The Post Money of Your Series A is Not My Problem

I was giving some advice the other day on how to approach Series B investors in terms of valuation.  Here is the hypo (all $$ amounts changed):

1.  Company X raised its Series A at a pre-money valuation of $5mm and it raised $4mm dollars.

2.  So the post-money valuation after the Series A was $9mm.  And the Series A investors then owned 4/9s of Company X.

3.  The Series A round was taken by $2mm of institutional investors and $2mm of angel investors.

Easy facts, but note that because the Series A round was rather large compared to the pre-money valuation the resulting post-money valuation is substantial.

So now is the time to raise the Series B.  Company X has met its milestones.  It has received necessary approvals to sell its device.  It has built out the team.  It has just started to generate revenue.  The team is energized.  It expects revenue of $1.7 million in the coming year.

What should the pre-money valuation be for the Series B?  First of all, when receiving a pitch from an entrepreneur, I hate it when the slide deck has a bullet that says something like “we are raising our $5mm Series B at a pre-money valuation of $17mm”.  Last time I checked, the pre-money valuation was the #1 most negotiated term in a deal.  And you are now trying just to dictate it in a slide?  That makes no sense to me at all.  You might even be low balling yourself by accident.  I would much rather hear “we are raising our $5mm Series B and our pre-money valuation thinking is reasonable; and the next slide has a simple use of proceeds for the proposed raise.”   Now you have opened yourself up to a normal negotiation if in fact I am interested.

Second, and the real point of this post is that while the management team of Company X certainly wants the Series B to be at a higher pre-money valuation than the post-money valuation of the Series A, that in and of itself is rather irrelevant to the valuation discussion.   The fact that the Series A investors accepted to live with a post-money valuation of $9mm in this hypo does not mean that the pre-money of the Series B should be above that.

For example, in this hypo, Company X expects to do $1.7mm of revenue in the coming year.  Let’s assume that the Series B investors think that is reasonable.  The first question they are likely to ask or research (or both) is “what do companies in this space sell for stated as a multiple of revenue”.  I asked the Company X team this question and the response was “3X range”.  So, the Series B investor might take $1.7mm times 3 and get a number that is obviously less than the Series A post-money.  The gap is real.  And the arguments for the gap are valid.  “I hit every milestone,” says Company X so “how can we not be worth more than the Series A post-money?”   To which the Series B potential lead investor says “hey, your post-money is not my problem – why should I invest at higher revenue multiples than what the industry is seeing?  If I do, then I am taking a huge risk that my return will stink.”  Expect this discussion.

One good answer to this gap is that the Company X team must show the Series B investors that they are investing in the future of Company X (not just the next 12 months revenue) and can still make a great return (say 6X and above).  This is obviously true and works well if Company X does not anticipate needing another round of financing, expects to build the revenue ramp quickly and has good product margins.  But beware of the gap!

Lessons:  don’t try to dictate a pre-money valuation in a slide deck and don’t think that the Series B investors will care about your Series A post-money (and this applies to Series C looking at Series B post-money too…..obviously).  The best route to a high valuation is to get multiple term sheets….again obviously.

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