How founders can avoid overvaluation death spiral by onboarding the right investors

We live in a world that constantly enhances our aspiration to get to the next level. Regardless of our discipline, we want to be better, stronger, faster, bigger, and more profitable than our peers. When nurtured the right way, this constant need to improve acts as an engine for remarkable innovations.

However, there are limits to aspirational thinking because unbridled aspiration comes with costs that an aspirer may not be ready to pay or even be aware of.

When a founder aspires to derive the highest valuation for their startup, it is rewarding for all stakeholders. If such aspirations are left unchecked, that sky-touching valuation becomes like the wings of Icarus, melting under the intense heat and pressure of delivering excellent performance to justify the overvaluation. 

So while everyone may celebrate pulling off a valuation coup, that celebration will be short-lived; that choice leads to a narrow path of overperformance or nothing for the venture. Because if the venture fails to deliver outlier results, the consequences will be catastrophic.

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One may argue that the previous sentence would be true of any venture that raises external capital. However, the price paid by an investor is directly proportional to their expectations of return on the investment. In simpler terms, lunches are never free. If the founder asks for outrageous valuations, they are betting everything on delivering incredible results. There will be no space for performance anxiety.

As entrepreneurs, we are excited and ready for challenges. However, this challenge is like swimming in the ocean with your hands tied together. While the founder may (want to) believe they have enough time to deliver on the promise, their window to do that is narrow–usually 6-12 months from when they get the capital in their account.

In that short window, the venture must:

• Discover their core customer
• Understand the problem worth solving
• Deliver an acceptable solution
• Derive Sustainable Unit Economics (‘SUE’)– the level at which the business makes a profit, and the customer gets more value than the price they paid
• Understand the size of the Serviceable Obtainable Market (SOM), i.e., the size of the customer base with the willingness to pay the price at which the venture will deliver the SUEs
• Attract a significant portion of the Serviceable Obtainable Market at speed and the SUEs
• Showcase size leadership in the category to justify the premium valuation

The venture may have figured out the earlier steps as the business matures. But Steps 6 and 7 drive those hundreds of millions of dollars worth of valuations in later-stage startups.

However, this requires the venture to fight against the law of diffusion of innovation, setting it up for guaranteed failure. Instead of having the time to allow its innovation to be adopted by a critical mass of early adopters, the venture must scale on an aggressive schedule.

Unfortunately, the scale-at-all-costs strategy does not give the venture the ability to sufficiently educate its core customer, listen to them, make adjustments, and let those customers influence the majority of the market.

Instead, the venture must continue to scale regardless, thereby alienating its core customer base and delivering a half-baked solution that is either here or there and facing its ire and apathy. The pressure to deliver on that fast growth is where most ventures will make their cardinal sin–dropping prices to undercut the current solution.

A deathly downward spiral begins, wherein the mass market switches over due to lower prices but expects their existing solution to be upgraded. Unfortunately, they do not have the patience or the vision to adopt the new (and half-baked) solutions. 

Instead, they flood customer service and social media with complaints, forcing the venture to drop prices further and ultimately lose their core customer base. Eventually, the selling price will go below the cost at which the venture produces the solution, which also skyrocketed due to the increased operating team required to deal with complaints and media bashing. Next, the burn starts to rocket out of control, and the investors aren’t willing to take any excuses for the catastrophe.

They want their return or the management’s head on a platter. Due to the high base set in the last round, no other investor will come on board, and even if it did, the negative product reviews would scare them away during due diligence. 

In an overvaluation scenario, the investor expects the founder to hit the bull’s eye 10 kilometres out while going full speed on a tora-tora ride. It lights out when things go wrong, as it usually does in such a situation.

But there is a preferred alternative for founders.

Instead of inflating the valuation of pieces of paper, the founder could focus their lens on getting the right investors at an enticing valuation, i.e., at a discount to the business’s current market value. The founders’ objective is to bring on board the investors that will provide the right mix of time, connections, insights, and patience.

As there is an intrinsic value for the investor, they can be coached into focussing the investor energy alongside the venture’s lens on recruiting critical customers willing to pay for new and innovative products or services. Then, with time on its side, instead of quickly cycling through these critical customer sets, the venture gets the time to address any shortcomings in its offering by involving the customer in the product development journey. This process has a secondary but essential benefit – it creates evangelists out of early adopters.

Now, armed with a better solution and a sales force of evangelists, the venture starts fighting a perception battle of what is the work versus the unwinnable fight based on price. The price premiums deliver healthy margins for the business through which it can choose its investors.

In conclusion, the founders must work hard to make a compelling pitch, whether to sell a premium share price or a product/service at a premium price. But a significant difference between either approach is that the latter is better equipped to withstand the most demanding funding scenarios because it is funded by the most perennial source of capital for a business, i.e., customer capital. It provides the venture with an abundant supply of the most precious commodity while building a venture – time.

Therefore, sell your shares at a discount to investors in return for a longer timeline to discover how to sell your customers at a premium.

Anirudh A Damani is a Managing Partner at Artha Venture Fund (AVF)