The Goldilocks Principle of Seed Stage Valuations
Seed stage startup valuations are a hard thing to get right. I've previously written three articles that cover strategies for figuring out 1) how much runway you need, 2) how to plan your current financing round in the context of your next financing round, and 3) how to estimate a reasonable valuation for your level of progress. In this post, I'd like to cover some of the risks of raising at either too high or too low of a valuation.
The Valuation is Too Low
The downsides of an unreasonably low valuation:
You might resent the investors. If you feel like investors are taking advantage of you, you might not want to work with them after the investment closes, which means you'll miss out on free help, and they won't be able to strongly recommend you to Series A firms because they are not close to you.
You might attract the wrong investors -- the kind who are looking for a bargain instead of the kind who really believe in you and your vision.
Low valuations can result in investor apathy. Because an investor feels like they got in at a big discount (e.g. the market price should've been $6m, but instead you raised at $3m), they do pretty well even if your absolute outcome is not that great.
Lots of seed stage dilution (due to a low valuation) makes it harder to raise more money in the future. If your competitor sold off 20% of their company before a Series A while you sold off 45%, you have a lot less equity for raising subsequent funding rounds. Lots of dilution is also a signal to future investors that either 1) you don't know how to negotiate, 2) you couldn't figure out how to be more lean in the early days of your startup, or 3) there's something amiss about your company. None of these will help you raise more money.
The Valuation is Too High
The downsides of an unreasonably high valuation:
- Expectations for your next round are proportional to your valuation this round, which means raising at too high of a valuation leaves no room for pivots or bumps in the road. If you raise at a $3m valuation pre-product, you might be hoping to raise a Series A at a $20m valuation in 15 months. However, if progress isn't as stellar as you had hoped, you might at least be able to raise a bridge round at a $7m valuation to extend your runway. If instead you somehow raise at $12m pre-product, you basically have to get to Series A traction because the valuation is too high for a bridge round. This is due to investors expecting an upward cadence of valuations over time, so if you raise at an $X valuation now, you have to raise at a minimum $X+1 valuation in the future. Because the traction required to raise at higher than $12m in this case is very close to Series A traction in general, you won't be able to raise your next round without Series A traction.
- You're self-selecting for worse investors. As an analogy, if you take a $1000 work of art and market it for $5000, you might still get a buyer, but it's probably not going to be a buyer that really gets art. Bad investors don't help your company as much as good investors, and they can also hurt your company.
- You're signaling short-term greed and pride while investors want you to be signaling that you'll prioritize the company's success over your personal desires and ego.
- Investors might resent you. If you raise at a high price "just because you can" (e.g. because the market is bubbly or you are well-known), investors may resent that and might not help as much. This is not because investors are assholes, but because they are human beings. The situation is no different than if you get ripped off by a car mechanic: you'll grumble and pay the bill, but you won't want to talk to that person after the transaction.
- Because a high valuation leaves no room for error, investors may get disillusioned more quickly and decrease the amount of help they provide. If an investor can see that your trajectory won't get you to your next round, then they may refocus their energy on other portfolio companies who have a better chance of success.
The Valuation is Just Right
As Khosla's Keith Rabois recently said on Twitter, the valuation should feel moderately uncomfortable for both the investor and the founder. Both sides should feel like it was a fair deal, not an amazing deal.
If one party loves the valuation, that typically means that the other party is getting screwed in the short term and both parties are likely to lose in the long term, for the reasons outlined above.
On the other hand, a valuation that seems fair to both sides is neither a bargain nor a rip-off, does not result in negative signaling about the company or its investors, and strongly aligns all parties toward the common goal of increasing the company's value. When it comes to raising your seed round, don't be greedy, but don't be a sucker, either.
If you have other thoughts on the downsides of very high or very low seed valuations, please let me know on Twitter!