Pricing your startup to perfection will hurt you

I’ve always believed in the old adage “Perfect is the enemy of the good.”

Most successful startup founders believe this to their core. They launch alpha or beta versions of their products and instead of calling them incomplete or imperfect, they’re promoted as “MVPs,” or “Minimum Viable Products.” When one business model doesn’t work, they don’t change models and hope no one notices; they celebrate their new path to success as a “pivot.”

In both of those instances, startup founders readily acknowledge that being perfect is not a perfect strategy.

However, when it comes to valuation, too many founders see perfect as the right goal. They aim to maximize their valuation and often ignore deal structure or the possible ramifications of that valuation. In my view, this “pricing to perfection” should more accurately be termed “pricing for dejection.”

Recent highly publicized down-rounds and markdowns – when a startup raises money at decreased valuations from their prior rounds — demonstrate the importance of this issue. Zenefits, one of the most noteworthy of the current herd of unicorns, was recently forced to mark down its value from $4.5 billion to $2.0 billion. But for every one of these high-profile examples, there are scores of other lesser-known startups whose pricing to perfection caused their next rounds to fall flat, as well.

Pricing to perfection is when a founder raises money and bases valuation on everything in the world going exactly as planned in the future. Evidence suggests investors have been happy to go along with this fantasy, with the average pre-money Series A valuation more than doubling over the past five years, from approximately $8 million to $17 million.

But perfect is hard.

Sales cycles can be longer than expected. Customers aren’t loyal. Products fail to work on day one. And things completely outside the founder’s control impact how investors view a startup, like Brexit or regulatory change. In short, real life gets in the way. So then, after nine to 12 months of falling short of perfect — of living in the real world — the next fundraising round comes in at a lower valuation.

Knowing that perfect is hard, that venture capital firms are becoming more discerning, and that most startups fail eventually, it’s more likely than not that a founder will experience a down round at one point or another. As such it’s important that founders know the ramifications, both positive (yes, it can be positive) and negative:

You will be diluted. All legitimate term sheets have anti-dilution protections, but they are for the investor, not the founder. In a down round, the value of the investors’ ownership will be protected by increasing the percentage of the company they own. The founder, on the other hand, typically has no such protections.

You will need to find new ways to motivate employees. The startup life is not for everyone, but one of the big draws is the potential for employees to strike it rich via stock options. A startup’s earliest employees and founders, many of whom may have options strike prices in the pennies, will feel a hit in a down round, but there’s still very obvious upside, because even if a per-share value falls, their strike price is virtually nil. But for later-joining employees with a higher strike price, a down round lowers compensation — potentially substantially — and hurts morale, potentially leading them to search for new opportunities.

You will lose momentum, a powerful part of a startup’s story. Momentum is the basis of all startup stories — in many ways as important as their disruptive potential or innovation. Momentum tells investors, employees and the media that they’ve done right to invest in, join or write about your startup. But a down round, even if some other metrics are moving up, kills the momentum story. This often has a long term impact on a startup’s ability to raise capital or attract talent in the future, even if the company is performing well. As Ben Franklin said, “It takes many good deeds to build a good reputation, and only one bad one to lose it.” A down round often has serious implications on startups’ reputation.

You will attract the deal hunters. In their truest sense, venture capital firms are meant to help grow companies, sharing expertise, capital and resources to improve the odds of portfolio company success. When raising money in a down round, a different kind of venture capital investor can arrive — one that is focused more on a one-sided deal than a mutually beneficial partnership. This is not necessarily a bad partner; it’s just different. And your expectations of this type of investor should be different.

You may be replaced. This is a sad reality, as no one cares about a startup as much as its founder. But many of the best startup concepts have failed for execution purposes, and sometimes that means investors need to right the ship with a new executive team. In other cases, a founder’s dilution in a down round may have new investors wondering if that individual still has sufficient skin in the game. For either reason, unless you’re at a very late stage, you’re probably going to remain a significant shareholder, so your goal should always be the company’s long-term success. This doesn’t mean you should roll over if you feel you are the best choice to lead the company, but getting a seasoned executive may be the best option in the long term.

You’ll start talking to the board a lot more. This is perhaps the least surprising result of all. During times of trouble, your board will be paying closer attention to the daily ins and outs of the business, inserting themselves into more decisions than ever before. Depending on how well you’ve chosen your investors, this can be a big positive of a down round, focusing a highly experienced group that might have been under-utilized before.

There’s no way around it. Down rounds are frustrating, and they can bring big changes to the founder’s life. They can be demoralizing to you and your team. They can lessen the financial upside of your idea and your hard work. They can even mean you lose control and see another CEO take over.

In the end, it’s important for entrepreneurs to think about the long-term implications of valuation. While high valuations in early rounds can be an incredible ego boost and limit dilution, “pricing for perfection” can invite down rounds that introduce many avoidable problems.

Imran Ahmad is a principal at OCA Ventures, a Chicago-based venture capital firm.