Intuitively you would think that you should work out a business plan and – depending on your strategy – work out how much money you need for the coming 24 months. This is how much you will want to raise.
However, founders are flexible: You will figure out what to do with USD 100k but also what to do with USD 100m. So the best way – even if this sounds a bit paradox – is to start from the other way round: How much money should you get at your current valuation? This chapter describes how to come up with this figure.
Fundraising is a long-term game, not a one-time transaction
Two things are critical to understand for entrepreneurs:
You will need much more financing than expected
Most founders massively underestimate how much money it takes to become a globally relevant company. While you may have a plan to reach break-even with USD 3m, this does not mean that you will not want to raise another 20m thereafter to scale quicker. It typically takes 5-7 funding rounds for a company to reach unicorn status.
Constantly increase valuation over time
Most first-time founders see a funding round as a one-time transaction. They try to get the highest possible valuation in a specific round (even if this may come at ugly terms). How wrong. You are on a journey with further financing rounds coming up, and want to optimize for the end result.
Let’s have a look at a typical long-term journey. Here is a fictional startup founded in India that reaches unicorn status over time:
Company status and valuation driver
Company status and valuation driver
Two young entrepreneurs have a convincing idea (and some wireframes) for an app that optimizes processes for construction companies
Pre-seed round of $100k at 400k pre
Successful pilot done with a renowned Indian construction company, letter of interest received. Plan to scale to entire company
Seed round of $1m at 4m pre
Product rolled out to various Indian companies, MRR of USD 100k, 15% monthly growth, plan to launch product in US
Series A round of $7m at 21m pre
First success in the US, MRR of USD 1m, 96% retention, 6% monthly growth
Series B round of $35m at 100m pre
Segment leader in the US and India, MRR of USD 3m, attractive margin structure (CAC/LTV), 5% monthly growth
Series C (also called "Pre-IPO") round of $100m at 380m pre
Great equity story, annual growth of 60%, EBIT of 20% in core business
IPO: $270m raised at 900m pre
The example provides some key insights: Rather than maximizing the valuation of specific financing rounds, the founders focused on creating sustainable value increase over time. While investors got more and more ownership in the company, they created substantial wealth both for themselves and their shareholders.
What percentage should I give away in a financing round?
The 3x valuation increase that we propose to aspire for over the coming 24 months is not a magic number: There are startups who have reached a higher increase – and most investor will not shout at you if your valuation is “only” 30% higher in two years.
But you need to be ambitious to build a unicorn, and 3x over 24 months is a reachable goal for early stage tech companies.
Let’s assume that you are planning to do a USD 2m seed round at a pre-money valuation of 8m, resulting in a post-money valuation of 10m. The 3x valuation increase means that you want to reach a pre-money valuation of USD 30m over the coming 24 months, which would then enable a USD 10m Series A Round.
- You could go for less – but most probably this will come at the cost of slower growth, and the work needed for a smaller financing round is about the same as going for a bigger round.
- You could go for more – but this will come at a higher dilution, which could lead to trouble in future financing rounds.
Make sure you understand the difference between. If we discuss giving away 15-25% of ownership it is the percentage of the post-money valuation that is relevant.
Fundraising is psychology: The sooner you get into FOMO stage (described in Phase 8
), the better your chances of closing the round and accelerate the process. So you should start your financing round with an explicitly stated goal of a funding round that equals 15% of dilution. If you get into FOMO stage you may increase the size of the round – up to 25% is acceptable. We will tell you in Phase 5
how to reflect this in the term sheet, and in Phase 8 how to execute it.
So what does this mean? Let’s assume that after some analyses you think that your company’s current pre-money valuation should be USD 5m. If you raise USD 1m you would give away 17% of your company (USD 1m / 6m).
It is ok to increase the size of the round to USD 1.5m if you see that you can oversubscribe it. Such a larger round would give new investors 23% of the company (USD 1.5m / 6.5m).
- Have a very clear mindset: You will give away around 20% of your company in the upcoming financing round
- For psychological reasons you will communicate 15% when you go out to investors, but be open to make the round larger (up to 25%) once you get into the FOMO phase
Play with valuation - and keep the other terms standard
There is a saying in the VC world that goes like this: “Tell me the valuation and I tell you the terms”. By playing around with terms such as you can technically reach any valuation wanted. In fact, this is how many companies have built exorbitantly high valuations. However, in many cases this has kicked back and even ruined companies.
We are very strict proponents of “clean” terms. This means that your term sheet should not contain any such terms, making valuation the key variable in the financing round. We will further discuss this in Phase 5
. Don’t worry if you are not yet fully comfortable with all the different terms of a financing round. For the time being it is important to know that valuation will be the key parameter to set in the fundraising round.
Shouldn't valuation be proposed by investors in their term sheet?
Right – this is how conventional theory goes: You go out with a deck, talk to potential lead investors, and they will provide a term sheet which includes valuation and other terms.
Having said this, you need to have a very clear view on expected valuation at the very start of your fundraising journey. Here is why:
- Experienced investors assume that the size of your financing round is around 20% of your post-money valuation. So by mentioning the size of the round you implicitly set your valuation. This is much less of a black box than sometimes assumed by entrepreneurs.
- You should have a very clear view about your current valuation and how it will increase with the funds you are raising.
- Fixed terms will make the fundraising process much more competitive.
So there is no way around having a clear view on valuation before starting the fundraising process.
So what is the current valuation of my startup?
Early stage valuation is more of an art than a science. However, there are different ways to get to a valuation that will be accepted by a relevant number of investors.
First of all it is important to understand typical valuation ranges. Here are some insights:
- Pre-seed (USD 20k-200k raised): Typical valuations will be in the range of USD 100k to 1m. The team is crucial here.
- Seed (USD 200k-3m raised): Typical valuations will be USD 1-10m (the upper range usually only reached in a highly competitive ecosystem such as Silicon Valley). It’s all about the team and initial traction.
- Series A (USD 3-15m raised): Typical valuations will be in the range of USD 10-50m. You typically need to be able to show product/market fit and strong revenue traction.
- Series B+ (USD 10m+ raised): Typical valuations will be USD 50m+. Most often the valuation will be a revenue multiple based on comparables
- Late stage / public (valuation of several hundred million USD+): Besides revenue, profitability / EBIT-margin becomes important. Also, as your forecasts become much more accurate, DCF can be applied more easily.
Obviously these valuations are only rough indications. However, knowing these ranges – and having a very good explanation if you think your company is in the upper range or even outside of it – will be a good starting point.
An often-heard advice is to go for the maximum valuation you can possibly get in the market. However, we feel that this is not the way to go. Here is why:
- Make the process work: Starting your financing round with a reasonable valuation in mind is the basis for getting FOMO and closing the round quickly. While some investors may accept a higher valuation, if too many drop out of the process due to concerns with the valuation you will be worse off. Getting back to investors at a later stage, telling them that you have decided to lower valuation, is not really an option: most probably investors will not be interested anymore, and it is hard to keep yourself and the team motivated to restart the process. Much better to leave some money on the table, get traction, and keep everybody motivated and performing at speed.
- Happy investors will support you in the next round: If you are able to substantially increase your valuation in the next round, you will make your investors happy. If they are happy they will participate again and make intros to their network – both crucial for making the next round happen. Happy investors = happy founders.
- Prevent down-rounds: It will take various financing rounds to build a successful tech company, as discussed above. You want to build a solid track record over time, providing steady growth of valuation over several rounds of financing, and with this building strong ties and trust by your investors. Most companies do not grow linearly, and have ups and downs during their path to an exit. If you don’t try to maximize valuation in every financing round you will strongly decrease the risk of a down round. Preventing this is usually far more valuable for founders and early stage investors than accepting a somewhat higher dilution in a specific round.
The most insightful way to test valuation is talking to potential investors. They see hundreds of different deals in your space and have a good feeling what sounds right. But hold your horses: Before going out (we will do this in Phase 7
) we will develop a convincing pitch deck for them to put your company into perspective with other companies.
So for the time being: Discuss valuation in your team, research the valuation of comparable companies (note that this is not always easy to find), check out valuation tools on the internet (e.g., this one
from PwC, this webinar
from 500Startups, or read this article
from a16z about the importance of growth in valuation), discuss with existing investors and board members, talk to fellow entrepreneurs who are at a similar company stage, and try to come up with a first hypothesis what your current valuation could be. Don’t worry – there is room to iterate over the coming two phases.
- Work out a first hypothesis what your current (pre-money) valuation is. Put this on one slide, with some argumentation how you came up with the number.
- Calculate the size of the upcoming fundraising (see step B above): The "official" target communicated externally is 15% of the post-money valuation, your internal objective is 25%. Write down the two numbers.
How should I structure my round? Equity vs. convertible/SAFE
There are different options to structure your financing round – and some of them may be easier to implement in specific situations than others.
So here are the different options you have:
- Equity round: Also called “priced rounds”, equity rounds are the standard in startup financing. An investor brings in money and at the same time gets shares in the company.
- Convertible loan: This is a loan that converts to equity in context with the next financing round. Investors usually receive a discount (e.g., they can convert at a valuation that is 20% less). There may also be an interest rate, and a valuation cap. It is crucial to understand local regulations to set this up in an intelligent way.
- SAFE: Similar as a convertible loan, a so-called “Simple Agreement for Future Equity” is an investment that is converted in a future equity round. It is technically a warrant and not a loan, which depending on jurisdiction can mean less regulation / easier implementation. It is used mostly in seed stage, and very common in Silicon Valley (where it was brought to prominence by YC).
Many entrepreneurs like convertibles/SAFEs as they can defer valuation. They think that their startup will be much more valuable once they do a priced round – which will be a great deal in case there is no cap. While this may play out in some cases it can backfire if you can’t execute the plan.
Unless you are a (pre-) seed stage company in the US (where you may want to go for a SAFE), we propose to go for priced rounds at clean terms. We will discuss in Phase 5
what clean terms means for us. In most jurisdictions this should not take more time or generate higher legal fees, and is preferred by most investors (everybody invests into equity rounds, not everybody into convertible loans).
In any case, looking at the big picture you should not worry too much about equity vs. convertible. Over time the structure of a specific round is much less relevant than making sure that you constantly increase valuation over time.
- Decide whether you go for an equity round, convertible loan or SAFE
- Discuss your choice with the lawyer
How should your financing round be called?
While the naming of financing rounds is confusing for most first time entrepreneurs, investors have very clear views around this. You will hear things like “We are focusing on A-Rounds”. So it is relevant how you call your financing round.
A general rule of thumb is as follows:
- Pre-seed: Idea stage
- Seed: Some first traction, maybe even some first revenue
- Series A: Product market fit, revenue of USD 1m or so, ready to scale
- Series B: Proven business model, substantial revenue (USD 10m or so), scale fast
- Series C+: Finance growth, product expansion, geographic expansion
You would look stupid if you called a USD 1m round before generating any revenue your “Series B”, even if you have raised 500k before and called this previous round your “Series A”.
So here is our recommendation: Don’t move up the “ABC-ladder” too quickly. Call your first round “pre-seed round” rather than “seed round”. Also, don’t be afraid to call a later round your “Series A2” rather than “Series B” if you feel that this makes sense – nobody will prevent you from doing this.
- Define how you will name your upcoming financing round
Define the size of the incentive program
The salaries you pay are most probably not competitive with the ones of Google, FB and other tech companies. But you still want to hire the very best talent. This is where incentive programs come in. A fundraising round is the perfect solution to set this up, or top up the one you already have.
There are different forms of incentive programs. Option programs (also called ESOP) and share programs are widely used. And virtual programs (sometimes called “phantom shares”) have gained popularity in different parts of the world. All options have pro’s and con’s, and you will need to discuss the best option for your specific situation and jurisdiction with your lawyer.
But independently of the solution you are choosing, you will want to provide 10-20% of your startup’s future upside to employees. Here are some further guidelines to choose the size of the pool:
- Rather 10% if the founders (who already own a substantial part of the company) cover the needed competencies, and/or if you tend to push towards a trade sale over the short to medium term;
- Rather 20% if you need to attract various key people, and/or if your objective is to set your company up for standalone success.
Beware that investors like to see that the incentive program is already created BEFORE the round (= dilution is borne by the existing shareholders). However, from a founder perspective you can argue that this should be part of the round, and be created at the same time as the capital raise. Your negotiation strategy should be the latter if you already have a 15% incentive program and “only” protect it from dilution.
If you have nothing and want to create a 20% program, you will probably need to set this up a bit more sensibly, and work out a proposal with your lawyer that is acceptable to new investors.
- If you don't have an incentive program for employees: Discuss with your co-founders and existing shareholders whether and how to handle this in the future
- Discuss your plans with the lawyer who will support you in the financing round