There are many options--and traps - when it comes to financings. We've talked about the virtues of priced rounds relative to convertible debt, as well as the key concerns of founders in approaching financings. However, one of the most fundamental considerations is the question of valuation.

When it comes to pre-money valuations, higher is always better, right? This is certainly a common misconception held by many entrepreneurs. Here's why it's wrong.

Valuation is An Illusion
If investors offer $1M on a pre-money valuation of $3M, there can be no disputing that the company is worth $4M--at that moment. Investors working independently at arm's-length have estimated and agreed your business is worth $3M pre-investment, and now the business has an additional $1M in cash on the balance sheet.

Here's where the potential trouble begins. Shortly after the money arrives, it is steadily removed from the balance sheet as it is turned into people, product and progress. The company hires new employees in sales, product development, marketing and other functions. It spends money on product development. It engages with customers, ups its marketing and public relations profile, and hopefully books some early sales.

Inevitably the money runs out. With careful planning and management, this happens approximately when projected. More often, however, things cost more than expected, and revenue takes longer to come together. And so the company has no choice but to raise more money on a story which is just a bit shy of perfection. This is the reality side of the valuation illusion.

Nowhere to Hide
It is at this point that the trouble comes home to roost. When investors first valued the company, they expected a certain level of execution. They were betting that the company's newly-acquired people, product and progress would be enough to justify that $4M post-money valuation. Pricing the next round becomes the moment of truth.

The first time you raised money, you sold on a promise. Now you are selling on the reality. As you ask for a second round of money, many of the same people who previously estimated a $3M value now know quite a bit more about the company. They know how wisely you spend money. They know how much the market likes your product. They know how well you hire, how much it costs to build the product, and how much it costs to sell.

The Trap of Pricing For Perfection
The reality of your execution shines a harsh light on every prediction and projection. This is why it is critical to give yourself a little wiggle room on your first round valuation. That's the subjective portion of your post-money valuation, whereas your execution is the objective. If things have gone well, and your original pre-money was reasonable, investors will agree that your company is still worth what it was projected to be worth. Even if things cost slightly more and took slightly longer, investors will accept a new valuation that is greater than or equal to the post money of the last round.

Overreach Leads to A Deadly Trap
If they don't agree, you are in a deep hole. If investors judge that you didn't execute well, and your original pre-money was aggressively high, it will be a serious challenge to justify your post-money valuation. You have fallen into the valuation trap: no new money is available at a valuation equal or above the post-money of the last round. Now you are facing an entrepreneur's worst nightmare: a down-round.

Down-rounds destroy forward momentum. They rattle confidence, and they hurt all of your early supporters. But no one is hurt worse than the founders.

Why? Because most priced rounds include anti-dilution protection for investors. These clauses state that if the company raises money at a lower per-share price than the investors originally paid, the investors' price automatically re-adjusts to reflect the lower price. The company issues more stock to those investors to adjust the price downward after-the-fact. The dilution for that correction has to come from somewhere, and of course it comes from the stockholders who don't have anti-dilution protection, namely you and the other founders.

Root Cause: Undisciplined Early Valuation
This catastrophe is most likely to occur when the arbitrary pre-money valuation of the first round is unrealistically high. Remember that $3M pre-money scenario? Likely the founders thought it was too low, while the investors fretted that it was too high.

One camp is close to the situation, excited about the opportunity, impatient to get started, and likely a little younger and less experienced. The other camp has more distance from the situation, more perspective from having been here many times before, and probably a higher average age and level of life experience. Given that both sides have economic incentives for their positions, you can cancel incentives out and just ask yourself, who is more likely, on balance, to be right?

Let Experience Be Your Guide
The truth is, it may not matter who is "right." Even if you don't agree that investors have your valuation correct, it may still be wise to agree with them. This is because of a simple fact of life: the company that keeps its early pre-money valuations reasonable is allowed much greater room for error in raising future rounds than the company that pushed really aggressively for the higher pre-money valuation. After the all-too-common "tough year" where the money didn't take you as far as projected, the last thing you want hanging around your neck like a noose is a huge post-money valuation caused by a lack of discipline in the previous round.

Step By Step
Valuation is not an either/or situation. If dilution is a huge concern, and you really cannot agree on valuation, there is an alternative solution to manage dilution: raise less at a lower valuation and go out and de-risk the business more before raising again. With patience and a consistent pattern of under-promising and over-delivering, you will have a far easier time raising money, a more valuable company, and an equal or greater percentage ownership of it. Reasonable early valuations are not a bargain for investors, they are a bargain for entrepreneurs too.

Next up we'll look at key investor concerns in approaching financing rounds. Stay tuned to this series for upcoming installments.

Published on: Dec 23, 2015