Beware the Sky-High Valuation

It's natural for entrepreneurs to want the highest valuations for their company, and lately those valuations have soared. A large of number of tech start-ups including Fab, Path, Evernote, and Snapchat have joined the Billion Dollar Valuation Club.

Because of that, it seems every start-up wants to be a so-called unicorn--that rare, elusive creature that brings investors, board members, and its staff a billion-dollar exit. But those sky-high valuations may not always be a good thing for start-ups.

For starters, these companies may have trouble finding anyone who can afford to acquire them, a problem Nick Bilton addressed in an article on the subject last year. "Apple, Google, and maybe Microsoft are on a short list of corporations that could finance an acquisition of this size without reaching for lint in their pockets afterward," he wrote.

Even an IPO comes with the fear that the stock might tumble after the hype dies down, as Facebook’s did six months after its lackluster initial public offering. Groupon is now trading at $9.69 a share, though it was valued at $12.6 billion before its public offering at $20 a share. Even some no-revenue start-ups are garnering huge valuations, including Pinterest, which was recently valued at $3.8 billion. 

"Certainly if you’re optimizing your strategy to get acquired, then it behooves you to keep your valuation down," says Scott Dietzen, chief executive of Pure Storage, an enterprise storage start-up that raised money earlier this year at a valuation of more than $1 billion dollars. But on the flip side, he says, "the valuation gives us heft and allows us to raise significant money, like the $150 million we closed in August."

Dietzen dismisses the idea that his company’s expectations for growth don't align with those of the investors. "Ours are as high or higher," he stresses. "They continue to be surprised at our rate of growth in our business," which he claims is the fastest-growing storage company in history. “The risk in having a high valuation is when your business doesn’t maintain the fast pace of growth. The street is prepared to pay for the companies that have rapid growth, but you have to just keep on doing that.”

In a recent column in Inc. Magazine, Phil Libin, whose company Evernote is valued at more than $1 billion, cautioned entrepreneurs against taking money from "crazy people" just to get the highest possible valuation. "If a company wants to jack up the valuation, all it has to do is find the craziest investor who's willing to pay much more than anyone else," he wrote. "That might sound good, and a lot of hot start-ups are quick to avail themselves of the multitude of crazy people with fat wallets. However, there's a problem with this that entrepreneurs should consider: If you take money from a crazy person, you'll get a crazy person as your boss. And soon, your boss will be an angry crazy person, when that unjustifiable valuation crumbles under the weight of eventual reality."

Maha Ibrahim, a venture capitalist with Canaan who has worked with Kabam, a game developer, and Cuyana, an e-commerce site, said that perhaps the most notable downside to an inflated valuation is the added pressure to hit big growth milestones, which can threaten morale. 

“If you’re set up too high, it can create a lot of morale issues among the team and the board and the investors,” she said. “At Facebook, everyone made a good amount of money,” but even founder Mark Zuckerberg acknowledged it “didn’t help” when the company’s stock nosedives and drew negative press. 

She also warns that a too high valuation might make it more difficult to get funding later. "When we’re guiding companies, either ones that we’ve invested in or are talking to about a potential investment, the conversation is always a balance between, on the founder’s side, not taking too much dilution and wanting to set the valuation so high that it is very hard to reach milestones that will allow you to raise money at higher valuations down the road," she says.

Ultimately, she says, there are other numbers more important than the valuation. 

"What matters is not how another VC firm down the street values my company but the ultimate exit price," she said. "That’s the only real metric of success, or financial success, anyway, for these companies."