Valuation planning for the lifetime of your business (and why dilution can be a good thing)

When valuing their company, many founders ask, “how high of a valuation can I get?” When founders approach valuation this way, it is a red flag to investors and a sign of inexperience.

Instead, we suggest asking the questions, “how does this valuation fit into my holistic company and capital roadmap?” and “how can I create a win-win for my investors, so they are incentivized to help me succeed?”

The high risk of a high valuation

Just because you can get a high valuation doesn’t mean you should. Jeremy Liew explains the risk of raising money at an inflated valuation in his post Asymmetric risk and the dangers of too high a valuation:

...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 problem is, things almost never go according to plan, and the founder may gain a high valuation at the expense of setting the company up to fail. The risk of raising at too high a valuation is severe dilution of both management and early investors, shareholder lawsuits, and decreased motivation of the management.

In addition, maximizing valuation might feel good for the founder, but it can also leave the investors with a sour taste in their mouth, which could translate to poor investor relation and less active support from investors, which can be crucial over the lifetime of the company. Paul Graham and Deepak Malhotra have good articles about why it is safe for founders to be nice: How to Negotiate with VCs, and Why It’s Safe for Founder to Be Nice.

Round over round capital planning and your definition of success

We think there is a better way to think about your valuation: begin with the end in mind (see the “Starting with the end in mind” section). Because it is likely that you will raise multiple rounds, it pays not to maximize your valuation in this round, but to think holistically about your capital roadmap.

Your capital roadmap is the series of ALL the funding rounds you might raise, including angel, seed, venture capital, debt, or other funding. Almost every startup raises multiple rounds, but there are more options than most founders think (see Finding the Types of Capital that Best Fit Your Company).

Defining a capital roadmap is easier when you know your definition of success is. Let’s say that your definition of success is to exit your company with $25M in take-home in 5 years. This means every round of funding should support that end goal. This allows you to design a holistic capital roadmap, and reverse-engineer each round to get you there. It gives you strategic — rather than arbitrary — requirements for each round.

Taking this example, let’s say the company above has raised $3M to date in one angel round and one seed round, and is considering raising a Series A round of equity funding. They have $1.5M in revenue, but are not yet profitable.

They could analyze comparable companies and say, “Other companies are getting a $12M valuation, I bet we could, too.” Or, “We only have 62.5% ownership left, let’s minimize our dilution.”

However, with a holistic capital roadmap in place, you have constraints that you can use to help you design the current round strategically:

  • Comparable company exit values fall in the range of $75M, at an EV/R multiple of 4x

  • Your target take home is $25M at exit

  • You forecast a 50% chance that you may not be able to get to your exit without another round of funding

  • After the angel and seed round, you have been diluted to 62.5% (investors have bought 37.5% of the company in the angel and seed rounds)

This provides some useful constraints in thinking about the current round:

  • Your company would have to reach ~$18.75M in revenue to hit your target exit

  • Your team must own ~33% of the company at exit to hit your target take home

You could raise a Series A of $3M at a pre-money valuation of $12M, and only give up another 20% (leaving you with 42.5%).

But what if you end up not hitting your projections, or wanting to raise more to hit your goal? You already raised $3M at a pre-money value of $12M, which means your minimum exit value to give investors a 5x return is $15M*5x = $75M. If things don’t go according to plan, you either have to do a down round and dilute your founding team and early investors, or raise again at a higher valuation (e.g. $5M at a $25M pre-money), which means you’d have to hit not $18.75M but $37.5M in revenue before exiting. That could mean an extra 3-5 years in the business.

Another option is to raise capital at a $8M pre-money valuation, accept more dilution (27% instead of 20%), and give yourself space to raise more money. It will give your team and your investors more options down the road, and more breathing room. Plus, giving your investors a better deal will mean they are more incentivized to support you along the way (with more funding, connections, time, etc.).

Yet another option is to find investors who are comfortable with you growing more slowly. This means you can raise less capital, take your time to build a durable, profitable company, and decrease your dependence on outside capital to exist.

There are many options; consider each round in the context of your definition of success to make choices that support you getting there.

Down rounds aren’t always a bad thing

Although they appear to be a bad thing, down rounds are not always bad, assuming they align with your definition of success and assuming that management and early investors are on board.

This case study provides a useful counter-example and spells out risks and mitigation strategies for dealing with a down round: CollabNet: The Down-Round Dilemma.

Dilution can be a good thing

Founders often spend too much time and energy thinking about dilution, and far too little time and energy thinking about share price. When you give up equity to a valuable investor or team member, your share price goes up so that your total ownership is worth more than it was before dilution.

Paul Graham has a simple heuristic for how to think about share price and giving up equity (whether to a co-founder, team member, or investor) in his post The Equity Equation:

In the general case, if n is the fraction of the company you're giving up, the deal is a good one if it makes the company worth more than 1/(1 - n).

For example, suppose [an investor] offers to fund you in return for 6% of your company. In this case, n is .06 and 1/(1 - n) is 1.064. So you should take the deal if you believe [the investor] can improve your average outcome by more than 6.4%. If we improve your outcome by 10%, you're net ahead, because the remaining .94 you hold is worth .94 x 1.1 = 1.034.”

When considering a deal, a knee-jerk reaction of avoiding dilution signals a lack of sophistication, and is not always what maximizes the value of your ownership.

Founders also often believe that investors are trying to get as much ownership in a company as they can, but this is not the case (for sophisticated investors). In his post Avoid Piecemeal Seed Rounds, Leo Polovetz points out that an investor should also be incentivized to make deals that ensure the founding team will continue to be motivated:

“Too much dilution hurts founders, but it hurts investors, too. Contrary to popular opinion, investors are not trying to own 100% of a company -- that would remove any motivation that the founding team and employees have, and investors would be left with 100% of nothing. Instead, investors are after a good return. I'd rather own 5% of a company whose value increases 100x than 10% of a company whose value increases 15X. A company that is over-diluted will have a much harder time getting to 100X because it might run out of equity to sell after a Series B while its competitors are able to raise large Series Cs and beyond.”

Planning for the lifetime of your business

By focusing on the whole lifetime of the business, rather than just the current round, we find that founders and funders find better partners, better deals, better terms, and ultimately better outcomes.







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