So you have started your business, acquired some customers, and now it's time go raise your first round of money from investors. This is commonly referred to as a seed round. How much should you ask for? What valuation should you put on your company? If you are like most founders, then you will try to get as much money as possible for the highest valuation you can. Although this seems like a very sensible approach, getting too high a valuation in your seed round may lead to bigger problems down the road. Let's explore some of the complications that could be attached to high valuation and what you should be looking for instead.
The Hidden Strings Behind High Valuations
Founders often jump as soon as they see a high valuation in their term sheets, but that often comes at a price. For example, you may may need to give up one or two seats on your board of directors. If you don't have a board, you may need to create one and include one of your investors along with a "neutral" party (no such thing) in the third seat. You might also need to create an option pool anywhere from 10% to 15% of your post-money valuation which further dilutes your position in your own company.
There's also much more to term sheets than just the valuation. As a tradeoff for a high valuation, investors may include a participating preferred liquidity preference where they get their initial investment back first and then get to participate in the pro rata allocation of the remaining profits in the event your company is acquired. Investors may also include anti-dilution provisions which punish you if your next round of funding produces a lower valuation, also known as a "Down-Round". Anti-dilution provisions usually come in one of two forms: 1.) Broad-Based Weighted Average or 2.) Full Ratchet. We won't get too deep into the weeds on how to calculate these in this article, but just know that they are both very BAD for founders and will usually lead to you giving away large chunks of your company.
The Biggest Valuation Risk
Let's say you are very lucky, or a great negotiator, and none of the provisions I outlined above are in your term sheet. Then you're home free to get the highest valuation possible right? Well not so fast, because the biggest risk with high seed round valuations is the change in investor EXPECTIONS as you seek later rounds of funding. In early funding rounds, seed and pre-seed, investors are primarily investing in IDEAS and PEOPLE. If they like you and your idea, there's a good chance you can get some money. However, around the Series A/B rounds (the next round after your seed) this changes. Investors at this stage are are primarily investing in PERFORMANCE. They have specific Key Performance Indicators (KPIs) or metrics in mind and your company doesn't hit them, you aren't getting funding, regardless of how much progress your company has made.
How about an example to illustrate this point? If you are a Software as a Service (SaaS) company, one of the key metrics is Annual Recurring Revenue (ARR). Let's say when you raised your seed round you only had $25K in ARR but a VC firm really liked you and your industry and gave you a $10M post-money valuation. You were able to use that money to bring your ARR to $500K, a 20X improvement, which isn't too bad. However, when you go to raise a Series A round you will be very disappointed. The benchmark for most Series A investors is $1M ARR, they really don't care where you came from or how much you improved since your seed round and you will find it very difficult to get anywhere close to a $10M valuation without checking this box. The high valuation you received in your seed round has betrayed you because you now don't have the results to back it up.
Dilution Trumps Valuation
So if valuation shouldn't be your North Star as a founder, then what should take it's place? The answer is DILUTION or how much of your company you are giving away. Taking less dilution throughout fundraising means you get to walk away with more money in your pocket at the end of the day. Let's take a look at two scenarios in the table below.
In scenario A, the founder needed to fundraise 4 times and although their company was valued at $100M, they only walked away with $2M because their position was so diluted. That is not a small amount of money but consider Scenario B where the founder only needed 2 fundraising rounds. Their company was valued at $50M but their position allowed them to walk away with $10M. That is a 5X increase over Scenario A even though their company was only half as much.
The reality is that very few founders will be able to grow their company to $100M, it's hard. To walk away with only a small percentage of your company's worth is deflating, especially when you spent so much effort building it. So if an investor offers you an opportunity to take less money than what you are asking for in return for less dilution you should ALWAYS consider it. That might not be the right answer if you believe in your financial model (more to come on that topic later) but it is at least worth thinking about if you get to hold onto more of your company.
Summary
Fundraising can be a very difficult thing to navigate, especially for first-time founders. Don't get distracted by the golden carrot of valuation that investors may dangle in front of you. Consider all the other terms in your term sheet and make sure you are actually getting a good deal. Above all else, make sure you aren't just throwing away huge chunks of your company in the hopes that investor backing with somehow magically turn your company into a huge success. Be mindful of your dilution and so that when it's time to exit your company you can do it with a smile on your face, and a lot more money in your pocket. If you have any questions on this topic, reach out to us at InfleXion Point. We are happy to help!
Opmerkingen