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.

We (Cayuga Venture Fund) just signed up a term sheet with a new company (Company X).  No need to disclose the company name or industry for purposes of this post.  Rather I want to briefly comment on the process leading up to the term sheet and next steps.

First, the process:

1.  We first engaged with Company X in mid August. It is now mid December.  So our diligence and exploration process took us 4 months.  That is normal for us.

2.  The diligence involved us learning a great deal about Company X’s industry because we have not done a deal in this space previously.  It involved calls with 4 or 5 parties in the space.  It involved a ton of back and forth with Company X’s CEO.  It involved Company X finding a technology lead during our process.  It involved a lot of work by Company X (and by us).

3.  Critically, during the process, we came to trust the CEO and the team.  The CEO was hyper responsive to requests.  He struck the right balance between “salesman” and “information provider”.  This is not always easy.  I loved the fact that the CEO was the person feeding us the answers.  No delegation.  And they were typically good answers.

4.  Also, during the process, we had to clean up the company’s cap table and make sure that we all agreed on who owned what on a pro forma pre-money basis.  Without having a complete pre-money cap table, it is impossible to calculate a share price.  I use the term “pro forma” as often there are equity issues that need to be resolved prior to the deal closing that are NOT currently reflected in the company’s current cap table (like planned grants to advisors, co-founder true ups, etc.).  Sometimes those issues take extra time to resolve.

5.  We presented our first draft of the term sheet to Company X about a week ago.  I told the CEO that I was presenting a basic Series A term sheet with very normal terms.  I called him prior to delivery to point out a few things to purposely draw his attention to them.  No surprises.

6.  He came back with very few comments after reviewing with legal counsel and some of his others advisors.  Perfect.  Fair all around.  The way it should be.

Now for the next steps.  Here is how I outlined them to the CEO:

1.  Line up the balance of the investors.  We are doing $400K out of $1mm, so we need to get commitments from about $600K of additional investors.

2.  Once the $600K is lined up or mostly lined up then I will ask our fund’s lawyers to draft the deal docs and we will engage IP counsel to do an IP review (high level).   It is important to “turn $$on$$” counsel only after we feel good about the deal closing.

3.  Company X will respond to our “boring” diligence request list items by setting up a file sharing box.   We will then review and get our lawyer’s input on items as necessary.

4.  Get the investment documents all negotiated and close the deal in January.  Hopefully there won’t be much to do on the documents, but there are always issues.

I am writing this all down as I think it is important to understand the process at a granular level.  There are a lot of steps and they take time.

Let me know what questions you have.  And Happy Holidays!

One of my favorite aspects of both my jobs (VC and Cornell) is making connections with people.  Real, in person connections that last.  I also find that using the connections is satisfying.  But perhaps the biggest reward is when using a connection results in something very unexpected.  Here is an example (and I am keeping names fictitious as this deal is not done yet).

Our fund recently gave a term sheet to a company in what I would call the technology enabled B2C retail space.  Company makes a custom made product that you wear, but the “making” is highly tech focused, specialized and personalized.  The company is quirky in that regard.  Quirky is a good attribute.  It also has the potential to get very big.

So I got permission from the founder of the company (let’s call her Suzie) to share the deal with one of my VC friends at Fund X (let’s call my friend Joe).  I have known Joe for a long time.  Both of us are Cornellians and our Cornell lives intersect professionally.  Anyway, Joe looked at the company’s materials and decided they were strong enough to share with a few other people that he knew had interest in the space.  One of those people is one of the most well-known female angel investors in NYC (let’s call her Jane).  I had no clue that Joe knew Jane.  I thought “Long Shot, but it certainly cannot hurt.”

So Jane gets the material from Joe, meets with Suzie (the company founder), loves what she sees, but more importantly really likes Suzie.  Suzie feeds Jane more information, and we talk about how to “on board” Jane and get her involved in the company as an investor an advisor.

Three weeks later, after a few more meetings between Suzie and Jane, my partner and I get an email from Jane that starts with “Okay…just finished speaking with [Jane]. SHE IS INVESTING!!”

What joy!  Suzie did the hard work, which makes me incredibly happy and validates Suzie’s abilities (always nice to know prior to investment – we have not invested yet).  Jane is known to be an incredibly helpful investor (lots of connections, passion, etc.).  And Suzie is so excited and motivated.  She wrote in the same email “[Jane] really gets what we are doing and believes its a game changer.  Okay…now I need to go jump for joy and burn off some of this extra energy!!”

Back to my point – this whole unexpected outcome resulted from my initial outreach to Joe.  I trusted Suzie enough to introduce her to Joe.  Joe trusted me enough to take the meeting with Suzie and then introduce Suzie to Jane.  Suzie got Jane on board.  And all without LinkedIn, Facebook, Twitter, Tumblr…..whatever…..

Use your personal connections carefully, but use them……the old-fashioned way.