Last week, I covered the inputs like low interest rates and the Crypto bull run that led to our current fundraising situation. These caused extreme FOMO, irrational exuberance, and a glut of capital needing to be deployed, leading to huge valuations, follow-on raises, and mark-ups.
When markets are based on irrational confidence instead of fundamentals, the momentum to keep things going can be very fragile. If investor confidence is shaken by say… a war, or fraudulent actors demolishing an asset class that a lot of personal wealth was tied to, the music can stop.
This is what happened in 2022. The music stopped. The war in Ukraine and the multiple shocks to the crypto markets created a ton of FUD (fear/uncertainty/doubt) in companies and in turn investments.
The illusion that you couldn’t lose disintegrated. The confidence that investments would always be up and to the right disappeared. So even with reported record amounts of “dry powder” left for VCs to deploy, investment activity completely dried up.
The reset of the market is happening NOW. This applies to what investors are willing to pay at different stages of the market and to expectations of how fast investor diligence takes.
Founders whose baseline expectations were set between 2020 and 2022 are quickly learning the issues with being an overvalued startup… and it’s not fun.
Side note: I have a lot of sympathy for these founders stuck with crazy high valuations. Some people think whatever hardship they’re experiencing, they brought it upon themselves. I think the market dealt them a bad hand. If investors offer and even push you to accept abnormally high valuations, it requires a crazy amount of self-control and perspective to go against the market and insist on a lower valuation. Some did it (see: Bubble founder Emmanuel Straschnov), but very few.
The two main challenges of overvaluation are keeping employees motivated and generating fundraising momentum.
To preserve cash, startups combine lower salaries with some type of equity compensation for their employees. That equity is pegged to the valuation of the company when they join. This can be problematic for the employees that joined during an over-valued period of the company’s life. If the startup's valuation outstrips the company's performance, revenue, and current fair market value, employees may become disillusioned and believe their equity or stock options are no longer as valuable as they were promised. Without that future upside, it can be tough to keep employees motivated or even prevent them from leaving. And hiring new talent can be difficult as well.
Generating fundraising momentum for startups with overinflated valuations is difficult because investors will find it difficult to believe the vision of the founders since they are already not meeting the lofty expectations they set at the last fundraise. Even though much of the miss is due to “valuation multiples” coming down and not necessarily company performance, this is still a difficult narrative to navigate. Startups routinely fall short of previous round expectations but as long as they drive growth and show the ability to command a significant step up in valuation, then marginal misses are taken in stride. This works when your last round valuation was reasonable. If you were overvalued however, slight misses on growth will be seen far less favorably.
Before we get to “How do we fix this?” some people are thinking “Why does this have to be fixed??”
If the explanation for valuations moving all over the place is just “the market,” then why can’t we just let the market price things accordingly? After all, the common advice that I and others give when it comes to any “valuation conversation” usually includes the recommendation that you say some variation of “we’re ready to listen to the market to help set our valuation.”
The first and easiest answer is that any dip in positive momentum greatly impacts a startup’s chance of success in the early days which in turn impacts fundraising. But there is also the answer that leading a down round is just a huge headache. Yes, technically an investor should just be able to price it wherever they want and the founder can choose to accept the deal or not. That’s how the open market works. In practice though, there is so much more to consider. As much as a founder says they’re open to whatever the market offers, I guarantee you most founders don’t react to a 50% valuation cut (or worse!) with hugs and smiles. If the company ends up pulling it out in the end, the VC isn’t revered as the investor who came in with the courage to invest in a down round, they’re labeled as the predator who took advantage of a founder in a tough situation… Existing investors who might need to be crammed down to make things work also won’t be super excited about how it all played out. In general, it’s not a great way to start a partnership.
VCs are already always looking for reasons to pass. Any sort of “hair on the deal” is enough to move on to look at an easier / cleaner deal. This long list of headaches gives them very easy reasons to pass on overvalued startups.
There is no straightforward approach to fixing the situation. But hopefully the lead up to this helps you better understand what makes the situation so difficult so that you can pursue an approach that fits your needs.
Here are three options:
Options #2 and #3 are challenging. They help grease the wheels to get a deal done, but if things go well and the company successfully raises, it’s easy to question whether or not those steps were necessary. In other words, if you price the round super low yourself (option 2) or reprice your last round (option 3) and get a deal done… could you have done it without forcing that extra dilution? It’s a counterfactual strategy addressing a situation that hasn’t happened yet.
I realize that this is a challenging situation with no easy answers. I will acknowledge it is much much easier for me to write about the options than it would be to follow them myself…
Here’s where I’ll leave things. As much as humanly possible… don’t anchor to where you or the market was at your last round. Don’t anchor to what you’ve heard others have done. Model out your own dilution and expectations (this dilution explainer could help) based on today. Reset your mind there to get back to a place of satisfaction with the path you’re on. As I’ve written in the past, happiness is the difference between expectations and reality…