Valuation Suicide

Therefore a poorly priced first investment round can kill a startup before they’ve even, well, started.

This post is about what a deadly valuation looks like, how it comes about and maybe a few ideas on how to avoid one.

If a startup is priced too low on it’s first funding round then this leads to serious dilution after necessary future funding rounds, which in turn causes de-motivation of management team and results in an ultimate inability to raise an institutional VC round.

The core to this is that both founders and investors are not accepting that early stage UK tech companies, probably have to raise 2 seed rounds before they are in a position to raise a Series A round (institutional VC round of £1m+). I’ve got no hard evidence for this, but of all the founders I know and of most of the companies in our portfolio, the majority have had to do 2 seed rounds.

Therefore — if a founding team is diluted heavily on their first seed round, their second is going to be very painful and have big ramifications.

Let’s play it out :)

Let’s say a typical lifecycle for a UK based tech startup looks something like this (pardon the names used, just using brackets and terms widely used):

  • Friends/family/angel/accelerator — £0k-£20k
  • SEIS Seed — £100k-£500k
  • Series Seed/Bridge — £500k-£1m
  • Series A — £1m+

I’ve started to see in the last couple of years that one typical seed round of say £300k-£500k just isn’t enough cash or time to get a company to the level required to raise a Series A from an institutional tier 1 VC.

This seed round is typical in the UK, partly because of SEIS/EIS tax breaks. Thanks to these incentives there is an inadvertent limit on the amount of angel money brought in at the first round. In that first round, Angel money doesn’t usually top more than £150k, which is the SEIS limit for any given UK company. Therefore there is a natural ceiling on the size of a total first seed round which often includes Angels. You might see angels + micro VC = £300k-£500k, which I think is fair to say, the typical UK seed round.

Given these finger-in-the-air funding brackets, lets play out a likely scenario and see how valuation comes into play.

  • Company goes on accelerator program — ~£15k for 6% — 10%.
  • Company raises ~£300k (~£150k angel + ~£150k micro vc) on £1m pre-money = ~23% dilution.
  • Total dilution already ~30%
  • Company needs more cash/time to hit Series A milestones (Funding gap)
  • Company raises ~£500k (existing investors + another early stage VC) on ~£2.5m pre money (generous!) = ~16.6% dilution
  • Total dilution ~46.6%
  • Add in options to advisors/key employees.

The Founding team are left with ~50% of the stock and haven’t even started raising a Series A yet! I imagine any Series A investor is going to need a 20%-30% stake to make their business model work.

Now think how the founding team may feel at this point. I genuinely don’t believe a lot of founders are very equity precious, if they were they wouldn’t raise at all. However, you can arguably say that the real hard work hasn’t even begun before a Series A, so to be at this point with less than 50% of their own business would be a very bitter pill to swallow (if they pulled the round off). Add into this the board seats, the voting rights, the preferences and all the other legal strings, a founder could feel like they genuinely own very little of the company that they started.

Heavy dilution and the legal handcuffs that come with raising this level of venture financing could seriously demotivate a founding team to even want to raise a Series A. It might put them into a position where they are happy to grow steadily, and not pursue the intense growth their VC was looking for. This isn’t a happy scenario for the VC as they may not get the exit/return they wanted.

So, after 2 funding rounds, plenty of dilution and a thick set of legals; either the founding team themselves may well be put off raising a Series A or they are not in a position to do so.

Even with what I think are pretty fair valuations in this example, the cash required to get to a Series A position is extremely costly and could then make it difficult to raise a Series A anyway.

[Let’s say at time of the £300k round this hypothetical company has a solid team, product live, maybe even early revenue, decent traction and a graph going up and to the right for a few months]

Whilst, I don’t think a £1m pre-money valuation at the seed stage is bad, it still makes a Series A difficult down the line. This is because I am predicting that more often than not, a second seed round will need to follow. The second seed round is currently referred to as the ‘funding gap’. It’s not quite your traditional seed round, yet it’s not quite a Series A. The Founders often argue they are just about to hit a growth curve to Series A. The investors may be willing to make the bet, but have no idea how to price it.

I don’t know what the answer to the ‘funding gap’ problem is (more VCs doing convertible loans would be a start I think).

What I do know is; more Investors and founders need to realise that it is likely that this ‘gap’ round will need to happen, and they need to price accordingly for it. Rather than waiting for it to happen, prevent it.

The answer, well I wish I had one! Instead, here are some possible answers which would be interesting to discuss:

  • Teams don’t give away any equity to get started. They bootstrap, lend, work at the weekends and don’t give away 5%-10% to launch.
  • Investors price valuations higher at first seed round. In our fictional example, maybe it would be £300k on £1.5m+ pre-money, which gives the founding team another ~7% to play with later.
  • Companies raise less money at SEIS seed. They are very frugal, they don’t scale as fast and build more traction to get a well priced second seed round. e.g £150k on ~£1m pre-money (instead of 300k)
  • Companies aim to raise much more at their first seed round. e.g £600k+ first seed round.
  • Investors write more convertible loan notes for bridge/series seed rounds.
  • Companies look to raise second seed round in US where valuations are often much higher (happening more and more).
  • Companies look to get to break even quickly to put themselves in a position of sustainability and ultimately in control of their own destiny.

Which of the above might work best?

Onwards,

James

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