There is a great post last week by Mark MacLeod, an experienced CFO, on the size of later venture capital rounds and the valuation of the companies receiving the capital in those financing rounds. A study by Silicon Valley Bank supposedly shows that if a startup raises over $5M in a Series B then it is more likely to experience a step up valuation from its Series A… while a company that raises less than $5M is more likely to not show any increase in valuation from its Series A VC raise. This trend continues with later rounds of venture capital financing.
Mark has a couple of interesting take aways from this study. Thankfully he notes that this shouldn’t be incentive for startups to raise more money… His main points are that A) VC’s do the math to see how much they will own of a company at an exit and provide a level of funding that generate returns based on that exit assessment and B) Tier 1 VCs have larger funds, so are looking to deploy more capital per startup, and also have access to superior investment opportunities - larger funds plus better companies to invest in mean bigger round sizes and higher valuations. I can’t argue with either of his points! However, I would like to add a couple of additional factors that maybe contributing to this:
- Hotter companies find it easier to raise cash. If a company has multiple VCs looking at a B round then the venture capitalists will need to find a way to prove to management that they are the VC who should be allowed to lead the B round. The easiest way to prove this is to propose a good valuation and large round size. This theme was mentioned in an earlier post where I referenced an article on creating a sense of competition during a venture raise.
- Faith in management. If the startup’s management team has executed well enough post-Series A to justify a serious step up in valuation, then they have also earned the trust of their VCs. VCs who have faith in management’s ability to execute also have greater faith in management’s ability to correctly manage larger amounts of cash.
- Venture capitalists also do the math on management’s ownership. Management needs to have enough of the upside to justify their time, and since management IS the company this plays just as much of a factor as the VC’s ownership.
- Negative selection from broken deals. Companies that needed to raise a large financing round but can’t probably depress both the amount raised and also the valuation of the round. If a startup needs to raise $15M in its Series B but is not able to do so, then it likely tries to raise a smaller amount. However, VCs realize that the company is not going to accomplish its value creation milestones with a smaller raise, and thus, if the company is even able to raise anything, it is very much likely to be at a depressed valuation. The VCs will realize that the company is not going to step up its value from the cash invested, so are not going to provide a step up at the B.
I will also see if I can get my hands on the original study, as it sounds quite interesting.
