The Price is Right…….(ish)

Let me apologise up front because this might not be one of the most upbeat of topics that I could have chosen to write about.

However, when not just one, but three opportunities came across my desk in quick succession recently all facing similar challenges, I thought there might be something worth exploring.

The companies in question were all looking to raise their next round of funding and looking for corporate finance advisers. Great! I’m a corporate finance adviser.

 On the face of it, they were attractive propositions – strong technologies tackling big problems and with some great investors already on board but in each case there was something troubling me. Casting an elephant shaped shadow over the opportunities was that I felt each company’s valuation was already too high.

Whether it was their last round price or this round’s expectation, warning lights were flickering and pointing to me that valuation was set to be a major issue – big enough to ultimately frustrate a process or at the very least necessitate some painful and protracted discussions before being resolved.

Valuations too high?

How can valuations be too high? Surely it is better to raise as much money as possible, at as high a price possible to minimise dilution?

In theory, yes but in practice….hmmm, you may be storing up problems.

A high valuation can have many causes – it might be a hangover from having raised money in a bull market and therefore different market conditions or the company having been too aggressive in fundraising and raising too much money too early. Maybe the company’s valuation today is too high relative to its commercial progress – having failed to deliver on its promise and not adequately commercialised the technology since the last round. In practice it might be a blend of them all.

Whatever the diagnosis, the treatment might be very painful.….

Securing funding at an excessively high valuation early on can introduce significant risks to a business so an awareness of how to mitigate them is essential for founders looking to navigate the venture capital world.

1. Pressure to Perform

Raising capital at a high valuation sets the bar for future performance. Investors will expect growth and returns that justify the valuation creating intense pressure on the founders and management team to achieve ambitious milestones. Failure to meet these expectations will drive intense scrutiny, and the likelihood of a down round increases eroding confidence among investors, employees, and customers.

AI-chip company Graphcore was recently sold to Softbank for a reported $500m, which might have been considered a success in normal times, until you realise that $700m had been raised and at its peak at the end of 2020 was valued at $2.8bn. Graphcore failed to adequately commercialise its technology despite this huge investment and revenues in 2022 were $2.7m!

2. Down Round Dangers

Down rounds are damaging in a number of ways – as well as existing management and smaller shareholders feeling the brunt of dilution, employee morale can also be impacted if share options lose value. A down round can create a negative perception in the market, making it harder to attract future investors or customers who may view the company as unstable or on a downward trajectory.

3. Challenges with Exit Strategies

A high early valuation can limit exit options as acquirers are unwilling to pay a premium that matches the inflated valuation, leading to fewer acquisition offers. Alternatively, if the company eventually decides to go public, it may face significant hurdles in justifying its valuation to public market investors, leading to disappointing IPO performance.

So, what can entrepreneurs do to mitigate these risks and help me as a corporate finance adviser do my job or to quote Jerry Maguire, to “Help me, help you”.

1. Set Realistic Milestones

It’s crucial to set realistic milestones and be transparent with investors about potential risks. By aligning on achievable goals, you can build trust and avoid the shock of unmet expectations. It’s better to under promise and overdeliver than to face the fallout of under-delivery.

2. Raise in Tranches

Consider structuring the funding in tranches, where additional capital is released upon achieving specific milestones. However, if you do this then any milestone need to be objectively defined with no wriggle room for delays or investment being withheld.

3. Focus on Sustainable Growth

Rather than chasing hyper-growth to justify a lofty valuation, concentrate on building a sustainable business with solid fundamentals. This includes having a clear path to profitability and positive cashflow, strong focus on customer retention, and a scalable business model.

Like Graphcore, on-line car marketplace Cazoo raised significant levels of investment, but successfully managed to generate significant revenues of £1.25b. However, rampant spending and widening losses of £700m could only be sustained for so long and a series of painful cost-cutting exercises precipitated its administration.  It has just been sold for £5m, three years since being valued at £6billion.

4. Manage Expectations

Transparent communication with your investors is key. Regular updates, both good and bad, help manage expectations and build a strong relationship with investors based on trust. If you anticipate falling short of projections, communicate this early and work together to adjust the strategy.

So, what happened with these opportunities on my desk? Although not afraid of a challenge, I nonetheless passed flagging that difficult internal conversations needed to be had before we would even contemplate getting involved.

If the company and investors had not already taken off the blindfold to see Nellie was not so much in the room but had also left them a nasty mess to clear up, then that would make for one frustrating process for all concerned.

Remember, a strong, sustainable business is the ultimate goal—not just a high valuation.

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