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The Trouble With a High-Priced Valuation

Lately, in spite of the down economy, I've been seeing what I would call rich valuations for companies in the digital media space. A certain white-label social networking site, a microblogging site, and a behavioral analytics firm all reportedly raised significant amounts of money at relatively high valuations (and some of these are pre-revenue). From an entrepreneur's perspective, that's fantastic news right? Raise as much money as you can while giving up as little of the company as possible. What could be better?

getting funded badgeCharlie O'Donnell, now with FirstRound Capital, wrote an insightful piece about this earlier this year, when he was still CEO of a startup. The article, titled, "Bizarro Fundraising: Aim Lower, Raise Less, and Lower Your Valuation," seems to go against the prevailing notion that entrepreneurs should try to raise as much as possible at the highest price. His basic message was to raise less money at lower valuations with more modest milestones so that the company can execute on more modest goals and be in a better position to raise money at better terms in the next round. There was some debate in the venture community but I have to say that it certainly made sense to me, and not only because I am an investor.

A high valuation is problematic for a number of reasons. The first, and probably most important, is the impact on the company's ability to attract quality talent. That's not to say that you couldn't (I'm sure the aforementioned microblogging site is seeing a flood of resumes). However, most people in the startup world join startups for the equity upside in a liquidity event or IPO (although the garage sale furniture and stale pizza at 1 a.m. is tremendously appealing). When a highly priced round is completed, guess what—the strike price of the options also go up. In effect, the hurdle for the options to be "in the money" has gone up and the value of the options has decreased. The motivation for the employees coming in after the financing has been materially altered.

Another difficulty in raising a highly priced round is the set of expectations from the new investors. Given the high valuations, the milestones that you'd have to hit to justify the valuation are usually aggressive. The difficulty in setting such aggressive milestones is that if you only complete 50%, you've basically built a bridge to nowhere. When you next need to raise capital, you may be faced with a down round, or in extreme circumstances, a complete recap or non-funding. Lawsuits and tensions around the board about fiduciary responsibilities are common. Not very fun stuff.

Now let me shift gears and look at it from an investor's perspective. There is logic as to why people invest at such high valuations. They don't want to miss the boat on the next potential Google, and while the valuation they pay may seem high, perhaps they can institute other terms in the term sheet that would "protect" their downside and guarantee returns.

One way to attempt to achieve this would be to get a higher liquidation preference or get participation rights. For those of you unfamiliar with the term, liquidation preference refers to the procedure for paying investors off in a sale or winding up of the company. It typically includes two components: a 'preference' (an amount that gets paid before other classes of investors, i.e., a 2x liquidation preference means you get paid twice your money back before any other class of investors gets paid) and 'participation' (the ability to take the preference and then take your share of the remaining proceeds). Even if a company is sold for only half the valuation, you could still double your money if you have a 2x liquidation preference!

The reality is that this scenario is highly unlikely. This is because new investors typically buy such a small percentage of the company that they can't influence the voting on any decision. Earlier investors and employees own the majority of the company and they won't sell unless they're meeting their return hurdles. Nevertheless, we're seeing investors going ahead in high valuations even without this type of protection.

So as you can see, while the media is abuzz about the high valuations, and it may seem like it's a great thing for entrepreneurs, there are risks. Take into account the pros and cons when raising your next round of capital.

paul-leePaul Lee is a founding member and Senior Vice President at the Peacock Equity Fund, a joint venture between NBC Universal and GE Capital. Paul's current Board and Observer seats include 4INFO, Greystripe, and Everyzing. He first started in digital media as a co-founding employee of Click2Asia, a venture-backed online media company. While at Click2Asia, Paul headed corporate development and played a pivotal role in the acquisition and integration of North America's largest online Asian media retailer. Paul entered the venture industry when he joined GE Capital's Technology Finance business. He leveraged his digital media experience and oversaw the growth of the digital media portfolio. Paul received a dual undergraduate degree in Mathematical Methods in Social Sciences (MMSS) and Economics from Northwestern University. In his free time, Paul enjoys competitive BBQ (dry rub only) and practicing mixed martial arts. He hopes to one day to see his beloved Chicago Cubs win the World Series. Follow him on his personal blog or on Twitter.