revenue model, which generated so much hype and advertised so much promise without standing even a brief test of time or the pressures of a heavier balance sheet, doesn’t quite prove out.
- With a shortfall in revenue growth, the Series A cash won’t go as far. The entrepreneur often needs to raise more investor money while she figures out how to gen up more revenue.
- If company fundamentals are sound, there may be follow-on investors who are interested…at a lower valuation. They achieve that by taking a larger share of the company, which reduces the holdings of founders and employees. The alternative may be that the company fails.
- Now no one celebrates. Employees are bummed. There is tension between founders and investors. A hard road is that much harder.
The moral: Entrepreneurs need to beware of valuations that are too high — especially when the round is a Series A.