The Coming Deluge of Challenge

In the last six months, the increase in seed deal valuations is truly stunning. Deals are 2-3x more expensive than a year ago. Post-money "wins" for founders may well prove to be Pyrrhic victories. Per Wikipedia, a?Pyrrhic victory is a victory that inflicts such a devastating toll on the victor that it is tantamount to defeat. A Pyrrhic victory takes a heavy toll that negates any true sense of achievement or damages long-term progress.

The phrase originates from a quote from?Pyrrhus of Epirus, whose triumph against the Romans in the?Battle of Asculum?in 279 BC destroyed much of his forces, forcing the end of his campaign.

I highlighted the phrase damages long-term progress for a reason. While a successful fundraise is always cause for celebration, a post-money in the relative stratosphere will damage the long-term prospects of a company if perfection does not follow.

In 2002, we saw this trend play out with devastating consequences. As market multiples, investor confidence, and company prospects pulled back to earth, the previous post-money doomed a generation of companies to real challenge. New investors needed down rounds to realize rational entry prices, however, insiders, fearful of write downs, were reluctant to allow for recapitalizations and CEOs and boards faced cash cliffs with a standoff between common, inside investors, and new investors who often were either reluctant to lead down rounds or faced boards looking to stave off write downs with inside rounds that protected prior liquidation preferences. The game theory of knowing insiders were going to work to protect prior economics eventually scared off new investors from doing the work to get to a term sheet that insiders would use to price a insider-friendly inside round. Many good companies died due not to failure of product-market fit but due to unsupportable cap tables.

Given the volume of seed deals being done, it is a mathematical certainty that a large number of companies will see growth, customer acquisitions, and product development that marks progress from the seed round. However, the rate and linearity of progress is the key to future fundraising success. A few slow/choppy quarters, team turnover, product pivots, will mean that as the cash runs out the company will be unlikely to live up to the post-money of seed round. Moreover, if multiples compress, for example in Nov '17 the BVP Cloud Index Top Quartile Forward Revenue Multiple was 7.1x and today it is 19x, even dramatic revenue growth will be impacted by multiple reversion to the longterm mean.

So what? My advice is to raise capital with a margin of safety to prevent the seed round proving to be a Pyrrhic victory that leads to your company failing not due to a lack of product market fit but rather a cap table that is not financeable. Optimize for the long term success and not a financing designed by definition to get you from Seed to A, or A to B. There will be another round and the markets will not always be paying 20x forward.