People always want to get the best deal they can. For entrepreneurs this typically means getting the highest valuation when raising money. The higher the valuation, the less of the company that the entrepreneur will sell to VCs when taking an investment.

Like all things in life, however, moderation is key. Entrepreneurs that succeed in obtaining extraordinarily high valuations can risk their own financial rewards; there are three problems that excessively high valuations can create.

First, inflated valuations can limit the company’s access to short-term resources. By maximizing the valuation, an entrepreneur may lose access to the credibility and resources offered by the most sophisticated VCs for the current round.

Second, as the valuation increases it is likely that fewer investors will be willing to invest in the future. If the valuation continues to increase after each round, entrepreneurs may find that there are no other investors willing to get involved, leaving them with the challenge of trying to milk their existing investors, reduce costs or consider reducing their valuation.

Reducing the valuation of the company in the future can be painful for the entrepreneur as they may lose a significant portion of their equity. This happens because many investors use anti-dilution provisions to protect themselves. These legal terms allow investors to partially protect their equity stakes in the event of future investment rounds being completed at reduced valuations (also known as ‘down rounds’). Ultimately, in a down-round the ownership of the current equity holders declines. These anti-dilution provisions leave the entrepreneurs to bear the brunt of this dilution. This protects the investor from the consequences of entrepreneurs that don’t perform well or over-value their company early on. Since these terms are commonplace, entrepreneurs have an incentive to value their company appropriately to ensure that future valuations continue to increase.

In sum, it rarely pays to be greedy. While some succeed in over-valuing their companies, cutting aggressive deals can come back to haunt them as sophisticated investors know how to protect themselves from overstated valuations. In the end, it seems that it’s always better to do deals that value your company reasonably.

Comments

[Rahul Pathak]

Mark,

Great post & blog. I've been enjoying it recently. This was a great articulation of the dangers of overly inflation valuation and also the role that anti-dilution plays in down rounds. Most people talk about how anti-dilution protects the VC. No one talks about how it actually means the VC is protected at the expense of the entrepreneur.

Rahul