Entrepreneurs, Rethink Those Term Sheets

Thesis: The current venture funding environment has created inflated valuations for startups, which may seem like a great thing for entrepreneurs, but its not

In a previous post, I’ve written about how it’s a good time to be an entrepreneur. With the rise of Silicon Valley and huge tech companies, entrepreneurship is flourishing and capital is flowing into private equity firms looking to cash in on the next big idea. The growing demand among firms to get a piece of the action has pushed up valuations year after year, and according to Dow Jones VentureSource, the median pre-money valuation, the value of a company before a venture capitalist invests, for all venture rounds to be $40 million, up from $20 million in 2013. After watching the season 2 premier of HBO’s Silicon Valley, the episode made me rethink my opinion on the private markets and I’d like to revise my old post Good Time to be an Entrepreneur.

In the season 2 premiere, the founder of Pied Piper, the hottest tech startup in Silicon Valley, is raising funds for his series A and is fielding offers from several VC firms. Since everyone is trying to participate in the round, each round drives up the valuation of the round. After speaking with a colleague who’s company took on too much money and didn’t meet expectations, Pied Piper ended up taking a lower offer with a better VC firm.

In my previous post, I talked about my view that today’s venture capital fundraising environment is a function of innovative business opportunities and over-valuations. I argued that as long as investors conduct thorough due diligence, invest for the long-term, and avoid building “castles-in-the-sky”, we could avoid another tech bubble in the private markets. However, as long as the amount of capital and competition continues to grow, investor behavior will be hard to change. VC’s invest their funds across numerous companies with the expectation of cashing in big on at least one portfolio company, so they’re willing to take larger risks, rather than miss out on the opportunity.

I now believe the simplest way to avoid a catastrophic bubble is for entrepreneurs to be the rational ones. If startup companies take money at an extremely high valuation, it’s hard to grow at a rate that meets those expectations. If they fall short of expectations, their next round will end up being a down round, where the following rounds investors buy in at a cheaper valuation. If that’s the case, most term sheets contain anti-dilution clauses where the first rounds investors are protected and the founders ownership is diluted. The entrepreneur digs himself a hole if they take on too high of valuations. Therefore, it’s in the best interest for startups to take on realistic valuations from the right VC’s in order to keep growing at a pace where they meet goals and are able to raise more money. It will be hard for entrepreneurs to turn down large amounts of cash if it’s thrown in their face, but it’s in there best interest.

3 thoughts on “Entrepreneurs, Rethink Those Term Sheets

  1. Chris Pedersen

    I think one problem with your argument is that start ups live from one round of capital fundraising to the next, using that money to fund R&D and pay employees salaries. If these entrepreneurs take less money in a single round of financing they might not be able to pay their expenses before the next round, causing them to go bankrupt or take on debt. Furthermore I think it is unreasonable to expect any entrepreneur to leave money on the table when it comes to how investors value their company.

  2. Thomas Wen Post author

    If startups take on more money in a round, then they’ll have a longer runway (time until the next round) and a higher expected growth rate (irr being a function of time). Therefore, they’ll have more aggressive goals and need to expand quickly, which will require the money to hire more employees, r&d, etc.

    If a startup chooses to take on less money in a round, their runway will be shorter and they’ll have a lower expected growth rate. Therefore, they can set more realistic targets and then work on raising a new round.

  3. Alex Rogel

    Great take. It is interesting to consider startups the next “castles in the sky” and important for entrepreneurs to understand this concept of accepting the right VC rather than the highest offer

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