This is the third post in a mini series that analyzes the startup investment cycle. If you are looking for a general overview of the cycle, please refer to the first post. The subsequent post then discusses the specifics of the cycle in the CEE region. I recommend reading both before moving ahead to the next two topics: valuations and investment sizes.
The right investment size
The investment size is actually not that difficult to calculate in the early stages when you don’t generate revenue: just look at your expenses (which is mostly salaries) and estimate how long it will take to get through that stage. How long does it take to build the first prototype of my product? 3-6 months? And will it take 3 people with 1,200 EUR each per month? So I should raise between 10-20k for the angel stage, plus a buffer. For seed investments the logic is very similar. Credo’s strategy is to give between 12-18 month run rate at this stage, so just estimate your costs for the next 12-18 months. Very strong startups can actually show promising traction earlier than that, and are able to receive the Series A round less than a year since the seed investment with a comfortable level of cash still in the bank. For venture rounds the amount gets trickier because you have to start projecting some revenue and the cost base is beginning to increase significantly. But the logic remains the same.
The European Private Equity and Venture Capital Association publishes annual statistics that contain some hard data on early stage investing including investment sizes, check out the 2012 report.
Below are some of my estimates of the average investment round size based on deals I see mostly in the CEE. They do not include hardware startups. The point of these numbers is not to be 100% correct (there are plenty of exceptions), but to give entrepreneurs a ballpark estimate as to what they can expect in our region in different stages of the startup investment lifecycle.
- Angel, FFF, Accelerators – EUR 10-100k
- Seed – EUR 50-500k
- Series A – EUR 400k – 3 MM
- Series B & further – EUR 2.5 MM+
The fairly wide investment range, especially in the latter stages, can be attributable to a host of factors: aggressiveness of expansion/desire to grow, sales/customer acquisition model (direct sales force vs partnerships vs marketing expenses etc.), cost of making/updating/innovating on the product etc. Key is to be able to identify and plan your costs ahead of time. And don’t forget to include a reasonable buffer in case things go south. Cash is king, and if you run out of it, the game is over.
You must be delicate when including a buffer in your numbers: on one hand if it is too low, the knife is always close to your neck. On the other if you artificially inflate your assumed costs and make them look unreasonable, investor will see through it and your reputation receives an instant blow. Just make sure to be explicit with the investor about what you expect your real costs will be and what kind of buffer you would like to add on top, don’t try to conceal it.
The valuation question is trickier to answer. Some quick ballpark numbers: seed and venture rounds tend to take between 15-35% in equity, while angels a bit less yet with higher variance. I would guess between 5-25%. The specific number then comes down to negotiation and various factors surrounding your company, such as its potential (market size/revenue potential in 3-5 years), strength of the team or current traction.
Under no circumstances should the founders give up majority of their company anywhere between angel and Series A rounds. Investors asking for majority stake in the company at this stage are financial predators who are effectively trying to steal the company. It is the founders who are the key to company’s growth, and how will they stay motivated and make key decisions if the investor has usurped control away from them? Similar logic applies to angel investors who take more than 35% stake in the firm: how can a fund like Credo make a follow on seed investment into such company, without having to own majority share together with the angels? Sadly, a lot of investors in our region don’t realize that taking high equity stakes in the early phases of the startup lifecycle significantly hampers company’s ability to raise future funding, which in many cases leads to premature and unnecessary end of the startup. I have seen multiple startups with a very promising product, which Credo was not able to finance because investors owned way too much equity in the firm, and yet weren’t adding any value to the firm.
The valuation of the startup also has to reflect its potential. If Sun Tzu was giving advice on fundraising negotiations, he would probably include something along the lines of: know what is the VC’s motivation. And the motivation for most VCs is the same: make money. A lot of money. How much is a lot? We at Credo like to see at least 10x potential return for Series A investment, for seed investments more than that (to compensate for the additional risk, as explained in previous post). Therefore, make sure that your company’s potential can justify your valuation. I am not sure if this is just a CEE phenomenon, but I see way too many business plans with a valuation that just doesn’t make sense given the financial forecast the company is presenting. Example: a startup wants to raise EUR 2 MM in exchange for 20% stake in the company, but plans to make EUR 2 MM in revenue in 4 years. In order to deliver a 10x return for the fund in that timeframe, the company would have to be sold for EUR 100 MM. Do you really expect your company would exit for EUR 100 MM if it generates EUR 2 MM in revenue? Not going to happen, unless you believe in miracles or have Jack Dorsey in your top management.
Once you know the needed investment size and expected equity you would like to give to the investors, the valuation calculation becomes quite straightforward: divide the investment size by % of equity given out to investors. Example: if you are raising EUR 1 MM and you would like to give an investor 25% stake in your company, your post money valuation will be EUR 4 MM. Why is it called post money? Because it includes money invested by the investors, i.e. valuation including the amount invested. The pre money valuation is then calculated by subtracting the invested amount from the post money valuation: in our example, the pre money valuation would be EUR 4 MM (post money valuation) less the EUR 1 MM investment = EUR 3 MM. Investors like to look at pre money data to compare valuations of different startups before they are inflated for the invested amount.
When you advance in talks with investors you would like to fundraise from, try searching for valuations on their previous deals and benchmark your startup against their portfolio companies. AngelList and sometimes CrunchBase can provide useful data. You can bet the investors benchmark prospective investment opportunities against their portfolio.
Choosing the right partner
What is more important than the actual valuation in my opinion is to choose the right partner. Don’t go with an investor who tries to compete on the best valuation. As a matter of fact, an investor who tries to convince you to go with him because of valuation is implicitly saying he can’t offer much besides money. If you choose to go with such an investor only to have 5-10% more equity for yourself, you might end up owning 5-10% more of something that is worth a fraction (if anything) of the value you could have gained with a partner that can open the right doors for you. I hope the previous posts gave you some guidance on choosing the right investor.
So much for the valuations and investment sizes. This post may appear more abstract in content. It is at least partially due to the fact that when it comes down to valuation, it is more an art than science. An art of negotiation.
During such negotiation, it is always useful to know how is the other side evaluating you and what is it looking for. And that’s exactly what the next post will try to uncover: what does a vc think about when looking at an investment opportunity?