The risks of high valuations in venture capital

When you hear that a startup has a high valuation, it might sound like a win. It makes the company look valuable, and founders get to keep a larger ownership stake. However, having a high valuation can cause issues that could hurt your business in the long run, especially when working with venture capital firms or raising money from equity investors. Let’s look at why high valuations aren’t always a good thing when it comes to company financing and capital raising.

For more insights on this topic, you can check out this post on LinkedIn by Jasenko Hadzic here.

1. Investors may not prioritize your company

When you raise money from venture capital firms or angel networks, these investors offer more than just capital. They provide guidance, industry connections, and support to help your business grow. However, investors have limited time and resources, and they’ll focus more on businesses where they own a larger stake.

For example, if an investor owns 1% of your business but has 10% in another company, they’re likely to spend more time helping the company where they have a bigger stake. A high valuation often means your investors hold a smaller percentage of your company, which may result in less support from them. This can be an issue in seed rounds or early-stage equity investment when you need all the help you can get to grow.

2. Startups need time to grow into high valuations

A high valuation is based on the expectation that your company will grow rapidly. But what happens if your startup doesn’t meet those expectations as quickly as investors hoped?

Let’s say you raise money at a $12 million valuation during your seed round. You spend the funds on product development and hiring, but after several months, the business isn’t gaining traction. Now, you need to raise more money, but investors might lose confidence in your company. As a result, they could suggest a lower valuation for the next round of capital raising, which can signal to others that your business is struggling.

This situation can hurt your chances of getting further company financing from VC firms and other equity investors. In a crowded market where investors see hundreds of pitches, a lower valuation can make them choose a new opportunity over your startup. For a deeper dive into why high valuations can be tricky, you can read Rob Day’s perspective on why founders shouldn’t always be excited by high valuations here.

However, in times of tight capital, like in 2023, a down round (lower valuation) isn’t always a bad sign. It shows that investors still believe in your business and are willing to support it, even at a lower valuation.

3. Recruiting becomes more challenging

Most startups don’t have the cash to offer competitive salaries to attract top talent. Instead, they use stock options as part of their capitalization table to motivate employees. These stock options give workers the chance to own a piece of the company, and if the company succeeds, their shares could be worth a lot of money.

However, if your company has a high valuation, the cost for employees to buy their stock options is also high. This makes the options less appealing, as employees might not be able to afford them. Combine that with lower salaries and long hours, and employees may lose motivation.

Potential hires who ask about your capitalization table and realize that stock options are expensive might also be discouraged from joining your team. This can make it harder to recruit the skilled workers you need to grow.

Conclusion: High valuations aren’t always better for venture capital and company growth

While a high valuation might seem like a success, it can cause problems for your startup, especially when working with venture capital firms and equity investors. It can affect how much attention you get from investors, slow down your growth, and make it harder to attract top talent.

For successful capital raising and equity investment, it’s important to have a balanced valuation that allows your company to grow over time. This way, you can keep investors engaged, give your business time to meet expectations, and motivate employees with realistic stock options, ensuring your startup thrives in the long run.