Run the numbers and a lower valuation with clean terms often beats a higher valuation with a large or participating preference, across the range of outcomes that are actually likely.
11 min read · Level 4
I think a founder or existing investor should be suspicious of the most generous headline valuation in a set of offers, not because generosity is bad but because it has to be paid for somewhere. When the terms are clean, a high valuation is a genuine win. When it comes with a large or participating preference, it is often a lower price presented more pleasantly.
Two offers for the same 10,000,000 investment:
Offer Post-money Investor ownership Preference A 40,000,000 25% 1x non-participating B 60,000,000 about 16.67% 2x participating
Offer B looks 50% better on valuation. Now compute what common holders receive.
Exit at 50,000,000.
Offer A: investor takes greater of 10,000,000 or 25% x 50,000,000 = 12,500,000 common receives 37,500,000 Offer B: investor takes 20,000,000, then 16.67% of 30,000,000 = 5,000,000, total 25,000,000 common receives 25,000,000
Exit at 150,000,000.
Offer A: investor takes 25% x 150,000,000 = 37,500,000 common receives 112,500,000 Offer B: investor takes 20,000,000 + 16.67% of 130,000,000 = 20,000,000 + 21,666,667 = 41,666,667 common receives 108,333,333
Common holders do better under Offer A at both exits. The higher headline valuation was more than offset by a preference that takes twice the investment first and then participates in the rest.
Because headline valuation is the most visible term and the easiest for either side to use as a signal of success. A founder may accept worse terms to announce a higher number; a later investor may offer a high number knowing the terms protect them.
High valuations also create a later risk: if the next round cannot match them, it becomes a down round, which can trigger anti-dilution protections and further dilute common holders.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
The next round. Under Offer B, the company's next round is priced at a 45,000,000 pre-money valuation - below the 60,000,000 post-money of the previous round. That makes it a down round, even though 45,000,000 would have been a clear up round from Offer A's 40,000,000.
The down round may trigger anti-dilution adjustments for the Offer B investor, damage morale and signal weakness to other investors. The higher earlier valuation turned a reasonable next round into a problem.
Choosing the term sheet with the highest valuation without modelling what common holders receive and what the next round will need to achieve.
Compute what common holders receive at realistic exit values, not only the best case.
Weight modest exits heavily, since they are more common than very large ones.
Ask what valuation the next round must reach to avoid a down round under each offer.
Treat a higher preference or participation as a cost in money, and compare it with the valuation difference.
When comparing competing offers, or advising founders of a company you hold.
Do not assume a lower valuation is always better. The comparison must be done with actual terms; sometimes the higher valuation offer is genuinely superior.
During the late-stage funding boom of 2020 and 2021, and again in some later rounds, reporting and legal commentary described companies accepting structured terms - such as higher liquidation preferences or ratchets - in exchange for maintaining or raising headline valuations, sometimes creating difficulties at later rounds or exits.
When a valuation seems unusually high relative to peers, look first at what terms came with it.
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