Bigger Isn’t Always Better: What SaaS Companies Should Understand About High Valuations

Virtually every start-up wants as high a valuation as possible. Seems perfectly logical, right? Turns out, the answer isn’t just a simple ‘yes’.

In many capital raises, there is an argument to be made for attaining a high valuation of a company. One compelling factor is that a higher valuation necessitates less dilution for the founders than a lower one.

Consider the following example: You’re a SaaS business looking to raise $1 million. If you raise this money at a $5 million valuation, your stake will be diluted by 16%. That’s because the new shareholders will own $1m of a company worth $6m post-raise. By contrast, if you raise $1m at a $20m valuation, you’re only giving away 4.7% of the company: Post-raise, the founders will own $20m of a business now valued at $21m.

Beyond dilution, there is also a case to make that a business whose valuation is steadily improving round after round can access the necessary capital to grow revenues. This, in turn, can lead to a virtuous cycle where growing revenues lead to a higher-valuations and so on.

The Downside of Shooting for the Moon

Founders don’t start companies dreaming of mediocre valuations. That would be like a baseball player dreaming of playing in the minor leagues. The highest valuation is the ultimate goal, and understandably so. There are stories aplenty of founders who struck it rich, making billions from ventures that started out comparatively modest.

Unfortunately, the reality is that very few start-ups make it to the coveted ‘unicorn’ status ($1 billion valuation or more). Instead, the vast majority don’t make it. According to one study, 67% of early-stage ventures backed by venture capital either fail or don’t reach a level of success needed to justify the outside investment. Meanwhile, only 1% become unicorns. Some of those, meanwhile, ultimately flame out.

The very low odds of achieving unicorn status are a reason to be wary of raising money at a very high valuation. And the reason for this goes back to that famous saying that the devil is in the details. In the case of VC funding rounds, one particularly devilish detail is that VCs often receive what are known as preference shares. These preference shares guarantee the VCs that they will receive a specified minimum return before the founders get anything. A 2X cap*, for instance, ensures that a VC will get a 100% return on their investment ahead of the founders.

As they’re known, preference caps can come back to seriously haunt founders. Here’s why: Let’s say your SaaS company is doing very well, and does a Series A at a $500 million valuation, raising $100 million from VCs who get a 2x preference cap, which equals $200 million. Then, imagine that the next round, Series B, is even higher, valuing the company at $1 billion and raising a further $250 million from VC investors who likewise get a 2x preference cap (meaning they get $500 million before the founders receive a penny).

Everything is going to plan—and then a relative disaster strikes: The high-flying company is sold for $700 million, 30% below its last valuation. You might be thinking, how can this possibly be a disaster for the founders? It’s pretty simple, actually. Even though they own 55% of the company at this stage (following the two prior rounds of dilution), they stand behind the preference shareholders in line. And those preference shareholders are entitled to a total of $700 million based on their 2x caps. That just happens to be equal to the total sale price of the business, meaning that the founders’ equity is worthless.

There is an alternative

The above example is a cautionary tale of what can happen to founders when VCs have the right to a guaranteed return when a super-high valuation returns to orbit. They are protected at the expense of the founders.

A better strategy for most founders is to focus on capital efficiency when raising money, even if that results in a lower valuation. Again, let’s use an example to see how this plays out in practice. Say your company does a Series A at a $50 million valuation, raising $5 million from VC investors who receive a 2x preference cap. Next, you raise $10 million in a Series B round based on a valuation of $100 million. As in the Series A, the VCs get a 2x preference cap.

Then the company is sold for $70 million, a 30% discount from the prior valuation. Based on the previous rounds, VCs are entitled to $30 million before the founders get anything. That leaves $40 million, which is split according to equity ownership. The VCs get an additional $8 million, owning 20%. And the founders get $32 million, based on their 80% equity stake.

The Lesson

In our two examples, the companies were sold for $700 million and $70 million, respectively. But only the founders in the former ended up with money at the end of the day. It’s counterintuitive because you would think the business sold for 10x more would have made its founders rich.

The lesson here is clear: Be very wary of super-high valuations. Unless you manage to cash out at a super-high valuation, the presence of preference shares can cause you and the founding team to walk away with nothing. Often with capital raises, you’re better starting low and making incremental improvements than shooting for the sky immediately.

We all remember the story of the tortoise and the hare. The hare had a great start, but we know who won the race.

Looking for founder-friendly finance? Element Finance offers easy-to-understand term loans, with no hidden fees. We’re always thrilled to meet new people, so feel free to reach out anytime for a no-pressure chat.

* The 2x Cap used is for illustration only, there preferential returns can take many forms and sometimes are an annual coupon which rolls up until an exit is achieved.

Related Articles
View All
Link Arrow