Gagan Goyal
May 1, 2019
Valuation myth

How to value the company while raising the first 2–3 rounds (Seed, Pre-Series A, Series A) is one of the common questions in a founder’s mind. More often than not, founders are seen trying to value their startup

  • In comparison with past benchmarks
  • By calculating on the basis of annualized revenue or GMV multiple
  • By using some proxy value such as users multiples, average contract value and so on

These rationales for evaluating their companies, is quite common among founders. I have personally come across this with many startups at seed stage, including my own portfolio companies, when they are raising their Series A.

This is the founder’s myth, there isn’t any scientific basis to the valuations for a startup before Series B/C round.

For initial rounds of funding, VCs do not think in the same way on valuation as the founder does, they calculate from their venture investing business model point of view.

Venture Capital and Startup Valuation

For early stage companies, institutional VCs value using 2 parameters— First, is the VC’s expected ownership share (% of share holding), and second, their standard cheque size in that company type (stage & sector). VCs do it this way because they think from the point of view of the eventual exit.

VCs in their mind try to visualize the exit potential while evaluating a company. They think in terms of the amount (ownership value) they would make at the time of exit. In doing so, multiple phases of dilution are taken into consideration, and then, a VC decides the initial ownership claim through back calculations. The investment needed to attain that ownership, is decided based on their portfolio construction approach, fund size and stage of the company.

Usually, an institutional fund (seed and Series A) works with a minimum ownership threshold, as well as, a standard first cheque size. The equity number is seldom flexible. The cheque size, however, is negotiable at times.

VCs first make up their mind about the investment decision. Once that is done, they try to fit the deal within these numbers. Once they get the desired ownership, in the successive round (next 2–3 rounds) they invest Prorata to maintain their ownership, and during growth/late stage rounds, they start diluting.

Sweet Spot

Below numbers are with reference to the Indian venture ecosystem and Seed and Series A rounds.

Note that above table does not include an additional dilution for the ESOP pool and prorata rights of existing investors (generally happens during series A)

Seed Round

So, for instance, consider a seed fund(early stage VC) which is evaluating a company for a seed round. Usually, seed funds demands more than 20% stake for a cheque of around 500k USD. This, however, might be slightly negotiated depending upon the founder’s ask and negotiating play. Generally, VCs increase the cheque size while negotiating to get the desired ownership.

Seed VCs also prefer a clean ESOP pool of a minimum 10% so the total dilution in the seed round is 25–30%.

On the other hand, a Series A VC, functioning in the same situation, usually demands at least 15% ownership for the same cheque size as above. In fact, some of them even offer a cheque size as large as 1Mn USD for 15–20% of ownership shares. Primarily, this difference is due to the fact that the Series A VC can raise the stakes in the next round. Better as this may sound to founders, it nonetheless has some significant downsides which I will share in another article :-)

Series A round

In this round, a new incoming VC will expect 20% or more for a $2Mn+ investment, there is some room for increasing the cheque size. In addition, the seed VC also retains its equity by virtue of its pro rata right so overall dilution goes to 25–30% for a $3Mn+ raise. Additionally, there is a dilution of 2–3% to top up the ESOP pool to bring it back to 10% (assuming between seed to series A, some early employees were offered ESOPs). So effectively, for a Series A round, total dilution from founders side goes to 27–33% for $3Mn-$5Mn raise.

There is definitely an exception to above, some of those situations are :

  • When a serial entrepreneur with a good track record is raising
  • When two series A investors are competing or jointly investing in a Seed round
  • When a company already has a Series A investor in the Seed round and is raising the next round from another Series A investor
  • HOT companies or Spaces — like a YC company, social commerce (currently hot in India)
In a Nutshell, during seed and series A fundraising, there is less of science and more of an art to valuation, founders need to budget for 20%+ and 30%+ dilution respectively, room to play is more on the amount, not the equity.
This post was written By Gagan Goyal for & appeared in the daily on 02-Apr-2019
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