Keep Your Early Rounds Small, Your Valuation Reasonable, and Close Quickly
December 1, 2014 | By Kevin Vela
It’s no secret that Dallas is blossoming as a startup hub. The communication and shared knowledge in the community has been fantastic, which has led to lots of excitement in the scene. One of the consequences, however, has been an inordinate amount of very early stage companies seeking outrageous amounts of money at obscene valuations. I’ve recently seen several seven and even eight figure valuations for pre-MVP companies. It’s silly. This is not to say that there isn’t a time and place for that, as early stage valuations are not one size fits all. But if you are going to market with a $1M plus valuation for your three month old company, your resume should sparkle with previous exits.
Really, I don’t think this is as much of a valuation problem, as it is a budgeting problem. Early stage companies are over-estimating how much they need, and how much investors are comfortable giving them at this stage. This is leading to a disconnect in early stage financing.
Ideally, you give up 15-20% per round. So if you’re raising $1M or even $500k, you’re going to need a sky-high valuation to stay in that range. But most early stage companies do not need to raise $500k or $1M, and they certainly should not have seven or eight figure valuations. This is a conversation that I routinely have with my clients. Rather than focusing on the valuation, let’s talk about how much money you actually need, and what you’re willing to give up for that cash. An early stage company should not be seeking 12-18 months of operating reserves. Scale that back to 6-9 months and then take $100k – $200k at a valuation of $400k – $800k, and start building your company. Focus on raising as little as possible to hit your next major milestone(s) and then go out and raise more at a higher valuation the next time around.
The benefits of raising less at more reasonable valuations are plentiful:
1) It’s much easier to raise $100k on a $500k valuation than $500k at a $2.5M valuation (and significantly easier than raising $1M at a $2M or $3M pre). Most early stage raises have a lead investor. If you can find that one investor for $100k, you can close the round off of just that investor.
2) Closing a round quickly is a great story. It will increase interest in your company and looks good in the marketplace. I’d rather tell an investor “Sorry, we can’t take your $25k now, but we’ll call you in 6 months” instead of “thanks, I’ll let you know when we raise another $400k to hit our minimum.”
3) You can let your investors know that you will stay lean and hungry.
4) You can get back to building your business more quickly.
5) You’ll likely have fewer investors to worry about. Funds and angel groups likely won’t invest in early stage companies, so you end up with a bunch of $10k and $25k chunks. Those can muddy your cap table if you do get to $500k in an early round. Instead, close your $100k – $150k round, then go to sophisticated/institutional investors in 6 months and tell them that you closed a small seed round, hit your milestones, built out your MVP, and now are ready for a larger seed round.
6) You can work out the kinks of dealing with legal, investor communication, accounting, etc. on a much smaller scale, and again, with few investors.
If this is done correctly, your valuation should increase accordingly so that after your second early round, you’ve given up approximately the same amount of equity as you were going to have to give up with your original larger seed round. Except that now your company is way down the development path, instead of stuck in fundraising mode.
Finally, the info above should be part of a capital raise strategy decided by the founder, advisors, and counsel. Like I said earlier, raising money is different for every company. But asking for unreasonable valuations very early on can be detrimental to your early stage chances for success. Make sure you’re asking for the right amount to get your company to the next stage.