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A high valuation is often seen as a success by co-founders, but it can become problematic if the company is not sold at a higher price. Two examples illustrate how investor expectations influence exit targets and can limit founders’ gains while affecting the motivation of stock option holders. It is essential to prioritize reasonable valuations and balanced agreements to ensure tangible benefits for all stakeholders.
During a capital increase, a high valuation is often seen by co-founders as a symbol of success and a means of retaining decision-making power. However, the reality is more nuanced, and a high valuation only makes sense if the company is ultimately sold at a comparable or higher price. Otherwise, an inflated valuation can backfire, especially in the event of an economic downturn.
When the dot-com bubble swelled beyond reason, a financial expert who remained skeptical of the prevailing euphoria reminded me of the adage: “Even turkeys can fly in a hurricane.” A few months later, after the bubble burst, those flying turkeys abruptly found themselves grounded.
Flying Turkeys and the Looming AI Startup Bubble?
It would be bold to assert that we are in the exact same scenario today with the astronomical funding and valuations of AI startups, but the resemblance is striking. It is highly likely that several companies will face a significant correction in their valuations, with some of today’s unicorns turning into turkeys.
The steep drop in startup valuations between 2021 and 2022 confirms this hypothesis, which we will illustrate with a representative example.
For a €4 million investment, a pool of investors negotiating 30% equity and seeking a 3x return equates to the demands of financiers accepting 20% equity while targeting a 2x return. In the first case, the post-money valuation would be €13.33 million, with an exit goal of €40 million. In the second case, a more generous post-money valuation of €20 million with a more moderate 2x multiple also leads to a €40 million exit goal.
These two scenarios show that every million invested in early-stage or venture capital rounds must generate €10 million in enterprise value. This 10x rule is corroborated by data showing the median exit amount for a startup is €38 million (close to €40 million) after raising a median €4 million (Source: Avolta).
How an Overvalued Startup Can Hurt Founders
If an acquisition opportunity of €16 million comes in a few months after the funding round, the shareholder configurations in these scenarios diverge. In the first case, this valuation would be 20% higher than the post-money valuation for investors holding 30% equity. In the second case, it would be 20% lower than the post-money valuation for investors holding 20%. Such a “quick” buyout offer might be readily accepted by the first pool of investors but rejected by the second.
This kind of sale would also affect employees holding stock options. If the company’s valuation decreases and a sale occurs at a price per share below the exercise price of their options, employees would realize no gain. This would inevitably lead to demotivation or even the departure of talent to more financially attractive opportunities.
An excessively high valuation can therefore backfire on founders, especially if investors seek to “secure their multiples” through liquidation preference clauses or anti-dilution provisions. While we will not delve into these clauses in this article, the complexity of investment agreements underscores the need for expert advice and, above all, realistic business development plans that benefit all stakeholders: co-founders, investors and employees.
Aim for Win-Win Financial Deals
In a bubble, an excessively high valuation can resemble a Pyrrhic victory. To avoid your company suffering the same fate as the ill-fated King of Epirus, it is often wiser to negotiate a reasonable valuation and grow your business in a way that ensures investors achieve exit multiples of at least 2x or 3x their initial investment.
A generous valuation at a given moment is merely virtual wealth, and it often takes nearly 10 years between a company’s creation and its actual sale (Source: Avolta). In the meantime, founders and investors only hold paper value. Employees holding stock options will likewise only have paper options tied to a potentially rising valuation.
In summary, startup founders are more likely running a marathon than a sprint. Successive increases in valuation are a good indicator of the quality of their strategy’s execution, but they must not lose sight of the ultimate goal: selling the company at a price equal to or significantly higher than the last post-money valuation. Otherwise, this virtual wealth will backfire on them, much like Pyrrhus, whose hard-fought victory ultimately weakened his prospects.
