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- What is Venture Capital?
- Angels, Pre-Seeds, and SAFEs
- Seed to Series Rounds
- Pre-money, post-money, and valuations
- What can go wrong for founders and investors?
A quick primer on a way startup equity goes bad:
VCs fund a startup with preferred equity. This generally means they get paid back first, so if you raise $100M at a $300M valuation and then the company later gets bought for < $100M, employees and founders get $0.
— JD Ross (@justindross) June 5, 2022
JD brings up a great point about both valuation and capital structure for startup founders to remember. By raising too much capital on too small of a valuation, founders and employees may price themselves right out of any share of equity when it comes time to be acquired or merged.
Forget abut getting rich, they can end up with nothing.
How does it all work though? Let’s get into that today.
🤠 What is Venture Capital?
Venture capital is a segment of investors within the private equity world. Structured and considered institutional investing, venture capital firms are often established as limited partnerships (LPs), or pools of capital, that have the mandate to invest in early stage companies. Some of the money in these pools are the venture capitalists’ own capital, and some is outside investors’ capital that is charged fees for management and performance.
A recent Informationist Newsletter details these fees and how they work, if you want to check that out you can find it here.
In return for the money they invest in the companies, venture capitalists are given equity ownership and often a seat or seats on the company’s Board of Directors.
Venture capitalists usually have knowledge and expertise in the industries they are investing in, and they can be extremely helpful to these portfolio companies, giving advice and guidance on financial efficiency, growth, and operational risk management. This expertise not only gives them an edge in investing, but also helps them when negotiating for the equity ownership and board seats in companies.
How much equity the venture firms get for their investment depends on many factors, including how much capital has already been invested in the company by the founders and/or their families and friends, aka the angel and pre-seed fundings.
😇 Angels, Pre-Seeds, and SAFEs
When an entrepreneur or young company has an idea or business prospect, the first money that comes into the company is called angel money. This capital comes from family and friends of the founder(s) and is considered something of a leap of faith. With no revenues or financial track record yet, the exchange of money for equity at this point is highly subjective and relies heavily on trust and belief in the founders themselves by the angels.
After founders have tapped and fully utilized their potential angels, they will sometimes turn to wealthier, non-institutional, sources for capital in something called a pre-seed round of funding. Pre-seed rounds are not quite large enough for the majority of venture capital funds but are too big or beyond the resources of friends and family. Pre-seeds typically fall below the $250k level and may have a more structured approach to valuation and terms, according to company prospects and expectations.
Angel and pre-seed fundings are sometimes structured as SAFE (Simple Agreement for Future Equity) rounds, where the SAFE converts to equity only when the company raises its first priced round, as then it has actual metrics to come up with a fair valuation.
Once the small company has used all the angel and/or pre-seed funds, and is in need of additional funding to either sustain the business or keep up with early growth, this is when they turn to the institutions and start talking to venture capital firms about Seed or Series Fundings.
🌱 Seed to Series Rounds
Seed funding is often the first round that officially requires an equity valuation, as this is where the smaller institutional investors and venture capitalists enter the equation. This round is to expand on the venture’s initial steps of research and development, patent protection, prototype building, initial product manufacturing costs, marketing, etc.
Outside of angel or pre-seed fundings, this is the the riskiest stage of capital raising most companies experience, and hence, the due diligence process of the potential investors can be the most rigorous that the company will face. The total due diligence process can take anywhere from weeks to months, depending on the interest level of the potential investors, as well as the complexity of the target market. While the amounts can vary greatly, as can the speculative valuations, seed rounds today are usually in the $1 to $3 million range.
Once a company has established itself a bit in its market and has one or more fully developed products, some revenue, and perhaps a growth trajectory, the next round of funding it may seek is called Series A.
This is still considered a development round, and while the company may be seeing some early success, this round of capital is meant to build out and solidify the company’s plan. One major use of Series A funds is typically to hire people to round out the company’s operation make it more effective and efficient.
There are often multiple investors in this round, one who will step forward as the lead investor, committing the most capital to the venture and receiving the most equity in return. One key driver of who becomes the lead investor is the matchup of investor experience and knowledge with the company’s operational needs for efficiency and growth. This active help can be essential for a company with a great product or idea and little to no business or financial experience.
Series A rounds these days are typically in the $3 million to $10 million range.
Once the company is well on its way and operating as a business, it may seek another round or two of capital in order to further its reach and accelerate growth. Series B funding is seen as an expansion round for the venture and is meant to give a boost rather than a base for the company. This allows the company to leverage its success and really take advantage of the market opportunity it is seeking to address.
This is where a company would add key talent rather than just important employee positions. Whether in advertising, sales, or technology, these adds are meant to take the company to the next level.
The investors in this round are often the same as the ones from the Series A round, however the size of capital the company is seeking often necessitates other, possibly larger, funds to participate. While most Series A rounds are under the $10 million level, Series B rounds can reach into the $50 million range, and higher.
If a company is still growing and looking to further expand geographically, push into new lines of businesses, or even make strategic acquisitions, this is where a Series C round may be considered. A much larger capital raise, Series C is often pushed out of the venture capitalist range and into the private equity investor world.
This is possible, as the business is most likely well established and much less risky to the investors, who will be seeking a lower return for the lower risk. For this reason, Series C rounds can easily reach into the $100 million range and above.
💵 Pre-money, post-money, and valuations
So how are all these rounds valued and what percentage of equity is given to the investors in return for the capital invested?
Good question, and the answer is that early valuations are more of an art than a science. And while in later rounds, investors can focus on revenues and future growth projections to make calculations, in early rounds there is often little data to analyze and use for valuation.
Because of this, angels and seed investors tend to focus more on qualitative rather than quantitative factors. They will consider anything from founder pedigree or experience to market opportunity and the estimated likelihood of product success.
As for the math, it goes like this:
Post-Money Company Value = Investment Amount / Percentage of Equity Stake
Where Post-money value is what the company is worth including any investment, and pre-money value would be a valuation that does not include investor money.
So a company giving up 25% for a $1 million dollar investment would have a $4 million post-money valuation:
$4 million = $1 million / 25%
or a $3 million pre-money valuation:
$4 million – $1 million = $3 million
Once past this super subjective phase, potential investors will use any metrics that are applicable to the company, such as KPIs (Key Performance Indicators) for products or offerings, the size of the market it is seeking to address, and its expected penetration.
🤬 What can go wrong for founders and investors?
So, let’s go back to @justross’s Tweet above. While everyone wants to ultimately be successful and make money, there are times when things don’t work as expected or hoped. And in JD’s example, the founders were hurt by raising too much money on too small of a valuation.
One key to note, in virtually all Seed or Series funding rounds, venture capital will end up owning preferred equity. Remember that in the capital structure of any company, preferred equity sits above common equity when there is a claim on assets. And if a company is liquidated or sold for a value that only covers the obligations and claims above the common equity, then common holders are left with nothing. Furthermore, venture capital sourced preferred equity may also require a 2x or even 3x payback before common equity can even participate in the valuation.
Another mistake founders make is raising too little money up front and winding up needing to do subsequent or larger rounds that end up severely diluting their ownership. Sometimes down to a level that is no longer an attractive incentive to do everything they can to ensure the company’s success.
In this case, both the founders and the later investors can be blamed for the structural failure. The founders miscalculated needs and the investors used that mis-step to feed their own greed.
And while you can imagine there are many ways both founders and investors can make a deal go sour, (far too many to go into in this short newsletter) the point is, the most important thing either party can do is to be both honest and conservative.
Striking a balance between each party on the terms is essential in order to align everyone’s incentives and ensure each person involved is rowing equally hard in the same direction and ultimately toward success.
That’s it. I hope you feel a little bit smarter knowing about venture capital, the different rounds of capital raising, and how deals are priced.
As always, feel free to respond to this newsletter with questions or future topics of interest!