The downsides of high valuation
I often get puzzled about high valuations. Sure, the market sets the price. If the founder is in a hot market with many investors wanting to lead the deal, founders often lean towards the fund that can give the biggest valuation.
Here’s an example I witnessed myself: A founder had a term sheet for 2M at 10M from one of the best VCs in their sector, but then they got a 2.5M at 15M offer from a bigger fund, and the founders went with this offer. They could have raised 2.5M at 10.5M and gotten the industry favorite VC, but they optimized for lower dilution.
As a founder myself for almost two decades and now as a startup investor for over five years, I feel that founders don’t appreciate all the issues that come from raising their first institutional investor (VC) round with a high valuation.
Raising at a high valuation can be a mistake: The goalpost became harder to achieve.
Let’s say you are an early-stage founder with much interest from VCs. You raise at a 15 million valuation, but you’d want to achieve the milestones for the seed round in 18 to 24 months. The company starts from 15M and should aim to get enough traction to raise the next round. There needs to be enough progress that the next investors are willing to pay a premium, hopefully of 2X to 4X.
It is tough to get to 3X. Crunchbase’s research says that only 25%- 30% of pre-seed companies reach seed rounds. It’s more likely that a higher-valued pre-seed company ends up raising a bridge round, where the valuation is pretty much flat or lower than previously. Recently, Carta reported that “in the first quarter of 2024, 42% of all seed-stage investments on Carta were bridge rounds.”
If you’d raised at a decent valuation and did more with less money, you could have quickly progressed to an “upround.” Going from 10M to 20M is much easier than going from 15M to 20 M. You optimized for dilution by taking the 15M; then, you pay the price in a bridge round. Note, you will still need to get that 2X to 4X happen unless you want to get stuck or dilute some more.
How founders still get into the rut of raising at a too-high valuation:
1) Industry peers raised at a high valuation. This is especially true in the hot bubbles like 2021, crypto, and AI. It’s hard to justify a lower valuation for yourself, even though hot markets usually mean more competition and only a few winners.
2) They got into a fancy accelerator. Some accelerators invest at a low valuation and then inflate the post-graduation valuation as part of their model. The accelerator’s business model will only work if they show quick 2x valuation growth because they were there to spot the company a few months ago, and their program made the company worth 2x.
3) Pressure from Investors. Investors with large funds may sometimes push for higher valuations to deploy more capital into their portfolio companies. By increasing the valuation, the size of their investment grows as well. This allows them to demonstrate to their LPs (limited partners) that they’re making sizable investments while maintaining meaningful ownership stakes. However, this can pressure founders into accepting valuations that may set unrealistic expectations for future funding rounds.
4) Overconfidence in early traction: Founders may overestimate the long-term potential of early success. If initial traction is strong—such as quick customer acquisition or revenue growth—there’s a temptation to assume this growth curve will continue indefinitely. However, early success doesn’t always guarantee sustainable growth, and raising at a high valuation based on this assumption can backfire if momentum slows or the market shifts, and the startup might become perceived as “damaged goods,”
Final words
If I were a founder again, I would attempt to raise my first institutional round that is more grounded. I would ask Harry Stebbings’ question:
What price do I think I can confidently raise at when I need to go out and raise next time?
