The Moral(e) Danger of Value Inflation

Times are frothy. No one doubts that valuations of startup companies are rising rapidly. In many cases value inflation is causing companies to see prices rising more rapidly than operations justify. But it’s a sellers’ market, and no one can fault entrepreneurs for stuffing their coffers while they can. Capital is ammunition to help attack new markets and grow rapidly. When it’s readily available it behooves you to consider reloading.

However, it’s not all as simple as that.

Recently, I’ve gotten fairly close to a few folks at a company that had raised quite a sum of cash some 18 months ago. At the time, the new investors in the deal were willing to offer an ambitious valuation. They just wanted in. They offered a valuation that the company could grow into.

The good news is that over the past 18 months, the company has grown into the valuation. The bad news is that all they did was grow into the valuation. As the company has depleted its reserves, new investors have balked at offering a meaningful step up in valuation. They’re willing to participate - but only at a marginally higher price than what was offered a year and a half ago.

Normally I wouldn’t write about fundraising during times of value inflation. It’s an over-covered topic and seems somewhat self-serving for venture capitalists. However, I do believe there is a little talked about facet of fundraising that runs the risk of derailing companies in today’s market.

Namely, a perverse incentive problem for early employees.

In public market finance, there is a pretty well known issue of generational discrimination. You and I, as fellow neighbors, might have an incentive to write other communities IOUs for decades - spending far more than we bring in. We might also die before it comes time to pay the bill. Unfortunately, in this scenario, we might have also saddled our grandchildren with insurmountable debt that they had little to do with creating. This behavior is known as generational discrimination and it’s pretty common.

Raising money on too high a valuation, too early, creates a similar problem. Early employees, founders, and investors always have an incentive to get the highest valuation as quickly as possible. If you’re going to raise 10 dollars, you’d rather raise 10 dollars for a company worth 990 (effectively selling 1%) than for a company worth 90 (effectively selling 10%). As a part owner of the business, you want to preserve your stake. You enthusiastically seek out higher and higher valuations to ensure that your dilution is minimal. And in a market like today’s, you can find those exceedingly high valuations rather easily.

The challenge is that once you’ve closed a deal, you saddle new employees with options at the current round’s valuation. If you grow phenomenally, this process works out fine.

If you just grow well after closing a round at a valuation you can’t really justify, it’s more difficult. In that situation employees will find that their hard work, great product development, and strong sales growth doesn’t translate into rising valuations. New employees become frustrated that good performance doesn’t translate into shared upside in your business. How can it? When you’ve raised on a valuation you can’t justify and can only grow into, you’ve already taken that value off the table.

The reality in that situation is that the early generation of investors and employees have preemptively captured the value yet to-be-created by your newest recruits.

In the case of the company in question, people are frustrated and defeated. Morale is low and dropping every day. If they’re not looking already, employees are thinking about leaving. Even though, from the outside, it looks like a great operation.

Great leaders ensure that when the ocean level rises it lifts all ships (old and new alike).  In today’s market, that’s harder than ever. It’s easy to track down enthusiastic investors willing to pay steep premiums to get into some rounds, paying meaningful premiums to be there. The challenge is making sure that you avoid unintentionally taxing future employees. You need your future employees to be happy and motivated. They’re going to help you build a great company. So make sure that you keep them in mind when you raise your next round.