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May 20, 2014

The dynamics of a series A round have changed in recent years. As seed rounds have become much more common, it’s been said that the “seed is the new series A”. This is sort of true – it used to be that Series A’s would often happen pre-product, and certainly before product-market fit. With capital efficiency, companies in certain sectors have been able to do more with less and show some market traction even after a pretty modest seed round.

The end result though is that the dynamics around series A rounds has started to seem pretty murky for entrepreneurs.  But for investors who see a lot of these deals, it’s not as unpredictable as it seems.  Below are some broad guidelines on the major topics around series A’s that I hear entrepreneurs thinking about.

VC Ownership:  Institutional VC’s that lead series A rounds still target ownership in the 20%+ range.  Historically, VC’s wanted a bit more, 25% or so, but 20% is a threshold that has been around for a long time.  This hasn’t really changed. As a result, questions around valuation are less about “what is the value of this company” and more “how much capital is a VC willing to part with to buy 20%?”  This is why larger funds are on average are able to be a bit more aggressive on price than smaller funds because they can stretch to invest a bit more to get the ownership they are looking for in a competitive situation.

This leads to some interesting sub-dynamics, especially when a larger VC is in your seed round. In theory, if that VC is really excited about the opportunity, they should be willing to pay a higher price for the series A than anyone else because they are already partial owners of the company.  It’s a lot easier to get an investor from 7% ownership to 20% vs. getting a new investor from 0% to 20%.  In practice however, this doesn’t happen as often as you think, because large VCs that bore the seed risk will often feel like they ought to get higher than 20% ownership because they put in the hard work early in the company’s life.

I find that it’s also pretty typical for an existing VC investor to be willing to syndicate the deal with another outside investor.  This enables the large VC to have another deep pocket around the table post Series A to be able to add capital into the company with less friction in both a good and bad scenario. In that case however, the founders might end up taking a lot of dilution. The existing investor will need to buy up to get to 20%+, and the new investor will want to buy 20%. This potentially makes it all worthwhile if the round is pretty large, and this is how some series A rounds end up being $10 – $20M of new capital, rather than the more standard range of mid single-digits.

Speed and Timing: Insitutional seed rounds typically provide companies with enough cash to take a company around 14-18 months.  This assumes some increase in burn over time, but the capital could also be stretched to go longer.  As an entrepreneur, one could always make the argument that it’s best to keep operating longer and show more progress before raising to get the best valuation possible.  In practice however, many companies that have the most successful series A fundraises raise their rounds much sooner, often <12 months from the seed. This happens for three reasons.

First, time is of the essence.  Waiting 6 months longer to raise may improve valuation in the short term.  But having the capital in the bank to make the most of an attractive opportunity sooner usually is the better move overall and will enhance valuation in the long term.  Second, when things are working, founders will usually lean into the opportunity with the capital they have, which will reduce runway but make their growth curve steeper.  Third, it’s more advantageous to raise capital when you don’t need it, and having a nice buffer gives you more boldness to negotiate a better deal.

This certainly is not to say that companies that take longer than 12 months or raise their A are not successful.  In fact, there are a quite a few examples of companies that needed to raise extensions of their seed to get to a place where a successful series A could happen.  But for companies that have something that is working, I find that being more aggressive and raising sooner tends to be better at the series A stage.

Who To Choose?: Series A investors are almost always going to want a board seat, and it’s very hard to get rid of a board member that you don’t like.  Therefore, who invests is much more important than valuation.  10/10 times, I will recommend that a founder go for the series A investor that they have good rapport with, trust, have aligned vision with, and they believe will most impact the long term performance of the company.  Investors that will pay a higher price but have misaligned styles and goals just aren’t worth it.

Valuation: Taking my own advice, I propose thinking about valuation in terms of round sizes.  There are broadly three buckets of series A’s, and therefore, three valuation buckets.

  • Solid Series A: New VC investor invests $3 – $4M and owns 20-25%.  This suggests a post-money valuation range of $12M – $20M.  Remember, usually the round is bigger than just the capital that the new investor puts in because of pro-rata rights or other smaller angels that may want to participate.  That’s why I’m focused on post-money here and solving for the ownership ranges of the new VC.
  • Great Series A: New VC investor invests $5 – $6M and owns 20-25%.  This suggests a post-money range of $20M – $30M.  These are terrific series A outcomes.
  • Outlier Series A’s: Outliers exist with extreme traction and/or extreme competition for the deal.  In these cases, a new VC investor invests $7M+ for 15% – 20% ownership. In these cases, the new investor may break their rule to own less than 20%, and is writing a large check for series A standards. This does not happen that often. Sometimes, you see rounds like look like huge series A’s and it’s discouraging to entrepreneurs.  The reality though is in those rounds very rarely happen and/or something else is going on. Something else might mean that the total dilution is a lot higher than one would think because an existing investor is also buying up.  It might mean that the “seed” was actually quite a bit bigger than the typical institutional seed, so the company has already taken in a fair bit of capital.

Founder Liquidity: It used to be that founder liquidity would almost never happen until very late into the life of a company.  Today, it’s become a tool that is used earlier to better align incentives between founders and investors.  Usually, it’s not a huge amount of liquidity – often a few hundred thousand dollars to a million max.  It’s enough so that the founders will feel emboldened to step on the gas and go for a big swing rather than play it conservatively to preserve value, but not enough that they won’t work maniacally hard to win.  I personally think this is a reasonable thing, especially when founders have gone a long time with limited pay and/or are struggling with the dilution of a big round. It’s not uncommon these days to see some founder liquidity in the series B and C rounds of companies. It’s still very unusual to see them at the series A stage as usually, an investor wants every dollar to go into the business they are investing in. But it’s not entirely out of the question, and can (in very rare instances) be orchestrated in large series A rounds when there is a huge amount of competition and investors are scrambling for ways to get as close as possible to their 20% threshold. But overall, I’d recommend not even considering this until later in the fundraising path of your company.

 

  • Andrew Pitz

    Great article! Thanks for providing a set of guidelines and industry standards to Series A financings.

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