Once upon a time, I met a startup team.

Let’s suppose the two co-founders are Maria and Carlos, with XYZ Startup in the architecture industry. The technology solved an industry problem much more effectively than the state of the art. Within the recent past, the startup had built out its product and was in full customer acquisition mode. In addition, the startup possessed good ability to be defensible against competitors.

Traction-wise, the company was about to cross the threshold into the next tier of growth. Recently, the startup had acquired a highly influential customer in the market. This influential customer had a such a powerful brand that much of the rest of the customers in the market took their cues from this lead customer. It became clear through conversation the startup was approaching or had already tipped a customer inflection point. (I cover customer inflection points in this article.) The startup had all of the telltale signs - they had one highly influential customer, the customer brands in the pipeline were highly compelling, and it was clear from the customer inbounds and word of mouth referrals that the customer demand was starting to pick up momentum - all symptoms of a customer inflection point.

This is a scenario that investors want to be in - before it looks like the dam of demand will break. The startup’s state of play had the makings of a fundraise coming together with strong FOMO.

So, I asked about the current fundraise situation. XYZ Company was trying to raise a round of capital to support the uptick in demand - a very sensible reason. They were raising a round that would include existing investors with some new entrants for those interested.

I then asked about the valuation. That’s when a yellow flag 🟨 emerged.

Maria and Carlos were soliciting a valuation three times higher than the valuation I would have anticipated. There was no lead investor. This was intended to be a bridge round with a combination of existing and new investors. I don’t mind that, but the valuation that they solicited was curiously high.

Furthermore, I was equally surprised to discover that the last round’s terms were substantially lower than the valuation that Maria and Carlos were now soliciting. If the startup had raised previously at a $2.5M post money valuation, this current round was at a $20M post-money valuation.

As an investor, it’s my job to understand that rationale. I went into a mode of curiosity and understanding.

At a fundamental level, I was trying to discover if this valuation jump was due to founder optimism, or because of something else.

✅ My job as an investor is to determine what is driven by founder optimism and what is driven by pragmatic factors. ✅

To take you into my mind for a minute, when I was a founder, I possessed incredible degrees of founder optimism. Thus, I can sense founder optimism with relative clarity. I know what it feels like and I have a keen sense of how it is communicated.

But I also have a sense for the pragmatic.

Especially when it comes to valuation, decisions and convictions around valuations are often driven by what happened in the past - i.e. the previous valuations the company raised at.

Seeing how the early round was at one valuation, and the current round was substantially, and I would even say, illogically higher that it raised a yellow flag 🟨 , I had a working hypothesis.

My working hypothesis was that company had given away too much equity too early in the company’s history.

Specifically, if a startup had given up too much equity too early then the founders would not possess enough equity relative to what is typical to the funding stage they are at.

If this were the case, it would be somewhat logical for the founders to solicit a much higher valuation in the next round (this round) as it would mean the founding team would give away less equity by not being diluted as much. Ultimately, allowing the founders to maintain more equity and still be incentivized down the line.

So, I asked about previous fundraise history and asked about who they raised from, as well as asked to see the cap table. Maria and Carlos asked to schedule a follow up chat to discuss the details.

I received the cap table ahead of the Zoom call and had a frank conversation with the founding team. I noticed a few things:

I discovered that a handful of investors provided the early capital… but then those same investors continued to stoke the fire across several infusions of capital across a span of time in which they were the only investors that had participated.

This was a yellow flag to me. When a startup is tied to a small cadre of investors, then it can easily become the only well the founders goes back to. Every trip back to the investors’ well costs founders equity.

Additionally, in reviewing the cap table and talking with Maria and Carlos, with each periodic infusion of capital, there was hardly any valuation increase… even over the course of the company building better and better traction over time.

As the traction story improves, the valuation should logically accrete to a degree. Except in this case, it curiously had not.

In the case of this startup, the $2.5M valuation in September 2019 was the same valuation as January 2021, then the valuation increased to $2.75M in March 2022. But between Sept 2019 and March 2022, there was a material uptick in traction. But hardly any uptick in valuation to match it.

This dreadful pattern of repeatedly going back to the same handful of investors, combined with the little valuation bump up over time led the company to a difficult snapshot in time - the handful of investors owned a large percentage of equity in the company. Not a majority, but a substantial amount. Maria and Carlos had quite a bit less, certainly much less than typical and appropriate for the company stage.

It is common for a founding team for a high growth startup to own less equity than the aggregate equity of the investors. Yet, in this case, the founders had far less equity that they should at such an early stage.

One of the things that I as an investor need to assess is “Can this company raise a follow on round of capital?”

✅ Investors don’t only think about the current round in play, but also the next funding round.

Investors ask, “Is this startup being set up to be investible in the next round?” ✅

After what I had reviewed, I was highly concerned with the current equity split up and had a low degree of confidence that the next funding round would pan out in the company’s favor. There were three main reasons that I believed this:

I made the decision to pass and sent this excerpt of an email to Maria and Carlos:

“I am concerned that you could raise this round yet that in the next funding round, the valuation will be corrected by a later stage venture capitalist or a recapitalization will be necessary if the valuation isn't more in line with where the market sits. Because of this, and due to the unknown risks on the fundraising side, we will pass on this opportunity.”

The early stages of startup and investor relationship is one of the biggest minefields of startups.

In can happen to any founder or investor, but in my experience, one of the biggest “watch-outs” is first time founders getting investment from investors that are brand new to the high growth venture space.

✅ The ultimate takeaway for founders is to be astute enough so the equity distribution and dilution happens such that you ensure that your startup is investible, in every single round. ✅

(To access other episodes of “Why We Passed on This Startup” series, click here)