The Curse of Overvaluation: a Breakdown pt. II

Jason Yeh
March 7, 2023
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Fundraising

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.

But when the music stops…

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. 

Reset of the market 

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.

2 main overvaluation challenges

The two main challenges of overvaluation are keeping employees motivated and generating fundraising momentum.

Employee motivation

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.

Fundraising Momentum

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.

Fixing the situation - why do we need to?

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.

Fixing the situation - so what can be done?

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:

  1. Only rely on clear communication - In this approach, you talk to investors in a straightforward way acknowledging that you raised money in an overheated market. You raised at the level investors offered. Share where you think it probably should have been done at if the market were in a more realistic place.  Once you establish that baseline, make sure they understand all the progress you made from that point and tell them you’re excited to again listen to the market on valuation.  The hope here is that the VC takes your opinion of where you *should* have been priced at and gives you a step up from there based on your progress. The issue with this approach is you don’t get rid of the baggage that the VC will have to take on to be the one leading the down round. They’ll still have to live with being the instigator in a very difficult relationship they’re joining
  2. Set your own lower valuation - this is easiest at earlier stages when you’re raising lower amounts on SAFEs (up to around $3MM) and it’s more commonplace for the founder to set valuations. The good thing here is you relieve the VC of the responsibility of swinging the ax. However, the key issue with this approach is founders will often not cut deep enough to make this work well. The founder will set a cap that they think is low but that the VCs still think is overpriced.  And if they do cut deep enough with a low enough cap, they won’t combine that with signals that other investors are excited about the deal so the lower valuation makes the company seem unexciting.
  3. Reprice the round with your last investors -  have a conversation with your existing investors to reprice everything to a level that makes the last deal look more like it was raised in today’s market. From this lower, more reasonable starting point you get to have a collaborative conversation with new investors to help set the next valuation at a natural flat round or a light step up into the current market conditions.  They avoid playing the role of bad guy, ensuring they are not blamed for the impacts of the new pricing, which is a huge win.  In addition, your existing investors win with better terms and are more incentivized to help. The downside here is that the founder likely takes the most dilution in this scenario…

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…  

Conclusion

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

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