Pros and Cons of High Valuation for Startups
The unspoken ambition of any startup is to secure a high valuation. While achieving a high valuation is often seen as a mark of success, it can also open up a can of worms. This blog will explore the pros and cons of high valuation for startups.
We will see how high valuations can make raising funds easy, boost market reputation, attract top talent, and bring positive publicity. We will also see how they can increase the risk of overvaluation, make it difficult to raise funds in the future, make ESOPs less attractive, and create enormous pressure to perform.
Pros of high valuations
Some of the advantages that can come out of high valuations are as follows:
Comfortable fundraising
When a startup secures a high valuation in a fundraising round, it has to offer less equity for the investment it seeks.
Let us examine this with an example.
Suppose a startup called GenSys.ai requires an investment of $1 million. Let us see how much equity must be offered to investors when the valuations are $10 million and $20 million.
| Required investment | $1,000,000 | ||
|---|---|---|---|
| Scenario 1 | Scenario 2 | ||
| Valuation | $20,000,000 | Valuation | $10,000,000 |
| Equity of incoming investors | 5.00% | Equity of incoming investors | 10.00% |
Also, if a startup secures a high valuation from a reputed investor, it can attract more investors. This will be seen as a signal of business viability and strong market potential.
Other investors in the market will have more conviction in the startup’s value and may even compete to invest. They may offer better terms or even higher valuations.
Boosts market reputation
One of the areas where startups tend to struggle is partnerships and tie-ups. Since the chances of survival are the lowest among all businesses, many companies will refrain from partnering with startups.
Some of the partnerships that may look for are:
| Type of partnership | Objective |
|---|---|
| Strategic alliances | Collaborating with companies producing complimentary products to enhance product offerings and market reach. |
| Distribution partnerships | Collaborating with an established retailer or distributor to improve product availability |
| Technology partnerships | Collaborating with technology companies to integrate new technology into their products |
| Supplier partnerships | Collaborating with suppliers to ensure a steady supply of raw materials at cheaper prices |
A benefit of securing a high valuation is that more companies will be open to such partnerships. This can significantly improve the startup’s product offerings, product availability, and cost efficiency among other things.
A high valuation gives other companies confidence and chances of survival. It also boosts market confidence in the capabilities. Thus, a high valuation can open the road to high growth for a startup.
Attract top talents
When a startup secures a high valuation, its perception in the minds of job seekers changes. It sends the signal that the company has a solid business model, a promising future, and the backing of reputable investors.
Also, high valuations bring in the resources necessary to deal with and develop cutting-edge technology. The startup will also have more freedom to pursue innovative projects.
These effects of securing a high valuation not only attract talented and motivated employees but also create a very positive work culture. In such environments, employees are much more likely to make meaningful contributions.
Media attention
When a startup secures high valuations, it becomes a hot topic for industry analysts and business journalists. Such an event really puts the spotlight on a startup. Such exposure can improve a brand and establish it as a credible player in the market.
Media coverage can open doors to networking opportunities, partnerships, and collaborations. It also makes potential customers curious about the product.
The improved visibility will attract the attention of any professional who wants to work in a high-growth environment.
The extra publicity can also help to secure additional funding.
Cons of high valuations
Some of the disadvantages that can come out of high valuations are as follows:
Risk of overvaluation
If a startup is indeed overvalued, it will spell trouble for investors down the line. To begin with, if it is overvalued, in the next funding round, it is more likely to get a similar or lower valuation than to get a higher one. Thus, existing investors will find it difficult to make an exit.
In such situations, the investors wanting an exit are likely to band together and exert pressure through the board of directors to achieve short-term goals that can inflate the startup’s valuation. However, such a mentality can be detrimental in the long term and will stunt the growth.
Now, let us consider what happens when the startup secures a lower valuation in the subsequent funding round. It sends a negative signal across the market. Businesses will hesitate to partner, investors will hesitate to invest, and job seekers may hesitate to apply. Thus, a myriad of problems will befall when it gets overvalued.
Future funding challenges
When a startup achieves high valuations, the market sets very high expectations and If it fails to meet these expectations,the startup will struggle to improve its valuation, a scenario we have covered in the previous section.
The pressure to maintain or exceed the valuation can drive founders to make risky decisions and be short-sighted, which may not always bring positive results. If such startups suffer because of poor decision-making and management, they may find themselves in a downward spiral where risky decisions lead to poor performance, and only risky decisions can be redeemed.
If a startup leverages its investors’ networks and then suffers a down round, it may prove devastating. It will not only lose the confidence of investors who were in it for the long haul but it will also lose its connections if these investors now decide to cut their losses and make an exit.
ESOPs become less attractive
The main reason why employee stock ownership plans (ESOPs)are more attractive than regular ESOPs is because of the growth potential. So, if a startup secures a valuation in a funding round, people may think that it has achieved a chunk of its growth potential and now, the expected returns from its ESOPs are not as high as they used to be.
This can have a detrimental effect in two ways. Firstly, it will become difficult to attract top talent. If someone’s main motivation for joining a startup is wealth creation, then they will prefer it with a fair but promising valuation against a startup with a high valuation.
Secondly, existing employees will start cashing in their vested ESOPs. Once they are done doing so, they will evaluate if they can continue to expect similar gains from ESOPs in the future.
So, there is a small possibility that you will find it difficult to attract and retain employees through ESOPs. Instead, you may have to compensate employees directly with cash.
Pressure to perform
When a startup secures a high valuation, there will be a lot of pressure to perform better so it can secure an even higher valuation in the subsequent funding round. So, founders will feel the pressure from investors. Ultimately, the pressure will also reach the employees.
If a startup cannot maintain a positive work environment after securing a high valuation due to the pressure to perform, it will create internal tensions. Instead of working collaboratively, employees may start working in silos. Instead of solving problems, managers may start focusing on finding culprits.
Also, gain high valuations, their business practices will be under greater scrutiny from investors and other stakeholders as well as regulators.
Unlock your true value and growth potential with Eqvista!
High valuations can be a double-edged sword for startups. On one hand, they facilitate easier fundraising, enhance market reputation, attract top talent, and garner media attention. These benefits can propel a startup toward rapid growth and success.
On the other hand, high valuations come with significant risks, including the danger of overvaluation, future funding challenges, less attractive ESOPs, and immense pressure to perform. You must navigate these pros and cons carefully to ensure sustainable growth and long-term success. The key to leveraging high valuations is to balance ambition with realistic expectations and prudent management.
If you are a startup heading into a fundraising round, you must invest in a solid valuation ask. At Eqvista, we have helped thousands of companies with their valuation needs. Contact us to know more!
