Lately, one of the big challenges I’ve been discussing with entrepreneurs is the massive reset in valuations. The huge ARR multiples are gone for all but the most exceptional of business models. If the last funding round valued the business at X, and the public markets value businesses with similar metrics at 2/3rd to 1/4th the value, the reality is that the business is considerably less valuable now. Human nature is to ignore the data and try hard to grow into the valuation so that the next round is at least flat, if possible.
The better solution is to make the hard call and reset the valuation and mental anchoring internally.
Internal valuations, for stock options, can be set at any amount equal to or higher than the 409a valuation from a third-party. The 409a looks at the landscape of similar company valuations, does a variety of calculations, and comes up with a valuation for the startup. A recent 409a will reflect the latest data, and likely a lower valuation than the last round.
Now for the tough part: what to do with the existing stock options that are underwater (the strike price is significantly higher than the the company’s valuation)? It’s time to make a plan and roll out new options to employees. As the company valuation is likely lower, this will result in more dilution to achieve a similar level of equity ownership for employees. My favorite methodology for equity grants is from Fred Wilson’s post: Employee Equity: How Much?
The sooner the internal valuation is reset, the sooner the team can start buying into the creation of new value from a lower starting point. Of course, it’s incredibly hard as everyone has the last valuation in mind. By reseting the mental anchoring, and issuing new stock options in a corresponding manner, alignment around the creation of new value becomes achievable. No one wants to go back to then go forward, yet that’s a common theme in life.
Entrepreneurs would do well to evaluate cutting the internal valuation and focus on value creation from a new starting point.