The winds and the birds are bringing the news today that valuation madness has reached the all time high. Startups with a little to no traction / revenue are asking for 10MM-15MM pre-money.
Here is my raw gut reaction to this.
The Psychology of 1MM dollars
When we were buying our house, we had an experienced realtor represent us. The house was listed for 950K and there were multiple bidders. She advised us to bid 1MM, which we did, and got the house. You see, the gap between 950K and 1MM is not 50K, it is much bigger. It is not the money, it is the ego.
No matter how much time we spent talking about valuation being last thing in the process, it is the first thing on every founders mind. Most founders equate valuation with the score. They ignore other terms like control of the board, or option pool, or how debt converts. The single pre-money number represents their entire score. It really shouldn’t, but it does.
Say as a founder, you can drive the price up. From 4MM to 6MM then 8MM and maybe even to 10MM or higher. Why not? Why would you not do that? Who wouldn’t? Well maybe you wouldn’t if you asked yourself who really wins here?
Who really wins?
Seriously, who really wins when we have out of control high valuations? Not the investors. Thats for sure. They feel like this whole relationship is starting on the wrong foot. The future is anything but certain. From day one they are concerned about follow on financings and euphoric founders.
The founders themselves are not winners here either. As Josh Kopelman eloquently explained these founders are set for a reality check in a few months, when they’ll go out to try to raise their next round. The Series A will be based on hard numbers and traction. It means that the company is setting itself up for either a down or flat round. Startup Jackson and Micah agree.
And you might think, well, whats the difference — get higher now and lower later OR lower now and higher later. There is actually a difference, and it is again, psychology. A down or flat round is a huge turn off for the founders and the team. Getting the outside lead is a lot harder. Morale is down.
On the flip side, if you raised a smaller seed at a reasonable valuation, and then executed and gained traction, you have a chance at a step up. You have a chance of finding outside investors or getting the insiders to take the round at a higher valuation. That’s called the wind behind your back. Thats called morale is strong. Thats called founders are full of energy, and stepping on the gas.
So back to my question — who benefits from unjustifiably high valuation in the Seed rounds?
Markets vs Values?
Okay, you say. What can we do? It is not us, it is the market.
Others do it too. Its free economy, right? The beauty of capitalism is that the magic happens when supply meets demand. And that is true, but besides capitalism there are also concepts like values and wealth creation.
If you spent 3-6 months working on a startup that hasn’t taken off in a major way, you haven’t really created 10MM worth of pre-money value. Arguably you haven’t even created 5MM worth of value. I mean these are actual future millions of dollars in value and wealth.
We all laugh and cringe these days at the old school sales people. When we ask: “How much is this?” They reply: “Well how much do you have?”
But wait, aren’t we becoming just like them by asking to raise the cap on the note or SAFE?
How much should the company be valued at — it is an auction — depending on how much people are willing to pay. Well, this is not really very much different from the old school sales. It is exactly the same.
We, the Founders
The issue of values and value creation is central here.
We, the Founders, are builders. We, the Founders, are dreamers. We, the Founders, have principles. We, the Founders, are fair. We, the Founders, don’t like to be screwed with. We, the Founders, don’t screw other people.
And with that, I call upon all founders to be students of history and data.
To not blindly follow the pack. To ask questions. To be fair, to be reasonable, and to do the right thing.
And to not create an immediate disadvantage for something you are working so hard for.
Engineer, Immigrant. Vegan. 3x Founder, Managing Partner @2048vc. Previously ran @techstars in NYC. I write #startuphacks: http://alexiskold.net .