High Valuations May Be Bad for Your Business…And Your Ulcer

With a handful of major technology disruptions sparking infectious excitement across venture, several key fundamentals are worth paying attention to including: don’t accept too high a valuation.

I was reminded of this by Saad Shahzad, who has been around the venture capital block a few times. Shahzad, presently SVP and chief strategy officer at dinCloud, was an investor at Norwest Venture Partners, and before that a member of the investment banking group at Goldman Sachs.

In a recent note, he offered advice on several fundraising mistakes to avoid. At the top of his list is the suggestion entrepreneurs resist the temptation to accept too high a valuation.

“Taking a high valuation, as many founders do today, could be a big mistake in future rounds,” he warns. “It may seem lucrative now to accept a rich deal from angel investors. But when institutional investors come in for the next round, a high valuation could scare them away or spark a down round and significant dilution for the angels.”

So how do you know what constitutes a high valuation? Here is what Shahzad has to say: “Valuation is not a science, but it’s not quite an art either. For the best investors, it’s a combination of the two. Understanding the scientific aspect of it is relatively simple. If you take forward-looking revenue and put an average revenue multiple on it based on where peers in the public markets are trading (or the closest peers you can find if it’s a novel idea) that would be a fair valuation. You can add a few points for high growth or unique business model, but if the multiple starts getting significantly higher then valuation is probably starting to run away. It’s the art aspect that is relatively difficult and what differentiates great startups/investors from good startups/investors.”

Shahzad has several other observations worth paying attention to. They start with structuring a company’s capitalization to permit future rounds and a sound long-term financial model.

Key among these is taking convertible debt instead of equity, which can cause issues with the next round of funding, he says. Taking convertible debt and allowing it to convert into equity at some discount in the next financing round will allow entrepreneurs to avoid putting a valuation on an infant stage business and offer the angel investor a nice return once an equity funding occurs. Furthermore, putting equity in place with certain preferences might complicate a future round.

“This is important because a high valuation early on can scare away potential investors,” he says. “The venture community has reported performance over the last decade that is well below the S&P 500 average. It’s not that the venture community hasn’t had good exits, but returns are really only a function of two things – where you buy-in and where you sell-out. If the buy-in valuation is very high, it becomes that much harder to show the venture community a base case of 3-5x return on the sell-out. Some venture investors still might be interested in the company if you have an A+ management team, but the high valuation could also cause a ‘down round.’ This is generally believed to be the beginning of the end in the venture community.”

Entrepreneurs also must remember to provide regularly scheduled updates to their angel investors with details on revenue, cost structure, market trends and execution strategy, so their investors know their investment is protected and more importantly in good hands. This includes passing on bad news straight and early. An entrepreneur should never sit on unflattering developments, says Shahzad. Angel investors realize there is risk associated with their investments, so they are generally prepared for challenges. But they want to know, and they may have good insight to pass along.

Hand in hand with this effort at disclosure is the notion of preparing the right materials prior to an investment, when the pitch is made. This includes, but is not limited to, a business overview, a market overview, competitor profiles, the financial model, use cases, roadmaps, the use of the funds and details on the management team.

Finally, diversify your mix of angel investors. This isn’t always an option. But be thoughtful about the people you reach out to. It may be good to have a business owner, engineer and a financial professional so you can get diversified insights as your business grows, he says.

Then step on the gas and make the company work.

Photo of Saad Shahzad provided by Shahzad.