The hidden risks of overvaluing valuation

Can your valuation ever be too high?

If that sounds like a trick question — ”what on Earth do you mean, too high?” — I’m really glad you’re reading this. As a CEO and 3x founder, I can understand how exhilarating it is to see the business you’ve poured your heart and soul into climb into or exceed unicorn territory.

But the air gets thin when you climb that high, and risks get different. If you put too much emphasis on valuation, you risk setting unrealistic expectations with future investors. Or putting more capital on the balance sheet than you actually need. Or hurting your ability to retain employees (yes, you read that right).

Unfortunately, in today’s frothy market, too many entrepreneurs are going to learn this lesson the hard way.

Consider the tragic case of WeWork CEO Adam Neumann. In 2019, he was toying with an IPO. Their valuation was a stratospheric $47 billion dollars, but in the headiness of the moment Neumann forgot that it was only pretend money. Worse, he also forgot that the company’s wild valuation was based on unrealistic growth promises. At one point, they counted literally any American desk worker living in a city with a WeWork space as a potential member.

The Wall Street Journal, discussing WeWork’s S-1 filing, scathingly wrote: “The document detailed a company with swelling losses, no clear path to turning a profit, and a history of self-dealing by its CEO.” That’s not a sentence you want to read about your company, ever. Yet despite the cautionary tale of WeWork, founders get pushed to be the next Adam Neumann every day.

Yet despite the cautionary tale of WeWork, founders get pushed to be the next Adam Neumann every day.

There is so much capital chasing opportunities right now. Where an average Series A among top VC firms was a modest $5.1M in 2010, it has risen dramatically in recent years. The overall average Series A in 2021 is now closing in on $22M, and existing investors who got in early will naturally want the next raise to be at a much higher valuation to make their early investment worth more.

The Wall Street Journal published a powerful opinion piece this week called “The Stock Market Fails a Breathalyzer,” highlighting (among other examples) how ridiculous it is that Coinbase is worth more than the NASDAQ. As columnist Andy Kessler says: “ The venture capital market is cuckoo. After investing $120 billion in the 2000 dot-com frenzy, and just $16 billion in 2002, U.S. venture capital invested $130 billion in 2020 and then $140 billion in the first half of 2021.”

While some in the media might be highlighting the problem, there are others contributing to it. Many reporters covering the venture space wouldn’t even look at a funding announcement earlier this year unless it was above $20M. Now, if you aren’t considered a “unicorn”, sorry Charlie.

It’s hard to blame them really. They’re fielding dozens of pitches a day and they need a way to filter through the noise and write about whatever is hottest — and a crazy valuation is always a better story than a sensible one.

Which means it’s up to founders to be a voice of reason for their company and their legacy. To help discover that voice of reason, let’s take a quick look at what I think are the top 3 risks of making valuation the goal.

Risk #1: Setting unrealistic expectations

If your valuation drifts too far from reality, you can find your business someplace you never wanted it to be. To achieve some of the valuations I’ve seen lately, execution needs to be near perfect. Every wind needs to be blowing in the right direction, and if 2020 and 2021 has taught us anything, it’s that rarely does anything go according to plan.

Your investors, who will never know your business as well as you do, might begin counting on a return on a valuation without realizing it’s inflated. And for greater returns, valuations in future rounds need to keep increasing.

As Electric CEO and Tercera Advisor Ryan Denehy, tweeted this week: “If you’re doing $10 or $15M in ARR and raise at $1B, are you then going to raise at $2B at $30M and $4B at $60M? Then what? Bigger is not always better.”

Let’s look at the real example of Instacart. Its most recent round of fundraising valued the company at more than twice what it was valued at in a round just five months ago. Time will tell whether their prior valuation was far too low or the new one is too unrealistic, but it’s fair to say that companies don’t generally double in value in 20 weeks.

Risk #2: Taking more capital than you need

As investors concede to higher valuations, they’ll often demand the ability to invest more capital in the business to achieve a target ownership. This holds two risks for founders. The first is giving away more control of your business than you really want. You might be fooled into thinking dilution doesn’t matter because the unrealistic valuation is so high. But when reality sets in, of course that dilution does matter.

The second and bigger issue is putting more capital on the balance sheet than a founder really needs, and without a real plan for how to use it. Having more money than you know what to do with might sound like a good thing, but it can result in bad decisions for the long-term health of your business. Whether that’s doing a large acquisition that your company might not be ready for or spending excessively on perks or programs that might not be sustainable over time. Too much capital is like too much champagne: the bubbles go to your head and you end up making short-term decisions you’ll regret in the long run.

Too much capital is like too much champagne: the bubbles go to your head and you end up making short-term decisions you’ll regret in the long run.

This is why it’s so important for founders to pick the right investment partner. An experienced investor may come in with a valuation that’s lower than a more aggressive, but hands-off investor that is just looking for a return. However, they’ll ask the tough questions and give you the advice you need to maximize value over the long-term. Remember, valuation only (really) matters once. When you exit.

Risk #3: Hurting employee retention

This one might seem counterintuitive, but stick with me for a second. Valuation sets the strike price for employee options, which especially in technology companies, are a critical component of compensation and a big employee retention tool.

When a new investor comes in, it (often) creates a new pool of options with a strike price equal to that round. But… If that strike price is disconnected from reality, guess what happens next? Employees find their options underwater. Morale plummets. Stock options flip from a retention mechanism to a good reason to take a phone call from a recruiter with big promises.

Not good.

Chase value, not vanity metrics

As Warren Buffett famously said, “Price is what you pay. Value is what you get.”

Your value is your value, not your multiple or your valuation

Yes, of course your valuation is a useful metric in the private markets. But remember it’s just a metric. It’s not money in the bank, and it’s not what you should be laser-focused on. Your value is your value, not your multiple or your valuation: it’s all about what you bring to market, what you bring to your customers, and what you bring to your employees. It’s about building a business that can thrive over the long-term.

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