Ryan Says…

There have been some VCs blogging lately about the dangers of taking an investment at too high a valuation. Despite the fact that VCs have an intrinsic interest in lower valuations (it gives them a larger share of your company thus a chance at making more money), these particular VCs argue that too high a valuation is also bad for the entrepreneur (the crux of the argument being that a high-valuation limits your exit options - it will require an extremely high valuation on exit and thus turn your company into a ‘moonshot’).

I don’t buy it, and here’s why:

We can simplify the discussion by forgetting about the idea of ‘valuation’. All that matters is the percentage of the company owned by the VCs, and the percentage owned by the founders (and employees). VCs give us $X in exchange for Y% of our company.

Now, it’s important to realize that when it comes time for an exit (usually an acquisition of our company by some larger company) the VCs will likely have the final say on whether or not to accept the acquisition offer (either through contractual terms as part of the investment, or because they own a majority - more than 50% - of the company).

The VCs linked above argue that if they invest in our company at a high valuation, and we subsequently receive an acquisition offer that does not provide them an adequate return, they will not accept the offer. Thus our company has limited its options to only really big offers.

I’ll use some numbers to clarify this point. Lets assume the VCs are making a Series B investment of $10M in our company. Under Scenario One, the investment is made at an ‘excessively high’ post-money valuation of $50M, which means the VC gets about 20% of our company. Under Scenario Two, the investment is made at a more ‘realistic’ post-money of only $30M, giving the VC 33% of our company.

According to Josh Kopelman, a VC typically requires a 4-7x return on a series B investment. This means the valuation on exit (i.e. the acquisition offer) under Scenario One must be at least $200M, and preferably more like $350M. Under Scenario Two an acquisition offer of just $120M would be acceptable. According to Josh, 72% of exits are for $150M or less, so he argues that Scenario One greatly limits our options, which is bad for VCs and entrepreneurs alike.

Lets cut to the real issue. The idea of ‘valuations’ is just a proxy. All that matters to the VC is this: if I invest $10M in your company, and my requirement is a return of 4-7x, it means I need to get $40M to $70M back at exit.

I argue that a high valuation is never bad for the entrepreneur, because even though he/she will be in Scenario One, he/she will always have the option to ‘fall back’ to Scenario Two.

Lets assume we are in Scenario One. We receive an exit offer of $150M. As entrepreneurs, we believe this is an accurate valuation of our company and that we probably can’t do any better so lets take it. Our VCs, however, block the acquisition because they only own 20% of the company, thus they will get $30M back. This is $10M less than their required minimum of $40M.

How can we convince the VCs to accept the offer? Simple - we can always just give them another 7% of the company. We can simply agree to grant the VCs an amount of our founder stock. This brings the VCs’ percentage ownership up to 27%, which means they get $40.5M of the acquisition money, and approve the deal.

As entrepreneurs, we are no worse off than if we had accepted a lower valuation and entered Scenario Two from the beginning. In fact, the 27% ownership given to the VCs is less than the 33% we would have given them in Scenario Two, so the entrepreneurs are better off and have still satisfied the VCs.

We kept our options open all along - we kept a larger percentage of the company and if we did happen to get a ‘home run’ acquisition offer we could keep all of our larger share of the company, while still satisfying the VCs.

A higher valuation is always better for the entrepreneur.

Update: Thinking about this more, one scenario where a high valuation may be bad for the entrepreneur is when future investments will be required before exit. These future rounds must be at even higher valuations, which means either taking a LOT of money from VCs, or trying to convince VCs to take a small percentage of the company. It may be hard to find VCs willing to do a deal under these terms. However, it seems to me that the founders could simply do a deal at a not-quite-so-high valuation in this scenario, take a hit by diluting their stock, and be no worse off than if they diluted their stock (raised money at a lower valuation) in the beginning.

Share This Story