If venture capitalists want to give you lots of money at ridiculous valuations I don't see why its incumbent upon the startup to create a worse deal for themselves. At the end of the day its the venture capitalists that will lose.
However the VCs aren't stupid, they understand this which is why most insist upon liquidation preference. Ultimately the high valuations will end up working against the founder because these unrealistic expectations mean that those with preference will win and the rest will get nothing.
When signing a deal you really need to consider what happens at every outcome. Not just the binary choices of wild success and abject failure. You can bet your adversaries in the negotiation have already done this.
Accepting lots of money at a ridiculous valuation is a worse deal for most startups.
+ Scenario 1
Imagine a VC offered you $100M on day 1 of your startup, valuing you at $300M. Is that a good deal? Or a disaster in the making?
Well, what if someone offers to buy the company for $100M, your VC will balk. Maybe you discover barriers that will prevent your company from ever being worth $300M. Your VCs encourage you to experiment and take a hail mary shot. Ultimately the company flops and goes out of business. In this scenario you raised a bunch of money, got a "great deal." but have little flexibility on the exit.
+ Scenario 2
Now imagine another scenario where you raise $5M, valuing your company at $10M. This is a "worse" deal in terms of dollars raised and valuation. But now imagine that same acquirer comes along offering $100M. Your VC will be happy with a 10X return and you'll pocket $50M.
The quality of the deal ultimately can't be assessed until you exit. But don't mistake big dollars and high valuations as evidence of success. Fab and Quirky both raised huge piles of money to build out new ecommerce businesses and failed dramatically. Wayfair by contrast, raised no VC and built a $4B business. Choose your metric wisely.
> Imagine a VC offered you $100M on day 1 of your startup, valuing you at $300M. Is that a good deal? Or a disaster in the making?
That's solely dependent on the terms. It isn't possible to say whether it's a good or bad deal without clarifying the exact terms of the investment. That's an amazing deal if the terms are stacked in the favor of the business owner/s.
Those valuations come back to haunt you when you can't get the public markets to stomach them. Those venture rounds get paid back before founders get a penny.
One way in which liquidation preference could be constrained is if potential employees of start-ups began actually inspecting the expected value of their job offers, or at least some heuristics that approximate such a thing. For example, I've always found [0] to be a very useful way to get a rough sense of what an offer is really worth, and from there you still have flexibility to shade to a more or less risk averse assessment depending on who you are personally. Crucially, doing this must include pieces of information such as what liquidation preference has been given to investors. And if a company won't share this with you, run, don't walk, away immediately.
So often people say that you should not attempt an expected value computation or even any attempt whatsoever to estimate the distribution of possible outcomes when appraising the value of a start-up offer.
The usual excuse is that you should value equity at $0 and just hope to be pleasantly surprised if it's worth anything -- in which case the sole reason you accept the below-market wages, long hours, poor benefits, etc., of the start-up job is because you (supposedly) personally get satisfaction from working on something "cool" that is "new" and "unproven" and "entrepreneurial" -- and I guess it is just personal taste as to whether you feel that applies to any given company. (Personally, I have encountered maybe 1 or 2 total start-ups that were doing any kind of work that was different from standard big-box corporate work -- in all other cases, start-up jobs are certainly marketed as more interesting/greater responsibility/learn about entrepreneurship/change the world/etc., but in reality you just do precisely the same rote sort of work you'd be better compensated for in other types of jobs with better work/life balance).
The other excuse is usually that you should view part of your compensation as "the experience" of working in a start-up (and this is supposed to be substantially more valuable than the experience of working for other types of employers) -- possibly combined with promises of quickly getting a very fancy job title, access to meet founders, investors, or other high-status folks, etc. -- none of which will be put in writing in your job description nor translate to cash earnings if such promises are never fulfilled.
I don't think there's much wrong with these lines of reasoning per se, except that they definitely aren't good reasons to avoid doing an actual expected value calculation of some kind. If the assumptions underlying your calculation are bad and someone who is trying to hire you thinks your valuation of their offer is wrong, they are free to provide evidence to back it up, and you can re-evaluate. But simply not doing any kind of quantitative appraisal of the likely value of a job offer should be straight out of the question, 100% of the time. Then, whether you personally attach any certain dollar value to the claims of enjoying the nature of the work, getting some type of more valuable experience, getting access to high-status folks, etc., is up to you to decide in comparison to that hard-numbers expected value estimate you come up with.
If we could get more of the start-up labor market participants to focus effort on directly and quantitatively appraising the value of their job packages, which in part will be calculated based on, for example, whether investors have liquidation preference, whether investors dominate the board, whether the particular investors have a track record of pressuring early exits, etc., then for start-ups that find themselves with these sorts of arrangements and bonkers expectations from investors, they will (hopefully) be completely unwilling to pay the correspondingly much higher wages, much improved benefits, much higher equity, etc., that ought to rightfully be demanded by someone to take an early-stage job with them as opposed to a differently structured company.
In this way, the drying up of their labor market would signal that the investors have not realistically structured the firm and the people who would do the work would not stand to benefit in an acceptable proportion. Unable to find adequate employees willing to take such a bad deal, the start-up dies, and hopefully the founders can find a different way to bring their idea to market such that it's structured to compensate non-investors correctly.
It depresses me how looney tunes the start-up job market is, because the availability of labor -- largely comprised of young individuals who, if educated about this, would care about this sort of valuation estimate, but who, without being specifically educated about it, are impressionable and willing to take jobs for reasons that are not rationally in their interest -- is not doing the necessary job of effectively raising "rents" for bad start-ups (costs of sustaining themselves with adequate staff), and many such start-ups live long enough to make investors money, and sometimes founders, while not bringing employees anything even close to the kind of compensation (not even in "cool experience" points) necessary to make up for the wages, benefits, and personal time they gave up (as compared to a non-start-up job) to make the company function to that point.
It's similar to the difference between people who are educated about their 401(k) options, with plans that are default opt-in and must be specifically opted out of, rather than the other way around. Saying that such people are just expressing a rational preference by not opting in (for plans that require opt-in) is just silly. No, it's some cognitive foible preventing them from doing something they actively want to do for themselves. With start-ups, it's the same idea. Many people in the start-up job market do want to reject companies that make poor wage/benefits/work-life balance offers, but have cognitive foibles that prevent them from correctly expressing their desire to reject without being guided to have a much more specific and structured appraisal of the value of their job offers. And people continue to prey on them by obfuscating that decision landscape by constantly talking about how you should not actually do an expected value calculation, and you should just believe certain things are intrinsically valuable about working for a start-up.
The average revenue multiple for all public companies is 1.62. It varies by industry (see [1]), but eventually most startups will settle into ordinary revenue multiples for their industry, whether they like it or not.
They'll settle into ordinary earnings multiples. Sofware companies typically have much higher revenue multiples because they have much higher gross margins. In this case, the article is talking more about brick & mortar startups.
The lack of financial modelling in most of the startup conversations is astounding. The poster say you should not make decisions only based on models, based on what then? Gut feelings? I know many people want to escape from Corporations into startups, but dismissing finance as non important is not the way to do it. Even a recent post from Buffer in the end was about bad financial modelling (and they had to fire people for that). There is a lot of wisdom in the financial world that would help many CEOs avoid "hard lessons" that didn't need to be in the first place.
"The stock market doesn’t reward big acquisitions in these categories as they often do with Silicon Valley giants, and they’re expected to justify these purchases, at least partially, on financials. This massively constrains the realm of possible outcomes."
> The stock market doesn’t reward big acquisitions in these categories as they often do with Silicon Valley giants, and they’re expected to justify these purchases, at least partially, on financials. This massively constrains the realm of possible outcomes.
Assume you have a 20% margin, then one year of revenue equals five years of profit, or a 5X profit multiple. It may not be ideal, but if the alternative is raising more money, increasing your risk, it's attractive. Also, VCs need liquidity so 1X on a large number today is more attractive than 3X you many never achieve.
However the VCs aren't stupid, they understand this which is why most insist upon liquidation preference. Ultimately the high valuations will end up working against the founder because these unrealistic expectations mean that those with preference will win and the rest will get nothing.
When signing a deal you really need to consider what happens at every outcome. Not just the binary choices of wild success and abject failure. You can bet your adversaries in the negotiation have already done this.