Lesson #239: Manage Towards Valuation Step-Ups

Most entrepreneurs think in the present.  They know they need money now and they go out and raise whatever they can for their current stage of growth.  But, it is critical that entrepreneurs are constantly looking far enough into the future, to know what financial targets will be required to successfully raising their next round of capital, and managing the business towards those targets, to ensure the appropriate valuation step-ups are achieved with each subsequent financing.  It is typically not good for the entrepreneur or the investor, if valuations are not continuing to move up over time, as detailed herein.

The Normal Startup Funding Cycle

As a representative example, venture-backed tech startups typically raise monies as follows:  $250-$500K seed round, followed by $1-$3MM Series A round, followed by $10-$20MM Series B round. If they sell approximately 25% of the company in each round, at the midpoint of the ranges, that would value the company at $1.5MM at the seed stage, $8MM at Series A stage and $60MM at Series B stage, after such investments.

What This Means for the Business Targets

The above example funding cycle is just numbers on a page.  To actually get investors excited about making such investments, you need to be making material progress with your business along the way.  So, for example, let's say revenues is the key driver.  Most high margin tech companies are valued at 3x revenues.  So,at the midpoint of the ranges above, you will typically need to have $380K in revenues to attract seed stage investors, $2MM in revenues to attract Series A investors and $15MM in revenues to attract Series B investors.  Revenues can be the annual run rate of the business based on the most recent month times twelve, it doesn't need to be the last twelve months.

What This Means for Management

If you want to ensure your future fund raising process goes smoothly, you need to have the above example revenue targets in mind as you are managing the business.  Said another way, you better make sure the use of proceeds from each round is enough to afford all the sales and marketing activities that will be needed to propel the business to the next target revenue tier required to attract the next group of investors.

Sanity Check

To sanity check this, let's say you raise $2MM in your Series A and need to add $13MM in incremental revenues to attract your Series B investor.  Let's assume we are a B2B company acquiring leads at $250 per lead and converting 10% of them into sales at an average transaction size of $25,000.  If we use half of our Series A capital for sales and marketing, that should attract 4,000 leads, 400 transactions and $10MM in revenues, understanding revenues will have a six month delay behind the sales and marketing spend.  So, by 18 months after the round, we did okay at growing the business, but we didn't get to the full target of $13MM.  So, we would want to rethink our sales economics, marketing efficiency or deal terms of the Series A round to make sure we have a reasonable chance of hitting our Series B funding goals.

What Happens if You Miss Your Target?

I think most investors are expecting entrepreneurs to miss their targets, and most everyone does, at one point or the other.  But, you want to do everything you can to ensure that any misses are kept to a minimum.  So, be ultra conservative in your forecasting. For example, if you normally convert 20% of your leads, run a sensitivity analysis to see what happens if you only convert 15% and pivot accordingly, to give your plan enough cushion.

The reality is, if you materially miss your sales targets, the following situations could occur:  (1) it will make raising additional outside capital materially harder, at least at the valuation you were originally hoping for (given slower growth rate of the business); (2) it could result in flat valuation rounds or down rounds for the next monies in (which could trigger all kinds of anti dilution protections for your investors, materially cramming down your personal equity stake); or (3) it could irritate your current investors (as it most likely means they will materialy miss their ROI targets on their investment in your business).  Do your best to make sure that doesn't happen to you.

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