The Poison Pill In Startup Fundraising: Optimizing For Valuation

I recently changed my thinking on a controversial topic among founders and investors. I used to think that founders should raise the most money that they can. Some call this “eating when the food is being passed.” The logic is as follows: It’s hard to raise money, you won’t know how long it will take, and closing deals are never guaranteed, so if someone wants to invest and you need the money (within reason), take the money.

After six months in venture, I’m not sure I agree with this anymore. I can see why first-time founders find it attractive to eat when the food is passed. It is really hard to raise money, statistically. And, there’s a social media culture and peer pressure to optimize for a high valuation, because it looks cool. Well, I can tell you now that it’s definitely “not cool” to optimize for valuation, largely because of the economics of acquisitions and the statistics around what happens to venture-backed startups.

Everyone knows, but it bears repeating; Most startups fail. Let’s say out of every 100 seed- or venture-funded startups, 90% will just die. Those companies tried to do something, and it just didn’t work. Of the 10 that remain, let’s say 7 of them have some modest acquisition activity (enough to make good for the founders and/or return investor’s money), and maybe 2 of them will have better outcomes, and maybe 1 will be a hit (or homerun). What this means for founders is that doing the cool thing and raising lots of money at a bigger valuation most often times ends up being a poison pill. [See also an interesting thread on Quora which touches on this.]

In time, I’ve come to learn that, when seeking venture financing, it’s actually a signal of sophistication and expertise when founders in fact do not optimize for valuation. Instead, raising what’s needed (plus a little cushion) at more modest valuations enable these founders to preserve their exit options while aligning incentives with those investors. Of course, it’s not cool to say that your company isn’t going to be a billion-dollar success, but once founders sign on the dotted line for Series B’s, and move out of the $20-80m acquisition range, investors need to have reasonable confidence the business could make $100m in revenues per year, and not all revenue is created equal.

In the worst-case outcome, founders who chase valuations often end up ingesting too much money — a poison pill. As the valuation creeps up, the table stakes get bigger, and investors will want to get to their 13% or 15% or 20% or 25+% ownership stakes, and as a result, the valuation may inflate to a point where a reasonable win-win-win outcome goes from being not very likely to extremely unlikely. Of late, my guess would be that this advice has been shared before but most likely cast aside because an old stodgy investor says “hey, it’s better to keep valuations in line” because that investor may have his or her own biases.

Yes, it’s awesome to swing big, take smaller options off the table, but doing so very early can be harmful and irreversible. And, now, having spent time on the inside, and helped many founders through a variety of financings, I’ve seen this movie play out, and those large checks, which stroke the ego, generate buzz, and create excitement can also be that poison pill that may lead to a down-round, may hurt company/employee morale, and could ultimately kill your startup.

Haywire is written by Semil Shah, and is published under a Creative Commons BY-NC-SA license. Copyright © 2014 Semil Shah.

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