Two thoughtful VC posts about the risk of high valuations in venture rounds reminded me once again why we obsess so much about capital efficiency:
- Josh Kopelman (First Round Capital) writes that entrepreneurs need to understand the return expectations of their investors at the time of the investment, as this sets the valuation floor for a sale of the business. That floor may be well higher than the 95th percentile of exits in his market, which means the entrepreneur won't be able to accept acquisition offers he deems reasonable.
- Jeremy Liew (Lightspeed Ventures) describes the asymmetric risk an entrepeneur faces when pushing up the valuation of his company: too low and he suffers more dilution, too high and he may never get an exit. Which is worse?
Because my firm (Kennet) tends to invest in companies that are commercially established and where the entrepreneur has already contributed many years of sweat equity, valuation is often an emotive issue. Some entrepreneurs focus entirely on minimising dilution in every round. This is a mistake. Dilution is one cost of raising capital which needs to be weighed against the benefits:
- Who is the investor?
- What can he contribute to increasing the value of the business?
- How does the investment accelerate my time to exit and how valuable is that to me?
- What new exit markets become available to the business because of this investment?
Generally speaking, an entrepreneur's interests are best served by raising capital at the 'correct' valuation, not the maximum achievable valuation, in each round. You can tell you've hit the 'correct' valuation if -- the day after the investment closes -- the investor and the entrepreneur believe they can sell the business today for no less than the post-money valuation. That puts both stakeholders on the same footing from Day 1.
One of the biggest mistakes made by both investors and entrepreneurs during the last bubble was raising too much capital at valuations that were too high. We are seeing the same trend again in certain sub-segments, eg Web two-dot-oh.
As I've shown before, the vast majority of venture-backed exits happen below $150m, and a large majority below $100m. For entrepreneurs, the risk of setting the exit bar for their only baby above $150m is huge. For investors, the risk of 'shooting high' represents only one element of a portfolio. That's asymmetric risk.