Pricing your seed round is more of an art than a science.
Of course, there are some benchmarks and comparables, but every startup is unique, and it’s easy for entrepreneurs to feel a little confused. Most entrepreneurs understandably fixate on the dilution impact of pricing their startup. But price can have much larger ramifications (good or bad) for your startup.
Based on my experience both raising a seed round for the company that I founded and now investing at the seed stage, here are 5 things to keep in mind:
Don’t attract the wrong investors
There are investors out there whose strategy to get into a round is to simply “pay up.” These funds will find the companies getting the most hype and bid aggressively. Remember that unlike the public market, seed-stage investors have to add value beyond just financial capital. The highest bidder is not always the best bidder. If anything, there is probably a negative correlation because the highest bidder is trying to buy into the round because they can’t get in otherwise. You should ask a simple question of yourself: would you still let this investor into your round if they paid 25 percent less? If the answer is no, then you may want to think again.
But price indicates quality
Ever bought a more expensive item because you perceived it to be of higher quality? As consumers, we generally believe in the theory that “you get what you pay for.” VCs are consumers too, and they are buying part of your company. There is not much information available to a seed-stage investor in terms of financials and metrics, so we are constantly looking for signals and proxies to help inform our decision. Too low a price can be a “turn off” by suggesting a low quality opportunity. I know most VCs won’t openly admit it, but it’s true. Make sure you keenly understand what valuation your peers are getting so you are not underpricing yourself. At the very least, you want to fall in a reasonable range so you don’t set off any alarms.
Be wary of a down-round
Entrepreneurs by definition are huge optimists. When you are raising your seed round you probably don’t even consider the possibility of a down round, a future round where your valuation is lower than the previous round. Unfortunately, it happens. Especially if the economy takes a bad turn and risk capital dries up. Turns out it’s hard to predict when or if the economy will tank, and you can’t always wait for things to get better before you raise money. I know this first hand because we were out raising money with Polar in the middle of the 2008 recession. Fortunately, we didn’t have to do a down round, but fundraising wasn’t easy, even though our company was doing well.
It’s very frustrating when the vagaries of the macro economy dictates the destiny of your fledgling startup. And even if the macro economy doesn’t go into a tailspin, entrepreneurs typically set very high aspirations (sometimes to live up to the high seed valuation) for what they want to achieve by series A. For various reasons, entrepreneurs may fall short of achieving all their goals. This can lead to down rounds, or perhaps make it hard to raise any money at all. The higher your valuation in the seed round, the more exposed you are to a down round in the future. Down rounds are extremely detrimental to the company and you want to avoid them as much as you can.
Price shows hustle
You are the guardian of shareholder value. It’s a good sign if you are pushing for valuation at the top end of the range. It makes us seed investors comfortable that you’ll maximize value for the company and its stakeholders at every stage. Getting in cheap might buy me more of your company now, but you’ll just give it away in a future round if you are not a hustler.
Don’t limit your exit options
We have seen a surge in “acquihires” and relatively small exits recently. While entrepreneurs don’t start companies to be acquihired, you don’t want to preclude yourself from that option. Selling the company for $10 million when you own 20 percent is not an immaterial outcome for most first-time entrepreneurs. And you build street cred for your next rodeo. But if you raised your first round at a $10 million or more post, it’s possible that your investors may block the sale, especially if they feel that the company has significantly more potential. The higher the valuation at your seed round, the lower the likelihood of them supporting a small exit. If you build the next Google, your investors won’t complain about the seed-stage valuation. But the reality is that most startups will have a smaller outcome and you don’t want to limit those options.
Clearly, the price of your seed round will impact more than just how much you get diluted. Perhaps even more so. I wish I could give you an exact formula to calculate the optimal price, but each startup and situation is too unique to be precise. Barring a formula, keep the above points in mind, do your research and make sure the Price is Right!
COMMENTARY:
Seed Startup and VC Firm/Angel Investor Due Diligence
Rest assured that VC's are going to conduct a thorough due diligence on the startups they plan on making a capital investment in. Startup founders should also conduct due dligence on the VC's they are talking to before they approach VC's for startup capital. You should understand the industry space they have invested in, the backgrounds of the founders and managing directors of the VC firms, the stage of development they invest at, and the amount of capital they are prepared to invest. Don't be afraid to speak with the founders of startups that these angels and VC's have already invested in in order to understand their management style and their expectations from their startup founders. I strongly urge that you review my blog posts (Click HERE) on venture capital and entrepreneuring to familiarize yourself with the different types of angels and VC firms, industry spaces where they are investing and current venture capital trends. This will eliminate a lot of misunderstandings and wasted time and effort on your part.
How Startup Valuations Work
The following infographic describes how the startup valuation process works in practicality.
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Startup valuations rise even as VCs don’t get as many exits
Valuations at startup companies continue to increase, even though venture capitalists aren’t cashing out on deals as frequently as they’d like.
According to a new report by PitchBook, valuations in angel/seed, early stage and late stage all increased versus 2011 levels. Meanwhile, deal flow declined and the number of venture-backed companies completing IPOs or getting acquired fell to the lowest level since the third quarter of 2009.
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Virtually all of the decline can be attributed to weakness in corporate acquisitions from software companies, many of which are still sitting on piles of cash.
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According to Pitchbook.
“VC investors realized just 74 investments through corporate acquisitions in 1Q 2013, down from 102 in 4Q 2012 and the fewest since 2Q 2009. We believe this may be an anomaly, however, as broader M&A activity has been fairly strong recently and corporations maintain large cash reserves and easy access to debt. ”
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Here’s a look at the specifics on valuations:
- Median pre-money valuation for Seed & Angel financings in 1Q 2013: $5.38 million. Up 23 percent over Q4.
- Median pre-money valuation for Early Stage financings in 1Q 2013: $14.5 million. Down seven percent over Q4.
- Median pre-money valuation for late stage financings in 1Q 2013: $67.8 million. Up 28 percent over Q4.
You can see the full report here:
PitchBook 2Q2013 VC Rundown Report
Courtesy of an article dated September 26, 2013 appearing in VentureBeat and an article dated April 17, 2013 appearing in GeekWire
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