My daily reading habit is kind of like my workout habit; some days, it just doesn’t go as planned. For proof of this, you need only look at my unread email count (a scary 2,557). I got a little spotty in my TechCrunch reading over the summer, so this past weekend I circled back to some old articles and stumbled upon Greg Sand’s (Costanoa Venture Capital) June post on ‘The Real Silicon Valley’.
I loved how Greg took aim at the obsessive focus on ‘unicorns’ (billion dollar plus valuations) these days, and pushed to shift the emphasis back toward building great companies, not great valuations. He was spot-on in pointing out that if you are trying to build a great company, focusing on a valuation goal will get in the way of executing the high priority items right in front of you.
While almost every entrepreneur or investor would love to say they created/invested in a ‘billion dollar’ company, adopting a one-track mind toward a target valuation can be toxic for a number of reasons:
- You Can End Up Taking Too Much Money: Valuations in the private market are established by priced equity financings. Each new round offers the opportunity to raise your valuation (assuming the business is performing well). If you are chasing a higher valuation, you can end up taking money for money’s sake. Big valuations often come with big rounds of financing, and as Goeff McQueen points out in his August TechCrunch post, raising too much money can cause a lot of problems. I’ve watched this first hand, as a company gets handed a big wad of cash and starts spending way ahead of their own market demand or capacity to grow. It rarely ends well.
- You Might Put Too Many Layers in the Capital Stack: Those same big financing rounds are also typically preferred stock, which has a liquidation preference. In other words, the investor gets their money out first in a sale of the business. As you raise multiple rounds, this creates a ‘liquidation stack’ of preferences through which any sale proceeds need to waterfall before reaching the common shareholders (e.g. founders and mgmt. team). This is not a big deal if your valuation keeps going up until you achieve a strong exit, but it’s painful for common stock holders and early investors when it goes the other way. While founders and early investors might sell some of their shares in later rounds, these rounds are typically not an exit for the existing shareholders. The real exit comes at some later point through an IPO or acquisition. If the ‘unicorn’ private market valuation is well ahead of where the public markets or an acquiring company will value your company, then you better hope a strong wind stays in your sails and you can grow into this valuation. If not, the money at the top of the stack may siphon off any proceeds from an exit.
- Your Focusing on a Performance Goal vs. a Mastery Goal: This may be the most important reason not to focus on a target valuation, and it strikes at the core of what I believe Greg was alluding to when he talked about valuations getting in the way of executing high priority items. Striving for a target valuation is setting a performance goal. Studies have repeatedly shown that for complex problems that require a lot of thought and ingenuity (like building a company!), focusing on a performance goal typically leads to a worse result than if you focus on a ‘mastery’ or ‘growth’ goal, where you aim to get incrementally better at a particular task or skill. As Dr. Heidi Grant Halverson’s studies have shown, people tend to be more resilient and motivated in the face of difficult challenges if their mindset is on ‘getting better’. Performance goals do work well in certain circumstances, but typically for more mechanical or brute force tasks. For complex tasks like building a company, you will likely be better off establishing goals that lead to a mastery mindset, where you put one foot in front of the other and set your focus on getting a little bit better every day. If you are really into what motivates people, spend some time reading Dr. Heidi Grant Halverson’s work in this area, read Dan Ariely’s books, or Daniel Pink’s Drive.