In our discussion of APV, we contemplated a single round of investment staged over two years (i.e. an initial investment by the VC in Year 0 followed by another investment in Year 1). However, entrepreneurs often raise capital in multiple rounds of financing, so that they can take advantage of higher pre-money valuations at each subsequent round. Valuations may rise over subsequent rounds as companies demonstrate proof-of-concept, grow their customer bases, or otherwise increase their probabilities of success. Unlike stages, each round is priced independently and involves a new term sheet specifying the characteristics of the investment. Investors in early rounds typically invest in subsequent rounds to maintain similar ownership percentages in a company over time.
Seed financing provides capital needed to support salaries for the management team, R&D, proof-of-concept, prototype development, and testing, etc. Sources of capital may include personal funds ("bootstrapping"), friends, family, and angel investors (typically a wealthy individual who invests in start-up companies). Valuations at this stage are typically driven by subjective factors like appraisals of the CEO and management team, novelty of the value proposition, evaluation of intellectual property, expected time-to-market, expected path to profitability, estimated capital needs and burn rate, syndicate risk, sector volatility, and deal structure. Capital raised is limited due to its dilutive impact at minimal valuations. The goal during the seed stage is to assemble a talented team, and achieve development milestones, proof-of-concept, and anything else that will enable a company to attract investors for the next round of financing.
Series A Round
Typically, the Series A is the company's first institutional financing, and is led by one or more venture investors. Valuation in this round will reflect progress made with seed capital, the quality of the management team and other qualitative assessments conducted in the seed round. Generally, investors in a Series A round will purchase a 50% ownership stake in the company. Typical goals of this financing are to continue progress on development, hire top talent, achieve value-creating milestones, further validate product, initiate business development efforts, and attract investor interest in the next financing (at an increased valuation).
Series B Round
The Series B is usually a larger financing than the Series A. At this point, development is complete, technology risk is removed, and early revenue streams may be taking shape. Valuation is gauged on a blend of subjective and objective data, such as human capital, technical assets, intellectual property, milestones achieved, comparable company valuations, and rationalized revenue forecasts. Goals of this financing may include operational development, building scale, further product development, revenue traction, and value creation for the next round of financing.
Series C Round
The Series C may be a later-stage financing designed to strengthen the balance sheet, provide operating capital to achieve profitability, finance an acquisition, develop additional products/services, or prepare the company for exit via IPO or acquisition. The company often has predictable revenue, backlog, and EBITDA at this point, providing outside investors with a breadth of hard data points to justify valuation. Valuation metrics, such as sales and EBITDA multiples, from comparable public companies can be compiled and discounted to approximate value.
Capitalization ("cap") tables are used to model ownership percentages for each round of financing. A round of financing may be structured to allow the VC to purchase a number of shares that target a specific ownership percentage or, alternatively, yield investment of a specific dollar amount. Exhibit 8.5 illustrates the former. The post-money value is equal to the pre-money value plus investment since the only effect the transaction has on the company's valuation is to increase its cash balance. The price per share is calculated as the pre-money value divided by the number of shares outstanding prior to the transaction.
Exhibit 8.5 – Round 1
The negotiated term sheet offers the VC an opportunity to purchase 1.5 million convertible preferred shares at a par value of $0.87/share. Prior to the deal, the company will have 1 million common shares and 0.5 million options outstanding, all owned by the management team. The proposed transaction would therefore result in 50% ownership of the company by the VC immediately after Round 1.
Exhibit 8.6 – Round 2
Suppose that, one year later in Year 1, the company holds another round of financing. This time, the company seeks $7 million in capital. The investor in Round 1 participates in this round, as well as a new investor.
Note how we calculated the pre-money value for Round 2. We applied a sales multiple to the exit-year (Year 5) sales and subtracted net debt to yield the expected equity value at exit. Then we discounted this value back to Year 1 using the VC hurdle rate. Next, we subtract future investment needs based on the company's projected free cash flows (not shown) to yield the post-money value. Recall that negative projected cash flows indicate a financing need or "hole" that needs to be plugged. We subtracted future investment needs because without this additional capital, the company cannot meet its expected operating performance.
Exhibit 8.7 – Round 3
In Year 2, the company holds a third round of financing to raise $6 million, and another investor is added to the mix.
Note that when calculating the pre-money value for Round 3, we discounted the equity value at a lower hurdle rate than was used in the Round 2 valuation. This lower rate reflects the company's improved prospects and higher probability of success.
When the pre-money valuation drops from one round to the next (because the company is not meeting performance expectations), the later round is called a "down" round. A large drop in pre-money value lowers the price per share, any makes any large investment by new investors seriously dilutive to existing investors by drastically lowering their ownership percentages. One way to avoid this dilution is for the existing investors to contibute all the cash needed in a down round.
Exhibit 8.8 – Down Round
Suppose that the pre-money value drops from Round 2 to Round 3, and a third VC invests a relatively large amount at this lower price per share. Note how Investors 1 and 2 are heavily diluted by this transaction (you may need to scroll the spreadsheet to bring the relevant cells into view).
- As a general rule, management is never taken below 20% ownership in the company. A significant equity stake in the company is an important management incentive.
- Investors will almost always require that the company set aside additional shares for a stock option plan for employees. Investors will assume and require that these shares are set aside prior to the investment, thereby diluting the founders rather than the option pool.
- For early-stage companies, VCs are typically interested in owning a particular fraction of the company for an appropriate investment. The valuation is actually a derived number and is not necessarily indicative of the company's actual "worth".