Series A Valuation: Dilution isn’t the Only Thing that Matters

Ricky-Pelletier by

Quite commonly, the biggest challenge to making an investment is coming to a valuation that works for both sides (see here – it’s rarely an easy conversation).

Usually, the first valuation that gets placed on a business is in the Series A round (many times, if a seed round was raised, it was done through a convertible note and no valuation was pegged).  Getting the Series A valuation right is absolutely crucial for both parties.  And it’s NOT simply dilution that matters!

Yes, dilution is going to be at the top of everyone’s minds, particularly investors and founders. After all, on the company side founders are struggling with wanting to hold onto as much equity in the business as possible. On the investor side, it is about maximizing ownership today in order to prepare for dilution in future rounds. It’s a tricky balance to strike, but getting it right will have a trickle-through effect on your company’s future.

How so? Let’s look at the following two scenarios:

 

Situation A:  You raise at the highest possible valuation.

Pros:

  • Your dilution is minimized and you continue to own a large slice of the pie.
  • Management/Founders continue to have a lot of skin in the game, which investors love to see.

Cons:

  • You likely shopped for the highest bidder rather than the best partner (though sometimes they are both!); hopefully the firm you selected will help you in becoming the successful business that you are shooting for.
  • You have now set the bar for future rounds – everyone around the table will be expecting an up-round for your Series B (nobody likes a down-round!), and given that your current investors likely had to stretch to hit the Series A valuation ask, your business needs to first grow into that valuation. That high Series A may make it VERY difficult for you to find the right Series B investor who can make the math work.
  • Options are now pegged at that valuation, which may make it difficult to recruit top-tier talent, who will want to see upside in their equity.

Situation B:  You raise at the lowest possible valuation.

Pros:

  • Assuming your business grows, the Series A valuation should not be an impediment to a Series B or exit.
  • You have happy investors who have a meaningful stake in your business and are therefore willing to work really hard to make the company successful.
  • Option prices are kept relatively low, allowing you to use equity to attract top quality talent.

Cons:

  • You and your co-founders took a lot of dilution and it hurts.
  • If their equity position is reduced enough, founders sometimes lose interest and motivation.

Truthfully, neither of those two scenarios is ideal for either side, and there is a little bit of Goldilocks syndrome here as you try to balance the trade-offs. So, the question that founders must commonly ask themselves is: Would you rather own a large slice of a small pie or a small slice of a large pie?

This sums it up pretty well. I think the answer varies greatly by person and company. And yes, sometimes a founder can continue to hold a large slice of a large pie, but those situations are quite unique.  In my opinion, it’s about striking a balance such that everyone around the table is properly motivated and all marching in the same direction. Unfortunately, that is all too often much easier said than done!

So, here’s another common valuation situation to consider:

Acme Inc is a b2b SaaS company that is looking to raise a Series A round of funding.  They are growing quickly, attacking a large market with a differentiated solution, and have a capital efficient business model. Great. The only problem is, they want to raise a big Series A round at a ‘Series B’ price. Based on their current traction and runrate, investors are having a tough time justifying the founders’ valuation.  The founder, in turn, are focused on minimizing dilution.  How can both parties arrive at a valuation that makes sense?

The “easiest answer” to solving that dilemma is to reduce the size of the investment and the pre-money valuation. 

From the investor standpoint, entry valuation will be a bit more right-sized for the risk profile of the opportunity. For the founders, less money invested = less dilution. They can then use that smaller amount of money to go out and get the additional proof-points needed in their model in order to support a big valuation. And, hopefully, if they picked the right partner on the first go-around, they’ll have selected a firm that has deep enough pockets to lead the next round with as minimal diligence as possible. In many cases, founders may even end up better off doing this than if they had raised that big round at a big valuation in the first place.