High Valuations Can Come Back to Bite You

Some founders optimize for minimal dilution in the current round when they raise capital from venture capital firms. They do this by setting high valuations. For example, a company raising $1 million that wants only 5% dilution will have a $20 million post-money valuation. If they accepted 15% dilution on that same $1 million, they’d have a $6.66 million post-money valuation. The difference is large. In isolation, the 5% dilution at $20 million post-money makes the most sense to the founder.

If a founder considers the next financing round, things look different. Investors in the next round might be willing to value the company at or above the $20 million assigned in the first round only if there is a significant amount of traction. Otherwise, the founder could face many bad options (assuming they haven’t reached breakeven). They could run out of cash and close the business. They could raise at a valuation lower than $20 million. I won’t get into all the math, but depending on the terms of the first round, investors from the first round could receive additional ownership when the second round of financing is complete. Depending on how little leverage and runway the founder has, the dilution could be massive.

To avoid all this, founders raising capital should agree to reasonable valuations that won’t give investors in later rounds heartburn or force the dreaded down round.