Valuations, Fundraises, and MPH
Good advice, given at the wrong time, is bad advice. And good advice, given in the wrong way, is also just as useless as bad advice. And so I’m trying to repackage advice I got a million times from VCs with more experience than I have, in a way that resonates. Since the first hundred times it didn’t resonate enough. And I’ve had a hard time communicating the advice to founders since.
As an early-stage investor, one of the worst feelings is backing a company with a compelling founder, a compelling idea, getting the thesis right, and still not making money. A common reason this happens is that founders raise too much money at the wrong valuation and are forced by the expectations of a large financing to do unnatural things. Usually, it happens because a company that has raised too much money runs out of TAM relative to the valuation and expectations of their last round. But instead of being willing to admit the previous round was too much capital at too high of a price, they try even harder to spend even more, and invest further into the product hoping the one last product extension will free them from the shackles of a capped opportunity.
Raising a lot of money at a high valuation is a bit like driving a car, and driving as fast as the car will go. If you’re a good driver, it works out, is fun, and you get to where you want to go faster. In a hot market, where multiple cars are all getting funded, it actually might even be a de-risking move because it ensures your car will get there faster than the others and win the race before other cars even have a chance. Especially in a winner-take-all market.
The problem is that most companies are run by new drivers, who won’t admit that they’re new, and who decide to drive as fast as they can anyway. Usually because of bad advice they’ve received. First-time founders are often the builders of the most epic companies, but watching startups grow can sometimes feel like watching a bunch of caffeinated sixteen-year-olds street racing in their parents’ shitty used cars.
The valuation a company raises at is basically like pre-determining the MPH a car is going to be set at. And the valuation is determining how far the car has to travel. But there are two problems: You know how many miles you need to go, without knowing how far the paved road actually lasts. And the faster you go, the less room for error you have.
If a company raises a lot of money at a high valuation they have to hit high growth targets. This causes a company to do the following:
Spend heavily on unproven growth channels (or channels where it’s unclear how deep they go)
Take risks on pricing, product launches, marketing, hires
Hire senior people quickly, and not be able to afford firing bad talent because their roles need to be filled to hit annual targets
Force product extension in unnatural ways
Expand to an unnatural and new customer segment that is less receptive
Begin lowering price/sacrificing margins
Strike crushing BD deals for extra distribution in the short-term, but less control/brand equity in the long term
I could add 99 more bullets here, but the first three bullets alone are often damning to a business.
And if the steering wheel of the car turns in the wrong direction by just a little bit, the car needs to swerve quickly (aka a bridge round), or crash completely (aka a year of 20% YoY growth) and potentially fail to raise their next round, suffering a pay to play round, or something similar.
Not only does the company feel forced to go fast, but it feels forced to go far. When backing a company early (or when founding a company), it’s really hard to know the actual TAM. And so the easiest way to screw up a good investment is to force a TAM that doesn’t exist. Sometimes, companies are meant to be $500M to $1B in value and no more.
I want ALL companies to be worth $10B+, but sometimes TAM is a risk we’re all taking together, and being sober about it matters.
Raising money at a $1B valuation takes a happy $1B exit off the table. So when raising at that kind of price, founders should start being more honest with themselves about what they actually think the TAM is. And if it’s not there, lock in the win. For you, for your team, and for everyone involved.
There are a lot of founders who used to be worth a ton of money on paper and live very average lives now. And I bet valuation/TAM mismatches, and driving at the wrong MPH, are two of the biggest reasons.
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