Higher Valuations can Backfire!
And more advice from Lorenzo Thione, Managing Director at Gaingels, a venture investment syndicate focused on investing and supporting diversity within the venture ecosystem and which finds its origin in the LGBTQ+ founder and investor community. Gaingels was born as an LGBTQIA+/Allies investment syndicate and is now broadly dedicated to supporting diversity in leadership at all levels within the venture capital ecosystem. Gaingels co-invests with select venture capital leads in any company resolved on building diverse and inclusive teams. They seek to drive maximum returns while influencing the ecosystem and representing the LGBTQ community as well as other under-represented groups and their allies, along with a diverse group of investors within the capital stack of its portfolio companies.
1.Adjusting to Markets
Throughout the past cycle, we learned how to deal with a crazy and super- active market, like last year, where every deal seemed urgent and pressing, and everything “closing tomorrow.” And we learned how to deal with an environment like today, where in a somewhat welcome way, investors are pickier and more rational and are deploying less capital. It is not something would necessarily have been able to predict because markets change suddenly and rapidly from a bull investor market to a bearish, more investor's friendly market. And so, as a founder, you effectively need to plan for the fundraising process to take longer and be more costly from a time and resource point of view. Any company looking to raise money now needs to plan on a process that lasts between three and nine months, and you have to consider that during that time, you can't otherwise dedicate yourself fully to running the business.
2.Don't think short-term.
You want to ensure that the effort, energy, and resources that go into fundraising result in a longer runway. Raise more money if and when it is available to you. Going out and raising with at least a 15-month runway and ideally securing a 24-month runway in that fundraising is the most important guideline this market. Companies that don't do that either very likely run out of time/money before they find support in the market. You can also find yourself squeezed for lower valuation when you have fewer and fewer options. And sometimes, good companies that would otherwise have built sustainable businesses end up failing. We have had some companies that we're unable to raise money in a new market and go lights out.
3. Higher valuations can backfire.
The second guideline is more broadly applicable to any market; there is always a tension between dilution to endure and the valuation that a founder may command at any given time, and how easy it will be to grow the business metric into valuations that get sustained in the market. This means that, more often than not, founders would be well served by enduring more dilution and setting the bar lower for a meaningful valuation multiplier for the next round. Obviously, this all needs to be evaluated in the context of any given business's runway, pipeline, and traction. Some of the companies we've seen failing in fundraising, not because they wouldn't have been able to raise money at any valuation, but because they had locked themselves into valuations so high from the prior funding rounds that anything the market could support would have meant massive dilution and a down round. Overall, many companies got funding last year that probably, in retrospect, shouldn’t have. And along with weeding out the weaker companies, we will also start seeing protective clauses come back into fashion, like anti-dilution protections in growth rounds, making it possible for companies to raise larger amounts even when the exit or public markets seem unsure and avoiding misaligning the incentives with existing investors when looking at flat or down valuations at exits/ipos.
4.Take smart money!
Another way to look at this is from the investor selection point of view. Trying always to choose the investor that will give you a higher valuation and therefore minimize dilution may seem like a smart thing to do in the short term. But, it can have massively negative effects if it leads to choosing a less valuable investor or a less disciplined or connected one.
The venture game is one of furious growth, but that should be applied to revenue and traction, not valuations. Growing into valuations in a steady, conservative way ultimately creates a broader set of iterative successes and more wealth and value for all stakeholders instead of burning through hundreds of millions of dollars in the chase of growth, and speculative value ultimately can destroy companies that could have been otherwise great. In effect, there is a big difference between taking any money from anyone who will give it to you at whatever valuation and taking smart money from committed and disciplined investors with a track record of judgment and returns. The knowledge, expertise, and discipline to support a business and to guide founders in making decisions can make the difference between companies succeeding or not succeeding. Last year has seen a broad kind of lead investors leading rounds that were ultimately unreasonable, not backed by business fundamentals, and only really backed by a frothy IPO market in line of sight. Everybody knew it was not sustainable and was hoping to get in and out with a gain and avoid missing out on opportunities for short-term speculation. Now those valuations are gone, and those comparable in the public market, which ultimately are the exits for private equity investors, are not there.
Optimizing for valuations at the earliest stages creates a balance between the business value, realized, and potential. The investors you choose will make the difference in helping the business or standing in the way of the right decisions to be made.
5.Don't take more than you need at the start.
The reality is it takes less money now to start companies. When I started my first company, we had to raise tens of millions in our very first round because it was super capital-intensive to build any kind of online service (we had to build and deploy our own datacenters). And, of course, some businesses are still capital intensive, but that business would not be as costly today as it was 15, 16 years ago because of everything from the cloud to the open source and reusable platforms and services that are now available (all of which are in their turn, valuable startups). Many fundamental aspects of starting a company have been productized, and it now takes a very small amount of ongoing operating cash to build such businesses, at least at the initial product-market fit phase. Investors typically will need the same percentage of ownership to make their economic return at various stages of investment, depending on the size of their fund. So, really, valuation should be a result of those two factors. Instead, Founders optimize for valuation and can therefore end up raising more money than they need, which is fine at the earliest stages if you can muster it - but it can also lead to the need to invest in growth before the business is well understood.
6.Why do companies fail?
Generally speaking, the “good reasons” for a company to fail in the earliest phases of growth are execution mistakes or product market fit. Later on, it’s also possible that the conditions that made their product needed or wanted to be shifted in a way in which what made it a good business no longer held. Think, for example, Quibi-it became clear that the pandemic had changed the fundamentals upon which the investment had been made; it became best for everybody involved if the company folded (and returned some capital to investors). Generally speaking, these are all risk factors that are a structural part of venture investing. When you see enough companies start and fail, the kind of lessons you learn and wish to impart to founders is more about flexibility and team leadership and being objective and relentless about making data-driven decisions and responding to the market. I don't think there are any drastic new learnings that are different from those that disciplined and smart investors have accumulated over time. Success for investors comes from expertise in recognizing the best ideas and founders and passing on their learnings from past wins and failures.