One lesson that Silicon Valley's wild venture funding environment of the past few years has clearly taught us is that higher valuations aren't necessarily better.
“Over the last three years, I think we've all experienced the negative effects of high valuations,” Hustle Fund co-founder Elizabeth Yin said onstage at TechCrunch Disrupt last week. he said. When a venture capital bull market arrives and startups can easily raise large sums of money before launching an actual, provable business, they are exposing themselves to tough times.
That's because “the hurdles for the next round will be even higher,” she says. As a general rule, each initial round needs to justify the growth of the business to double or even triple the previous valuation, Yin said.
So the initial valuation “shouldn't be something really crazy that you don't think you can realistically grow under your own traction, because it's always going to catch up to you,” she says.
Renata Quintini, a venture capitalist and co-founder of Renegade Partners, said if the company can't grow to a high valuation, it could end up laying off its most valuable employees.
Most start-up companies grant stock to employees, or in some cases, stock options that employees are required to purchase. And most startups offer that stock as a significant portion of their employees' salaries. People join startups because they believe that if they help build the company, they will be rewarded with their equity. So it's clearly not good for an employee's stock to decline in value over time.
“If we don't close that gap, we're going to be discouraging people who join us early on,” Quintini warns.
A better way to raise money is to “create a rigorous process” by setting reasonable valuation expectations from the beginning, Greylock partner VC Colin Reilly said on stage. “You don't want to get bored and go on rounds for months. You're wasting your time. You're wasting the VC's time,” she said. “I want to know exactly how much I want to raise.”
Quintini advises founders to keep a range in mind, both in terms of money and valuation. To do this, she says, founders need to spend more time in the information gathering phase than in the actual pitch phase.
They should ask VCs in their network for their opinion on their company's valuation. They need to understand the type of market they are in and the multiples of revenue and other pricing metrics that are currently prevalent in the area. They will need to carefully consider how much dilution they are willing to accept – how much of their stock they will sell and how much of their stock they will retain after the round.
If a founder wants to sell a smaller stake (10% versus the typical 20%), the founder needs to find out which companies are receptive to the idea. Many companies don't bother with small bets because they are less likely to make big profits.
Going into a pitch meeting asking for too much means “better be an outlier company that has a great business and backs it, otherwise you'll actually turn off the VC.” says Quintini.
When a VC submits a term sheet that significantly outperforms other VCs in terms of valuation, founders need to pay attention to the fine print. Did the venture capitalist include a term sheet in a way that gave it extraordinary powers? This could also mean that the company cannot convince other VCs to invest in later rounds.
Startup accelerator Y Combinator distributes a sample terminology sheet that shows what most VCs consider standard terminology. These cover everything from voting rights to board seats.
“I've definitely seen a lot of my founders, especially international companies, get all kinds of term sheets with all kinds of terminology that I don't think are standard. ” Ying explained. “Strange board composition” seating, such as venture capital firms wanting multiple boards, or setting up “liquidations of any kind.” A liquidation preference greater than “1x” means more money is paid to the investors and firstly occurs if the company is sold and is not standard.
In addition to being prepared to negotiate amounts, valuations, and stakes, founders should also be prepared to negotiate items such as board composition and who can elect independent board members. must be. How you decide on the terms under which VCs are empowered can permanently impact your company and its future valuation.
“I encourage founders to say no to things that are highly non-standard, and there are some things that are borderline there. You may accept them because you have no other choice, but once you Once it’s over, it’s really hard to relax,” says Yin.