A few weeks ago I bumped into someone I worked with at a previous startup.

He was still at the company, and had just found out some exciting news: the company’s valuation had increased! Wasn’t that wonderful?

I got to the Hustle Fund office and excitedly told my co-worker the news.

But she wasn’t as excited. In fact, she looked worried.

“What’s wrong?” I asked. “Isn’t it good that the valuation went up?”

What happened next was a 30-minute conversation around why high valuations can be dangerous for early-stage startups.

And today I’m going to pass on these learnings to you.

But first….

Why are high valuations attractive?

Raising money from investors is essentially selling off parts of your business.

Of course, most founders want to own all of their business. But if they need capital to keep the ship afloat, they have to make some sacrifices.

So, an investor will give a founder a check in exchange for a piece of the business (also known as “equity”).

Let's pretend that an investor comes along and offers you a $1m investment and values your company at $4m after that investment.

Since $1m is 25% of $4m, that investor would have 25% ownership of your company, leaving you with 75% ownership.

Still with me?

Now let's pretend that your company is valued at $10m after a $1m investment.

Since $1m is 10% of $10m, the investor only has 10% ownership of your company, leaving you with 90% ownership.

So it makes sense that a founder might want a higher valuation, because it means that she can own more of her company while still accepting the same amount of money from her investors.

But there’s more to consider.

Consideration #1: Investor Incentives

I learned something when I joined Hustle Fund… which is that investors can be really, really helpful.

Investors can…

• Introduce you to other investors for future fundraising
• Introduce you to strategic partners
• Introduce you to customers / users
• Help with hiring
• Give advice on your pitch deck
• Give operational advice (IE - how you should structure your business, how you should launch that new product, how to position the company to be acquired…)

Investors tend to have many portfolio companies. With 24 hours in a day, they’re only able to give meaningful help to their highest-priority investments.

So if an investor has a 1% stake in your business and a 10% stake in another business, and you're at the same stage, which company do you think they'll dedicate more resources and time towards?

Consideration #2: Startups Need Time to Grow Into Valuations

Investors want to see a startup improve.

Stay with me.

Let’s say a founder generates interest in her idea or an early version of her product.

She raises money at a $12m valuation. She uses that money to improve the product, acquire users, and hire a few people.

After 8 months of working on the business, the founder doesn’t see the traction she was hoping for. And she’s out of money.

She decides to raise another round of funding.

Only this time, investors have less conviction in her business. Since she hasn’t proved that her idea is successful, they might recommend a lower valuation, but that looks really bad.

Any new investor wouldn't want to bring the valuation of the company down, so most will likely just reject the invitation to invest.

They’ll see the lower valuation as a signifier that there is something wrong with the business.

And since investors see anywhere from 10 to 1000 pitches every month, they’re more likely to invest their money in a new company with a lower valuation.

Consideration #3: Recruiting

Most startups don’t have the capital to offer competitive salaries to high-quality talent.

That’s where employee stock options come in.

By attracting talent with stock options, founders are able to conserve cash, while employees feel like they have ownership in the company.

Those employees are incentivized to work really hard to make the business successful – because if the business does well, their options will be worth a TON of money…

Right?

Here’s the problem: joining a team with a high valuation means that the price for the stock options is also high.

Employees will realize that they can’t actually afford to buy their options. Couple that with the low salary and long hours, and they won’t be incentivized at work.

This can lead to ugly company culture and low productivity.

And the savvy people who are smart enough to ask about valuation and exercise price will realize that the opportunity isn’t as good as they thought.

So hiring those people will become very difficult.

Well, that was depressing.

Nothing like a harsh dose of reality to start off the New Year, huh?

If you’re looking for more information on valuations, check out Elizabeth Yin’s 2016 post on valuations for seed-stage companies.

And stay tuned for more content from us about this topic.

We deliver tactical, BS-free startup tips via our newsletter once a week.

Interested? Sign up here.