Too Long; Didn’t Read?
If you want to raise a seed round at a stratospheric valuation, then you’d best be sure that you find enough traction before your Series A — as that valuation will be based on metrics, not excitement.
Transitioning from Seed to Series A
A serious sticking point in any term sheet negotiation is the pre-money valuation. At first glance, it might appear that VCs and founders have entirely opposing goals. Entrepreneurs want the highest possible valuation, to maximize the capital raised and minimize the dilution of the founders’ equity. Investors want to buy the largest possible stake at the lowest possible price.
Now before you jump to conclusions (that investors are ruthlessly, singularly interested in “buying low”), let me make an important clarification: one key goal for a VC, as we see it, is to prepare portfolio companies for their next financing round and to work with them on planning and executing those rounds. A great deal of that work starts with setting a present value that will allow founders to raise the next round with a minimum 2x, ideally 3x bump in valuation.
“One key goal for a VC, as we see it, is to prepare portfolio companies for their next financing round…”
Planning what needs to happen for a startup to achieve that increase is what valuation negotiations should really be about. To see everyone’s interests in alignment and to labor side-by-side on distribution strategy, CAC, sales projections, and on a real number — that’s the work.
Founders are right to argue that it is self-serving for an investor to want to bring down the price. In some cases, this may be true. But let me walk you through the potential consequences of the valuation chasm between Seed and Series A.
A Clash of Two Very Different Valuation Methods
In brief, the way we value a firm at the seed stage is very, very different from Series A on up.
In their beginnings, investors value startups almost exclusively by their potential. Investors look to several factors: the founding team’s vision, their ability to execute, the business model and unit economics, the size of the market (TAM), the competitive landscape, so on, so forth. This process is more art than science.
Valuations from Series A, in sharp contrast, take a more analytical approach because there is more to go on. Investors run numbers, look at traction, multiples. The team is still hugely important, as are TAM, business model and other factors, but investors are likely to arrive at value through some form of calculation.
So, what is our biggest fear when we fret that a seed valuation is too high? That when the time comes — as it must — for that startup to go out and raise a Series A, the numbers won’t add up. That the company cannot support that 2 or 3x increase from its previous valuation. And that this will end in a flat round, a down-round, or, worse, in no round at all.
Picture an imaginary SaaS startup trying to raise seed financing. The company launched less than a year ago, raised a $500k pre-seed round to build the product, still in beta but with some interesting initial traction. Last month they made a bit more than $20k in monthly recurring revenues (MRR), or a run-rate of ~$250k in annual recurring revenues (ARR). The market in which they operate is large and growing. The team is solid. Founders are incredibly excited about their initial promising results and raised $4 million on a $20 million pre-money valuation.
In SaaS, valuations of public companies derive from a multiple of ARR. For example, Salesforce is currently pinned at approximately 10x annual revenues, while Adobe is at ~17x revenues. (If you want to learn more about public SaaS company valuation and metrics, check BSV Cloud Index.)
For simplicity’s sake, let’s assume that a good starting point when valuing a SaaS business is a 12x multiple on its annual revenues.
ARR * 12x multiple = $250k * 12 = $3 million valuation
The above calculation is not the major challenge today, as multiples don’t factor in early round valuations. But multiples will most likely be used in future rounds. If the founders expect to double the company valuation between their Seed and A rounds, that would mean an ~$45 million pre-money valuation.
In order to justify that valuation, using the same 12x ARR multiple, the company’s revenues should be around $3.75mm.
ARR * 12x multiple = $3.75mm * 12 = $45 million valuation
This means that the company needs to grow its revenues 15x between rounds. Workable for a sky-rocketing startup, of course, but still extremely challenging, particularly for a young startup that might be better focused on tooling its product-market fit and learning from initial customers.
Valuation negotiations should not be zero-sum. Done right, they are a conversation around milestones and revenues forecasting, where both founders and investors feel comfortable with a variety of growth scenarios and their consequences.
Run the numbers, take educated risks, and look to the long-term. Onward and upward!