Valuation Lessons from 100 Seed Rounds

Entrepreneur First had its 10th European demo day last month, welcoming in another 24 deep tech companies, this time including those formed through EF in both London and Berlin. We had 500 investors in the room, another 1000 on the livestream and as always, it was a great show!

At EF we’re lucky enough to have done 100+ seed rounds alongside European and Asian VCs in the last few years, with the rate accelerating to more than 50 in last year alone.

I’ve seen most of these deals personally (particularly in Europe) and helped many of them across the line by working with most of the UK seed investment scene.

As our latest batch of companies start to receive term sheets, I thought I’d share of the seed round pricing traps we’ve seen and how to avoid them.

If you remember only one thing from this post, please let it be:

Choose the best investor for your company, negotiate hard, but don’t pick based on the highest price!

Here’s a few reasons why the highest round can be a mistake:

1) High Anchor, Bad VC

The best VC don’t compete on price. They don’t have to. They’re the best. They have a business model which relies on owning a minimum % of your company (usually 15%+ for seed, and 20% for Series A). They know what is required to make their business work and return their funds.

Weaker VCs will compete on price, sometimes very aggressively. We’ve seen less respected VCs entering a bid on an EF company at a very high price. The company then uses this as a high anchor to push the good VCs to their limit, not always a wining strategy.

We’ve then seen all the good VCs withdraw, leaving the company with only a weak term sheet, from which its hard to come back down. The result is a bad round with a weak VC, whereas the company could have had the best seed VC available at a lower price.

Why does the VC matter? They have higher follow on rates, better reputation and relationship with Series A VC, better commercial and talent networks, and are smarter and more interested. You want the best one you can get.

2) VC Party Round

Another possibility when a very high anchor has been created, or the company has received a number of term sheets and pushes the price high, is that no single seed VC can take the round. The VC business model allows them to write a maximum cheque size (varies by fund) for a minimum %.

If the round gets too high, they may hit their max cheque size, and end up at their minimum ownership threshold. The result of this is that you can have 2 or sometimes 3 VCs in your round as none of them can do it alone.

Now that may sound like 2 or 3x the support, but the reverse can be true. If you have 2 or 3 VC on your board at Seed — you’ve just created a Series B style board in terms of complexity at the most fragile stage of your early company life. If the VCs disagree over strategy or execution, you’ll spend much of your board time aligning them, not getting their support.

There’s also the chance that as each one has a small position, none of them have the critical mass to concentrate their attention. The lower their stake in your company, the biggest the risk that they could walk away.

There is of course the chance that both can support you, and both can provide further capital — and we have seen this too. So if you’re going down this route, make sure both VCs share the same vision for the company, and ideally have a history of working well together.

3) Follow on Death Trap

The last major issue we see with very high seed rounds is the follow on death trap. The average age for a company raising Series A from founding is 40 months (yes, 3.5 years!).

Some do it quicker, a handful from each EF batch go straight from Seed to A. But most do it slower, and if you raise your first round for 18 months runway, you’ll probably need a 2nd seed before you hit real Series A.

(Mish and the Local Globe team have published an excellent post on capital requirements and timing to Series A, which provides more detail on the path to A.)

Most VC are looking for a 2 or 3x upside on their seed investment. If you raise at £2m-£5m pre, and you don’t get enough traction to get to A, you can still raise a second seed at £6m or 7m, or even £8m or £10m pre and still have room before you hit the Series A valuation space at £15m+. If you raise straight away at £7m or £9m pre — there is very little room for error in a second round that isn’t an A.

You risk becoming too expensive for Seed VCs to lead a follow on round, and with too little traction to attract a Series A investor. No one wants a down round, and without a new lead it’s hard to get existing investors to follow on — hence the follow on death trap. We’ve seen this too.

So what does a great round look like?

It’s led by a VC that knows your space, cares about your company, you respect — both at the partner level and the associate level — who has a significant enough stake in your company to really care, and at a round price which appropriately values your company, but is not so crazy that it damages your chances of a great follow on.

You want strong governance, e.g. they will take a board seat, or at least hold regular meetings with you to help out — being left alone by your VC is actually a bad thing. Having to prepare for meetings, having someone to chew things over with and be challenged by, is all useful to focus your mind, develop your thinking and raise your game.

A great round composition will have the VC take the majority of the round, (for EF companies, we’ll come in alongside the VC at Seed and continue to support you), and you’ll have enough space for some really great industry specific angels. Mostly this is with a single VC.

Sometimes you could fill a whole round with angels or small cheques — but the danger is no-one cares and no-one has enough capital to bail you out. No governance is not good for you (yes, even if you’ve done it before — you’ll make new mistakes this time — I know I did).

So there you have it. A high price isn’t always best. The best performing companies aren’t always those that raise the most.

If you’re lucky enough to have multiple suitors — choose carefully the best option for you and don’t get carried away on price if it damages you.

We certainly won’t tell you what to do and for EF companies we’ll join your round and support you in any case and at any price — but we want you to succeed and learn from the lessons of EF companies past.