Why We Passed on This Startup (Episode 3)

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.

A Valuation 3x Higher than Expected

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 about the Startup