The Founder’s Financing Conundrum: A Cautionary Tale

Any economist will tell you that it is human nature to opt for instant gratification rather than a delayed reward. Why wait for an uncertain prize tomorrow, when I can get something pretty good today? Unfortunately, entrepreneurs who obsess over the early valuations of their company tend to do worse in the longer term.

The only valuation that really matters in the end is the last one, the one founders get to cash out and realize the value creation. Getting to that desirable outcome, however, involves a road-map of achievable milestones and the momentum to push forward. Like the fabled hare whose overconfidence and lack of focus made him lose to the steady and focused tortoise, unfocused, impatient, and self-congratulating startups tend to burn out as well.

To illustrate my point, let’s consider company X’s (anonymous to protect the guilty) choices that eventually led to its downfall.

Company X option – Company X raised an $8M Series A on an $16M pre-money valuation. The lofty early valuation for an Indian company caused quite a bit of excitement in the media. Flushed with cash, the company became overconfident and lost focus which led them to try tackling too many strategies at once. They hired aggressively and cast a wider, thinner net to fulfill a broader strategy.

The result? Spreading themselves too thin inevitably led to horrendous execution and created relatively little equity value for the firm since they had blown through their funds and hadn’t built new revenue streams. The company was in a considerably weaker position than when it had started out. The significant value erosion is directly attributable to the lack of execution focus and “illusions of grandeur” that came from raising irresponsible amounts of money.

Fast forward three years: Company X is running out of cash. Two of the three founders have left the company. The remaining management team is in disarray, and employee morale is low and turnover high. They have slashed the team down dramatically and are gearing up for a Series B round. Ideally they should have created 2.5x ($60 M) more value than their previous round to merit an expansion round. They are nowhere close to it. This puts enormous pressure on the team and board, which further strains morale.

Unfortunately, the next round of financing for company X will be a down round. Down rounds cause substantial dilution of ownership for existing founders and investors.

Company X ultimately proved unworthy of its initial lofty valuation, and that valuation has now become a burden to the company. This is a depressing situation all around, but a lot of it was avoidable.

My Suggestion – Instead of setting an excessively high pre-money valuation, strive for an appropriate amount and build towards the next financeable milestone. Let us say that Company X needed $1.3M to get the product ready and some customer validation within 12 months after financing. It would be reasonable to add a buffer to have an additional 6 months of runway. I would advise Company X to raise $2M and a reasonable pre-money valuation would be $4M.

In this scenario, Company X completed the primary product, just like in the previous scenario but without all the distractions of premature expansion. Two to three customers have validated the product and now the team needs money to expand sales and marketing. The team was focused and in month 14 decided to raise $4-5M to propel growth. The company created a value of more than ~$15M, as the team was focused on the primary objective. The situation now is a happy one. The team went back into the market to raise a Series B at a stepped-up valuation. Morale was high and the team was charged. It was like a winning cricket team that has its eyes on the prize but is focused on accomplishing short term goals of winning individual matches and building a team that could win the World Cup.

Crunching the Numbers – It might seem counter-intuitive at first to advocate for an early lower valuation for a company. Afterall, isn’t it better to take more money for the same percentage of the company? There is no absolute right or wrong answer here. As I mentioned earlier, it is all about value creation, not valuation of a company that has not yet produced anything. Let us analyze this closer in the table below and look at the numbers in detail around the two options:Company X pathMy Suggestion1st Round pre-money valuation $16 M$4 MMoney raised $8M$2MPost-money valuation $8M$2M% to investors133.3%33.3%% to founders/employees 66.6%66.6%2nd Round pre-money valuation $8M$16MMoney raised $4M$4MValue creation 2 0.3x2.7xDilution33%20%Post-money valuation $12M$20M% to investors (both series) 55.6%46.4%

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