Why lofty AI valuations are hurting startups in the race for talent.

Perplexity raised $63 million last week, doubling its valuation to more than $1 billion in just three months, while a startup called Foundry recently emerged from stealth mode with a $350 million valuation, and Cognition, a six-month-old AI coding startup is reportedly being valued at $2 billion.

As the funding deals generate a blur of headlines, an interesting side effect is starting to play out behind the scenes. Take Lightning AI, an open source AI development platform that raised $40 million in a Series B round in July 2022, and whose CEO, William Falcon, say he is intentionally holding off on raising a Series C in part because of valuation. A steep jump in valuation, he says, could hurt his ability to attract the best AI talent.

“I don’t want to be in a situation where it’s hard to hire people,” he told Fortune, explaining that he wants to make sure the company’s revenue lines up with a potential valuation.

The higher the valuation, the thinking goes, the less opportunity for the price of an employee’s stock awards to soar. Worse, there’s a downside risk: If a startup at some point finds itself in a situation where it must accept a funding “down round,” employee equity shares could end up underwater.

In Silicon Valley, where equity is a major element of employee compensation, valuation is closely entwined in recruiting efforts. A startup that’s snagged a high valuation is communicating to the market that it has a lot of capital and is stable for the time being, said Matthew Schulman, CEO of data compensation platform Pave. But on the other hand, employees might be skeptical of the value of equity offered. “They might say, ‘this company is overvalued, I’m not actually going to get the value that they’re communicating with me.’”

It’s a challenge that tech workers have long had to grapple with when considering a gig at a startup, but it’s becoming particularly pronounced as AI startup valuations have soared into the stratosphere. And it’s left some AI startups trying to maintain a tricky balancing act between the need for capital to pay for compute-intensive AI efforts and the need to compete for the finite amount of AI talent.

David Katz, a partner at Radical Ventures, says more startups are facing this dilemma as the pace of funding rounds accelerates. “You may be in a situation where you’ve been trying to win over a team or a really strong researcher or a very strong machine learning engineer and the financing is coming at you fast and furious, and you’re concerned that if you don’t bring them in before the jump in your valuation, it’s going to be harder,” he explained.

Today’s job candidates are smart about asking questions about a company’s financial future, notes Lightning AI’s Falcon: “Every single hire asks me ‘What’s your valuation?’ ‘How much money do you make today?’ ‘How many customers do you have?’ ‘What’s your revenue plan?’”

For some of the biggest AI startups, sky-high expectations may be tough to meet even with an extremely long runway. “OpenAI is worth $90 billion or something,” said Schulman. “For that equity to 10X, that means that OpenAI needs to be worth like a trillion dollars. Maybe that’s in the cards, but that’s also asking for it to be the same size as, say, Amazon.”

A high valuation could be a recruiting disadvantage

May Habib, CEO of enterprise generative AI platform Writer, which raised a $100 million Series B in September 2023, told Fortune that she, like Lightning AI’s Falcon, believes job candidates have become more sophisticated about asking about financials. She said she has not only seen an uptick in people asking about the company’s last valuation and how much it will raise next, but that in her view, too high of a valuation can be a disadvantage in recruiting.

“I think it’s because of so much of the loftiness in AI, people want to understand whether they are coming to work for reasonable founders,” she said.

One Bay Area job candidate specializing in tech recruitment, who requested to remain anonymous, told Fortune that he recently interviewed for an AI startup that has already raised several rounds of funding. As a recruiter who often schooled job-seekers in the ins and outs of equity shares, he dug into the details.

“I asked for a meeting with their finance person and with their product person, to understand how they were thinking about the various challenges,” he said, adding that he wanted to know about go-to-market strategy, about the company’s unique value proposition, as well as about fundraising.

Aishwarya Srinivasan, who started a role six months ago as a senior advisor at Microsoft for Startups, said she had previously interviewed at several AI startups. Joining any startup is “borderline gambling,” she argued, but taking the most calculated risk is essential. That means not only asking about valuation and fundraising but about the company’s product launch roadmap, the business model, and the mindset of the founders— how prepared are they to make the startup successful?

Valuation isn’t the only funding-related issue that can come into play. Raising a new round often means that equity shares get diluted, as the company often issues new shares. This is where the reasonableness of the founder, or lack thereof, becomes especially important. Bringing in new investors, at a higher valuation, means that the company has even more to deliver on.

“If you are diluting both current employees and bringing in employees right before a higher valuation it is harder to get the best people,” said Habib, the CEO of Writer.

The worst scenario for any AI startup is a down round—reducing its valuation from the previous valuation. “You’re an AI zombie company, you never recover,” says Muddu Sudhakar, CEO of enterprise AI solution Aisera. If you’re raising money and your growth does not meet your valuation, “that is not good for employees,” Sudhakar added.

One CEO says no valuation is too big if the business is healthy

Of course, not every founder thinks a rich valuation is immediately a bad sign. Renen Hallak, CEO of AI infrastructure platform Vast Data, said if the valuation doesn’t match what the company is actually doing, that could be a problem, especially if the company then needs to raise more money.

“For employee morale, nobody wants a down round and for employee options to be underwater.” But as long as the valuation keeps growing alongside the business, then “I think it’s healthy,” he said, adding that he believes Vast Data’s recent valuation, which doubled to over $9 billion, is warranted. “If you look at the graph of how fast is the business growing versus how fast is our valuation growing, the business is growing faster,” he said. “So employees that joined today, hopefully, three, four years from now will have made a lot of money on their equity.”

Hallak added that Vast Data actually uses the higher valuations to benefit employees with a secondary round after the primary round at a certain valuation, where employees can sell part of their equity based on the new price per share. (Usually this is the sort of thing that would take the form of a tender offer.) “We don’t publicize this so much,” he explained, but “that way, they benefit from these higher valuations because they get to sell at a higher price.”

Jett Fein, general partner at VC firm Headline, also pushed back on the notion that hiring and valuations are tightly connected. “The best talent, they’re looking for the best companies, and the best companies have high valuations,” he said. “But this is where the nuance comes in––there are probably cases where a really good company is overvalued and a very sophisticated potential hire is going to double-click on that and say ‘hold on.’”

Overall, he argued, transparency is key to square the circle between AI startup founders and employees. And both the Bay Area and New York-area job candidates told Fortune that the AI startups they interviewed with were very open about their financial prospects.

“They were very forthcoming,” said the recruiting candidate, who added that he thinks there is an expectation now that these issues will be an important factor. “I think companies are ready for it,” he explained. “Certainly any role of note is going to probably meet somebody from the C-suite, who is generally armed with answers for this kind of stuff.”

Finding the right balance 

Of course, not every company has the option to play the waiting game when it comes to fundraising. Matt Turck, a partner at FirstMark, told Fortune that you need to be “in a fortunate position where you don’t need to raise now or soon and you’re doing something that VCs are excited about so you’re pretty sure you will be able to raise when you need/want to, and you can afford optimizing for hiring top talent now.”

Lightning AI’s Falcon says that is where he is at—and he argues that it helps the company access the best talent. “I can send an email today to most engineers, and we’re gonna get back a response,” he said. “Employees know that the companies they should be working for have lower valuations that have more upside.” Falcon acknowledged that won’t last forever: “When we raise our Series C next, it’s likely our valuation will go up—the question is, is it in line with the revenue so that the next time it will continue to go up? If it is, that’s fine. If not, we’re back to the same problem.”

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