Startup Valuation: Sometimes Less is More. Part I.
A good rule of thumb when you are selling something is to sell it to the highest bidder. Alas, if you are an entrepreneur selling a stake in your startup company, this seemingly self-evident rule is subject to a number of exceptions, large and small. In this first installment of a couple of blogs exploring startup world exceptions to the higher is better rule, we’ll be looking at one of the biggest and for some entrepreneurs most frustrating exception: what we’ll call the “Over Zealous Investor” exception.
Of the more frustrating experiences of my 25 years in and around venture capital, among the most frustrating is the otherwise interesting deal that prices itself out of the capital markets. It goes something like this. A usually less sophisticated entrepreneur with an at least fundable idea but little else finds some usually even less experienced investor willing to buy in at some outrageous price. Like, say (you can’t make this stuff up) $100 million pre-money for a somewhat generic IT idea. The entrepreneur takes the money, uses it more or less wisely, and through hard work and determination gets the company to the “next stage” where it needs more funds – but is now worth, in the minds of more sophisticated investors, say, $2-5 million on a pre-money basis.
Or would be worth $2-5 million but for the fact that the over zealous investors already in the deal paid $100 million. With that baggage, it isn’t worth the paper the entrepreneur’s new PowerPoint presentation is printed on.
Now you might think that the losers here are the over zealous investors who overpaid, and you would be right. But so, too, is the entrepreneur, who can’t raise more money because she took too high a price early on. And so, even, are the investors who would be very interested in the deal at a $2-5 million admission price. It turns out, in practice, that the initial investment was such a good deal for the entrepreneur that … everyone ends up with nothing. Thus the Over Zealous Investor exception: an entrepreneur who lets less sophisticated investors pay a scary high price for a deal runs a very high risk that when more money is needed no one (unless the initial folks want to poney up) with any brains is going to provide it.
In this situation the “sell to the highest bidder” rule led the entrepreneur astray because it brought a bunch of people in to the company as shareholders who (i) clearly (consider the price they offered) had no business making the kind of early stage high risk investment they made, and (ii) probably are the kind of people who would make good plaintiffs if the company and some group of new, smarter investors made a success of the business – albeit one that would almost certainly not, in retrospect, justify the early investors’ $100 million valuation. To put a finer point on it, no sophisticated investor is going to come in and wash out the prior investors and – management has to remain incented – jack up the shareholdings of the founder and/or management team for the simple reason that if they do that they are inviting the wrath of the earlier investors. Such wrath often taking the form of an expensive, time and energy-wasting lawsuit of uncertain outcome. As I have heard at least one top tier investor say about a company with a Over Zealous Investor problem, “I wish we could do this deal, but life is too short, and, as you know, there are too many other fish in the ocean.”
So, if you are an entrepreneur with a good, fundable idea, the first exception to the “sell to the highest bidder” rule of thumb is “don’t sell if the price offered doesn’t pass the blush test” (which is to say, could you look a judge in the eye and say the price was reasonable without blushing). When you break the Over Zealous Investor rule you all but eliminate bringing in smart money down the road.