## Introduction Founders of Silicon Valley startups often chase the highest valuation they can get for their companies during funding rounds. While this may seem like the obvious, logical thing to do, it often does a disservice to the long-term interests of the firm and its stakeholders. This essay explores the pitfalls of excessively high valuations, and advocates for a more measured approach: raising lower-priced rounds at regular intervals. ## Perils of a High Valuation ### For Employees **Current Employees**: A soaring valuation translates into substantial (paper) wealth for the startup's employees. On the surface this may seem great - employees are being rewarded for turning down other, higher-paying offers to go work for the startup - but there's a hidden risk: complacency. Employees gain a newfound sense of wealth, and the focus shifts from working to enjoying the fruits of their labor. Furthermore, the high valuation round may cause employees to think that they have been able to capture most of the upside the firm was destined to achieve, and think that the firm is unlikely to get to a much higher terminal valuation. This causes them to cash in their chips, and start looking out for other offers. Soon, key talent starts to exit, draining the company of crucial institutional knowledge that was the very reason for its success. Additionally, a very high valuation raises the likelihood that the company won't be able to grow enough to justify its new valuation, increasing the chances of a future down-round (a round at a lower valuation). This drop in the value of the equity leads to an erosion in employees' "perceived income", which in turn leads to a drop in morale across the firm. **Prospective Employees**: One of the main reasons people choose to join a startup is the hope that the equity they get will appreciate substantially over time. That also means that the allure of equity diminishes as valuations get higher. Potential recruits realize that the equity they are awarded at this substantially higher price is unlikely to appreciate to the same extent as it did in the past. So, hiring new talent starts becoming difficult. ### For Founders After raising a round at an extremely high valuation, founders face an incredible amount of pressure to deliver results and grow into the valuation they were just awarded. These aggressive targets are most often focused on **Annual Recurring Revenue (ARR)** and **Gross Margins**, come with strict deadlines, and meeting those targets determines whether the company will be able to raise another round in the future. The side-effect is that these aggressive sales and growth targets often sideline the most important component of a business - product-market fit. The firm no longer has the time to go slow, experiment, and see what works. They are pressured to take whatever they have and scale it to as many users as they can, regardless of whether users really want the product in its current form. Essentially, the firm loses the flexibility to pivot or refine its offering, potentially stalling genuine innovation and long-term viability. What does this look like? Dramatic increases in employee headcount and computing; large spends on advertising and marketing; spending more money on acquiring a user than they will ultimately get from that user (LTV < CAC). All of these line items are counted towards **SG&A and Opex** rather than **COGS** (which affects gross margins), so firms are incentivized to spend a lot of money in those areas to hit their ARR and gross margin targets. A lot of these dollars ultimately end up in the hands of firms like Amazon (AWS), Google, and Facebook (ads), while the startup is left with high user churn due to a lack of product-market fit. All of this makes it unlikely for the company to reach its growth targets in the long run, increasing chances of a down-round and potentially triggering another landmine - *non-dilutive clauses*. Investors often add these clauses during funding rounds to ensure that if the company issues new shares at a lower price than what the investors originally paid (aka a down-round), their stake will not be diluted. In extreme cases, this can cause the founders to lose most of their equity in the firm, leaving very little upside for them to work for. Founders may also not have the option of walking away from the business - investors may also include clauses that force the founders to stay at the firm and may only be allowed to leave when they are asked by the board. ### For Investors **Current Investors**: A lot of existing investors may favor a high valuation for the company, as it gives them something to point to as evidence of their investing ability, which ultimately helps them raise their next fund. The problem is that since the high valuation comes with aggressive growth targets, there is an increased likelihood that the company will not be able to grow into its new valuation in time, making it harder to raise future rounds, and potentially having to raise a down-round in the future, which is bad for morale in the company. And even if it does meet its targets, it likely would have done so by spending money to grow unprofitably, not achieving true product market fit, and ultimately losing the customers it spent so much money to acquire. **Prospective Investors**: A very high valuation deters future investors from investing because they see limited upside potential remaining for the firm. They might be skeptical about the company's ability to grow into its valuation, leading to challenges in securing future funding. Furthermore, high valuations significantly narrow the pool of potential investors capable of supporting follow-on rounds, thereby restricting the startup's funding options. As companies achieve multi-billion dollar valuations, they often must shift from relying on venture capital firms to seeking capital from larger institutions like *TPG* and *T. Rowe Price*. This transition is necessary not only because most venture capital firms lack the resources for such substantial growth funding but also because partnering with marquee investors like TPG and T. Rowe Price boosts the firm's credibility in the market, which is advantageous when the firm eventually decides to go public. The reason this is important is that these firms are considered marquee for a reason - they are far more disciplined in their approach than VCs, and their investment decisions are strongly rooted in the fundamentals of the business, rather than future promises/potential (not that future prospects are not important, just that they are far less speculative than VCs as an asset class). So, unless the firm has grown into its valuation and proven the strength of its business, they are unlikely to secure the capital they need from the institutions they need. ## The Solution: Smaller Rounds at Regular Intervals Raising smaller amounts more frequently presents several advantages: 1. **Stable Growth Trajectory**: A series of smaller rounds encourages a focus on stable, incremental growth rather than unsustainable expansion. This aligns more closely with building a robust and enduring business. 2. **Customer-Centric Approach**: Unencumbered by the pressure of rapid scaling and justifying an enormous valuation, companies can choose to move slowly and focus on true innovation and product-market fit, ensuring sustainable growth, and long-term customer loyalty and satisfaction. 3. **Maintaining Morale**: Regular funding rounds can create a sense of momentum within the company. Employees witness a steady increase in their equity value, boosting morale and incentivizing them to stay at the firm for longer. 4. **Enhanced Attractiveness to Prospective Employees**: Reasonable valuations make the equity offered to new hires more appealing, as there is still potential upside left on the table. ## Conclusion While high valuations can be tempting, they come with significant risks and pressures for all stakeholders involved. A more balanced approach of raising smaller rounds at regular intervals offers a sustainable path, fostering steady growth, innovation, and long-term success. This strategy ensures that the interests of founders, investors, employees, and customers are aligned, leading to a more favorable outcome for everyone.