The Price of High Seed Stage Valuations
Valuing a company in the early days is extremely difficult, not just for venture capitalists, but for entrepreneurs too. The problem is that conventional wisdom says, “the higher price the better”, but in the world of seed investments this a proven fallacy.
Based on Crunchbase data on Pre-Series A funding, the marginal benefits of $500k commitments disappears between $2MM-$2.5MM, where additional capital no-longer has a correlation in improving the odds of supplementary funding rounds.
In the earliest stages of a business, without the benefits of balance sheets or income statements, valuations are generally a product of how much money a business raises. Investors will own between 15%-30% after an institutional seed round, so, working backwards from the raise amount, one can assume the more money invested, the more the companies were valued.
So, why is it that the companies that were once valued more highly than their peers, didn’t see an increase in future fundraising success? Well, the answer may lie with the fact that an illiquid asset valuation isn’t what it’s cracked up to be.
The paper millions that founders are sold on as the “valuation” isn’t really valuable to the founders at all. For starters, in 18–24 months the valuation is going to have to be justified by the numbers. Without being able to do that, and in doing so securing a next round of financing, the value is actually going to be close to zero.
Further, unless the company exceeds that initial valuation, the VC partner is going to take pretty much all of the pie.
Consider this scenario, rounded out for basic math. A founder receives a term sheet that values the company at $4MM and raises $1MM from VCs. So, after the raise, he owns 80% of the company and VCs own 20%.
After a few years, he reach a deal to sell the company for $2MM to a competitor instead of continuing to grind it out. The VC takes at least $1MM of that deal, leaving him with at most 50% of that $2MM asset sale. Why? The deal that had the investors owning 20% of the company only works out like that if the investor converts to common stock. Instead, in this scenario the investor will use the preferred stock to keep 50% of the proceeds despite their 20% ownership.
So, how much is the right amount to raise? I would argue the focus should be on raising just enough to devote all of one’s energy over the next twelve to eighteen months building the best possible product or service. From there, it will be about creating a story that not only justifies that initial price but enables building a compelling case to increase it.
In conclusion, there is asymmetric risk raising a highly priced seed round. On one end, there is a tolerable but costly chance at more dilution than necessary. On the other, there is a fatal chance that raising too much will kill the odds at a future round (or the next round is at a severe discount, cramming down the cap-table). Although some may argue as a VC I’m “incentivized” to bring down prices of seed rounds, I disagree for the reasons discussed above. My incentives lie in helping early stage companies succeed. Even 100% of zero is still zero.
