man looking at board
Image by StartupStockPhotos from Pixabay

Bigger is not always better. The adage holds, especially in the highly volatile capital markets, which have seen their fair share of ups and downs in recent years. A higher valuation does not necessarily translate to higher growth for startups, where the capital could quickly become a liability and a stakeholder's worst nightmare.

Reasons for a Higher Valuation

Startups can easily get a higher valuation when the markets are doing relatively well. In a bull market, companies can raise substantial funds even before they have proven their worth or gained substantial market traction.

'Inflated valuations in early rounds often come with pitfalls and set unrealistic expectations for startups as they progress,' says Cosmin Panait, founder of GenCap Management.
GenCap Management has backed numerous pre-IPO companies, and Panait has seen firsthand the impact that valuation strategy has on long-term success.

One critical consideration for founders is whether the valuation aligns with the company's performance and realistic growth projections. If an early valuation is set too high, it can become a burden when the business cannot keep pace with investors' expectations.

Why a Higher Valuation Might Not Always Be Beneficial

Startups bagging high capital initially might not always succeed, especially in the financial part of their operations. A higher initial valuation sets a lofty bar for subsequent valuations. For a startup, this would mean projecting significant growth for future valuations, which might not be practically viable. The pressure to hustle might lead founders to make decisions that might impact the company's operations and profitability in the long run.

If a startup fails to meet investors' expectations, its valuation could take a big hit. In certain cases, this could lead to a 'down round,' where the company's shares are sold at lower prices than previous rounds. Such a move not only impacts the founders and other shareholders but also lowers morale among the company's employees.

Key to Establishing Realistic Valuation Deals

GenCap Management encourages startup founders to maintain a disciplined approach to valuation and the fundraising process to avoid pitfalls that could affect their businesses in the long run. The first step is to create a well-defined plan that aligns with the company's vision, which would not only attract the right investors but also demonstrate that the company is committed to sustainable growth.

'Startups benefit greatly from setting a valuation that matches their current traction and potential without succumbing to market hype,' observes Panait.

Preparation is another key to achieving realistic valuations. Panait and others advise founders to spend time gathering information and understanding the current market conditions before they begin pitching.

This means reaching out to VCs in their network to gain insights into what valuation ranges might be reasonable and understanding the prevailing multiples on revenue or other relevant metrics in their sector. The know-how enables founders to enter the pitch phase with realistic numbers, making finding the right investors easier and reducing the risk of overvaluation.

The structure of term sheets also makes a big difference during fundraising.
'Some term sheets, particularly those offered by investors who promise the highest valuation, may contain provisions that give the VC excessive control over the company's future decisions,' says Panait. 'For instance, some term sheets might include "liquidation preferences" that guarantee investors a larger payout in the event of a sale, or they may specify unusual board structures that give investors multiple board seats.'

Panait stresses the importance for founders to think beyond each funding round and gauge the impact that early valuations could have on the company's growth and profitability in the future. While higher valuations may look good on paper, they may become a burden if a company can't meet its milestones through to its IPO.

The End Game

'It can be tempting to go with the highest offer in a competitive market, but it is not always the wisest choice,' states Panait. 'By setting a realistic valuation and focusing on building a strong, well-aligned investor base, founders can create a foundation for enduring success. A company that has achieved sustainable, realistic growth will find itself well-positioned to attract public investors during its IPO phase, creating value for its stakeholders.'

A company's valuation is just the start of its journey towards establishing a sustainable partnership with its investors. To make its mark in the long run, a startup needs factors such as expert guidance, industry connections, and operational assistance. Therefore, founders must focus on attracting investors who bring more than just money. The right partnership can add significant value to the business and help a company navigate future challenges and pursue opportunities in its sector.