On seed rounds valuations

Valuations on seed rounds are a timeless debate.

Every 6 months at YC Demo Day time the debate gets reignited given the average YC company raises at a pretty vertiginous valuation.

As usual, a tweet sparked it all:

Ilan introduces the debate from the founder’s perspective: if you are raising a seed round at a $15-20M cap (which if pre-money, means a $25+ post most of the time), Ilan’s argument is that it dramatically increases the difficulty of raising a Series A or Seed extension at a higher valuation.

Should you maximize the valuation when raising a seed round?

That’s the question every founder asks himself. Well, not everyone: some just go straight for the highest val possible.

There is a whole LOT of advice online, but the survivorship bias present in all of the advice received from both founders and investors doesn’t really help making the decision.

The way I like to think about it is in the framework of upside maximization and downside minimization.

If everything goes amazingly with your company and product during the seed phase, then obviously having maximized the valuation will result in the lowest possible dilution.

But, if things don’t go that well, and let’s face it – things never go that well, and the road to Series A will be a tad longer, then having a super high val starts to become a truly existential issue for the company.

I’ve raised two seed rounds on the entrepreneurial side, both very large and both at steep valuations, and I’ve regretted both of them.

Raising 2.5-3M on a $15M cap, means that you’re already at a $18M post. If it takes you a bit longer to find product market fit or prove the metrics that are needed for a Series A, then you’ll have to do a seed extension (second seed, seed +, bridge, whatever your preferred naming is) – and things get ugly very fast there, for both the entrepreneur and the investor.

So at that point you have three choices:

  • Extend the seed at the same valuation. This sounds easy enough but there’s a number of problems:
    • raising at the same valuation of 2 years prior is never a great sign, for previous nor prospective investors
    • the dilution hit will be significant, as it’s essentially doubling the amount of the initial seed raise
    • and on top of that, a $18-20M post is still steep for a company that hasn’t proven itself!
  • Raising at a lower valuation: this is basically a no-go
  • Swinging for the fences and trying to do a seed+ at a slightly higher valuation:
    • not everyone will be able to achieve this
    • the problems of the first point all mostly stand, especially the new even steeper val

Note: YC has recently introduced post-money SAFEs which should solve this aspect, but the point on dilution stands.

So essentially as a founder, you have a bit of extra equity to gain if all goes well, but you’re essentially gambling the company away for it, because if something doesn’t go to plan, those three options up here aren’t all that desirable.

Should you care about pricing when investing?

Soon into the debate, Garry Tan weirdly enough missed the whole point of it all and switched it completely towards the investors side.

Felt really weird, but now we’re here. And pricing is one of the most interesting debates going on in venture investing – and one where you usually find two very opposite camps.

The argument for price insensitivity

As you can see, the YC camp is firmly in the “price doesn’t matter” camp. For the YC-school thinkers, the power laws of venture capital make it so that getting into the right company at a high price will dwarf the returns of getting into an average company at the right price.

Essentially, the only thing you should really care is finding, and getting into that unicorn.

They make it sound like it’s the most obvious thing, but the reality is way more nuanced.

The first thing to realize are the incentives: YC, until recently, used to get a ridiculous $300k post valuation (they invested 20k for 6.06% common stock, and the $100k at $10M post for 1% actually came from a YCVC fund with other investors). (I don’t know the structure of the new $150k deal).

And then, when you look, the people that tell you this, all got into their best deals at extremely cheap pricing. The first round for Twitter, Uber and so on, where all on single-digit post valuations, something that rarely even happens again now.

But the argument usually goes: getting into Uber at $5 post or $20 post doesn’t really matter, the important is getting it.

But the reality is that it does matter. The difference is a 4x return.

Some quick venture math

So say that you have a $30M fund ($25M investable after fees, 20 $500k checks and $15M follow ons)

Your $500k check. At $5M post, you’re getting a solid 10% of a company. At $20M post, you’re getting 2.5%.

Skipping pro-rata math for simplicity, and assuming a solid 70% dilution before exit (option pools and other investors do take a lot of space on the cap-table), you will be left with a 3% or .75% depending on the post valuation you invested in.

This means, that to return your fund twice over, the first investment requires a $1B exit, and the second one a whooping $4B. A $15M difference in cap at seed means $3B plus in difference at exit (or $30B, if we’re talking about a $10B vs $40B exit).

This simple math makes it clear to me that both camps are right: if you get an Uber / [insert other ginormous decacorn here] then you will be just fine.

But it’s also clear that raising the post-val meaningfully raises the stakes.

First of all, even in a decacorn-like situation, you’re returning a fraction of the capital you would have at a lower valuation.

But more importantly: not everyone will get a decacorn in their portfolio.

Imagine getting a company you backed at the seed round with one of the leading seed checks in the deal achieve a $1B exit (and there are only 10-20 every year in the US), which would make you one of the top investors in the country, but returning just a quarter of your fund on it. ($1B*.75% = $7.5M)

In my book, that would be a pretty miserable failure.

So: if you are extremely confident that you will find your decacorn, then by all means, investing at $20M pre is fair game. But, if like most investors, you think that already finding one $Billion dollar outcome in your fund would be a success, then being disciplined on pricing is a must-have attitude.