The Silent Killer: The Threat of High Valuations
Often unmentioned when it comes to raising capital are the perils of raising too much. While some founders might be quick to dismiss this as an issue, an overstuffed cap table can prove disastrous as subsequent rounds unfold.
To help illustrate the issue, we’ll run some numbers with last week’s fake pitch startup: Tabatic Energy Corp.
Let’s say Tabatic is looking to raise a Series A. They’ve determined that in order to scale their business they need $5M and want to offer 20% of the company. However, in the process of their raise, investors are so impressed with their idea that an offer of $15M for 20% is made.
It sounds like a no-brainer — three times the cash for the equivalent equity dilution. Who wouldn’t opt for a $75M post-money valuation over a $25M post-money valuation?
Runways Have a Natural State
The founders of Tabatic might think that triple the cash equates to triple the runway. What was previously 20% dilution for 18 months can now be 20% dilution for 54 months. But in reality, diverging this much from the frequently recommended 18-24 months is incredibly rare.
There are a number of reasons for this. . Some of it boils down to the time-constrained outlooks of VCs (something we discuss in The VC Logic Loop), but a lot of it has to do with the purpose of funding rounds themselves. Different rounds are like different gears in a car. 18-24 months is often an adequate time frame to get to your next value inflection point. Staying in a lower gear longer than you should will constrain acceleration (and possibly exit velocity).
With this in mind, rather than tripling their runway, if Tabatic Energy were to opt for the $15M investment, they’d likely just end up burning three times the cash in the same amount of time due to the increased growth capital.
This might not seem like a big deal. After all, the more they spend the faster they’ll grow right? It’s not necessarily that simple.
Their Series A investors will want to see 2-3x valuation growth when Tabatic’s Series B comes rolling around. It’s one thing to turn a company worth $25M into $50M+ in 18 months; but it’s a whole other ballgame to turn $75M into 150M+.
Facing Accelerated Dilution
In the face of such large differences in offers, one would be reasonable to think that dilution/accretion of company value occurs solely in conjunction with transaction events. In reality, these vast differences in offers are largely a result of the currently overcapitalized VC industry.
In practice, dilution is a function of your burn rate relative to your value accretion. When you burn a dollar of investor capital, it should accrete more than a dollar’s worth of value to your company. Transaction events are simply measurements of all the value accretion/dilution up until the date of said transaction.
If Tabatic spent $10k on a marketing stunt that flopped, they just diluted their company by $10k. If they spent $100k to file for patents worth $500k, they just accreted their company valuation by $400k.
Tabatic knew they only needed $5M to make it to their next milestone. They knew that burning $275k a month ($5M / 18 mos.) was all they needed to execute on their best hypothesis and accrete 2-3x of their company value over the next 18 months. They were on track to hit that $50M valuation target for their Series B.
But if Tabatic were to sign that $15M term sheet, statistics show that they’d likely end up tripling their burn rate, runway remaining relatively unchanged. At first, things would be smooth sailing, ideas known to accrete $5 for every $1 spent would be scaled up. But as Tabatic’s burn rate moves to north of $800K a month, the limits of those 5x ideas would be met. In turn, less and less confident ideas would start to be put to use. Ideas that generated 4x per dollar would be implemented, then 3x, then 2x, and eventually 1x and under.
It might sound absurd to hear of a company burning money on things that won’t accrete value — but overcapitalized companies in the pursuit of growth do it surprisingly often. Revenue growth possesses great power to mask the shortcomings of a business model. Founders will say that they’ll fix inefficiencies down the road, or that customers will just pay back acquisition costs over longer periods. In the mind of a founder, anything is better than stalling growth.
The Dreaded Down Round
It all comes down to this:
Trying to triple the valuation of an already overcapitalized company is like trying to shift from first to fifth gear in a car, your engine likely won’t keep up. Tabatic might be able to build up enough hype for their company to still secure a Series B with a 2-3x valuation, but this will just compound the issue at hand. Eventually, the market will correct itself and the true value of Tabatic will come out of the woodwork in the form of a down round.
While survivable, down rounds will often knock the wind out of a company. Anti-dilution protections will be triggered for previous investors and in turn founder equity holdings will be shredded. Relationships with past investors will likely be damaged, employee morale will likely go down, and a red flag will be thrown up to your customers.
The good news is that all this can be easily avoided. Tabatic can raise just what they need when they need it, opt for an accurate valuation, and achieve reasonable growth targets without doubling down on damaging burn.