On The Perils of Pricing to Perfection

By Eric Paley

These days I find myself talking with our founders often about the perils of pricing to perfection: Founders need to balance the desire to optimize in the short-term against potential long-term fundraising complications.

Imagine you are a “hot” early-stage startup and have $500K in ARR. VC’s are keen to invest and you get two offers:

A) $6M on $30M

B) $12M on $60M

Seems pretty obvious which one you should take, right?

You might ask, “Why would anyone choose anything other than B? You’re literally getting 2X more money for the same dilution?”

I call this kind of short-term optimization “pricing to perfection,” and while it is satisfying at the moment it creates many downstream problems.

E.g. If you raise the $12M round and burn the money growing ARR from $500K to $5M over the next two years, there’s a good chance your investors will be underwhelmed!

If you raised the $6M round, and make the same or even more modest progress, your VCs will likely be excited about the business and eager to put another round together.

Expectations management matters!

This is one of the hardest conversations I have with founders.

Taking less capital seems illogical. However, unless you can efficiently use the extra capital, the valuation premium comes with costs. Very few companies get twice the results from burning twice the capital.

Here’s what you stand to lose when you get an unrealistically high valuation:

More capital isn’t for more runway. They expect you to hire & burn the money in an 18–24 month timeframe in the hope that it accelerates your startup’s progress, and puts you in position to raise a much larger round.

The pressure to grow at all costs will be immense and you’ll be encouraged to spend on underperforming activities to boost growth. As a result, your burn rate will rise, giving you less time to respond to challenges in the market or to fix problems in your execution.

This post explains the dynamics involved in greater detail, but in short, high valuations will increase your stress levels and eliminate most of your margin for error — a costly tradeoff for excess capital you don’t yet know how you’ll use.

When founders can command high valuations it’s usually because their story-telling/reputation precedes their startup’s results. VCs believe they are investing in a rocketship. Slow progress shatters that illusion and creates discontent.

Think of the initial hypothetical from the investor’s perspective. They paid a premium price and are seeing disappointing performance. Is it surprising they are impatient with the founders and don’t want to continue funding an underperforming asset?

If you raise a smaller round and have solid results, there’s a good chance that goodwill & a revised narrative can unlock another round of funding from insiders. If you raise at a higher valuation, have a higher burn & not much better results, inside support will evaporate.

If you’re optimizing for price, you’re getting the investor who was willing to pay the most and that’s seldom the investor you really want to work with — this is short-sighted optimization that often proves irresistible.

Imagine after two years you get an offer to buy your company for $100M and you think it’s a good idea.

If you chose option A, you’d stand to make tens of millions of dollars!

If you chose option B, your VCs wouldn’t likely support the deal.

Founders tend to have big dreams at the early-stage, but running a startup is *really* hard and you may appreciate the exit optionality earlier than you think. Don’t give it away casually.

Startup failure is less frequently the result of bad product decisions or poor financial management. In most cases, what separates failure from success is an extra year or two to get product/market fit or go-to-market dialed in. More capital makes this harder, not easier.

Valuation metrics are extremely generous right now, but they are still primarily driven over time by user/revenue growth. Building metrics that keep up with sky-high valuations is incredibly difficult.

Benjamin Graham famously said “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” This is ultimately true for private market valuations too. What will happen when your once-popular high-priced startup is inevitably weighed?

Growth flywheels can be powerful, but they take time to get going. When you raise at a higher valuation you are trading precious patience for money with diminishing utility while simultaneously raising the hurdle you must clear to raise your next round.

Raising at the highest possible valuation is the startup equivalent of buying more house than you can afford. You may be able to make the payments for a while, and you’ll enjoy a more comfortable lifestyle, but any minor shock could put you out on the street.

At a startup there is so much that is out of the founder’s control — Playing the long game and not inflating value in the short term is one of the few levers entrepreneurs can and should guard jealously.

In summary:

🎰 “Pricing to perfection” increases founder risk by increasing burn rates, shortening runway, decreasing investor patience & eliminating lucrative exit options.

😡 High valuations feel “founder-friendly” but actually create profound misalignment between entrepreneurs and investors that is only seen long after the “awesome” financing deal is closed.

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