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When Should Startup Founders Discuss Valuation with Seed VCs?
As the seed-stage startup fundraise process has received more transparency in recent years, ranging from published advice on how to raise seed capital to increased availability through AngelList, Funders Club, and various accelerator programs, I’ve noticed another trend emerging. In short, more and more entrepreneurs are signaling their price expectations earlier in their seed fundraise process.
Using NextView as an example, since we both seek to lead the seed round and only lead during this round, I’ve seen this trend manifest in one of two ways: In a priced round, the entrepreneur will often share their valuation ask (or a stated floor) for the pre-money valuation of their company much sooner in the process. Or, in the case of a convertible note, they’ll explicitly state a valuation cap.
Sharing these pricing expectations early with potential lead investors fundamentally qualifies your conversations, but it also runs the risk of prematurely losing a potential financing partner, or else it can reduce options to maximize your fundraise outcome.
Like any economic transaction, the pricing of a startup’s seed round ultimately depends on the equation of perceived supply (in this case, the quality of the team, product, and market opportunity) and the demand (how many competitive alternatives there are to any one given funder, including non-consumption).
In theory, there are three levels of pricing for an entrepreneur to potentially signal to a prospective investor:
1. Lower-Than-Market Value
This approach is almost never a good idea. Although some investors will certainly recognize value in a startup which is raising at a modest valuation level, sharing this aspect as a feature to the investment (which I have seen) will likely result in the perception that the company is weak and undeserving of additional capital.
2. Market Value
By overtly sharing that an entrepreneur is “looking for the best partner and will accept whatever the market dictates” — or by stating a figure or range which falls within market — it sets the tone of a collaborative process moving forward, as the parties involved are looking for a mutual fit.
3. Above-Market Value
By definition, all entrepreneurs should think that their endeavor is truly exceptional and above average. But, also by definition, that just can’t be the case.
On the positive side for a founder, directly stating a high valuation expectation up front can anchor the negotiations to a higher level, assuming that an investor takes the leap of faith to invest. Additionally, setting a structure and price in advance at above-market value can expedite the negotiation process, especially when it’s with multiple parties.
But on the other hand, stating a high valuation number early in your discussions can run the risk of unnecessarily disqualifying one or more great, qualified, value-add investors. It may seem to some of these investors that a zone of possible agreement doesn’t exist. With finite time to spend on exploring new investments, some individuals and firms won’t spend time on an opportunity where they don’t think a plausible scenario for them to participate exists. Even if you’re willing to negotiate, stating that high price up front may cause these investors to quickly move on. (And as my partner Rob Go likes to say, “Time kills all deals.”)
The key to the calculus above is this: as an entrepreneur, you must know (1) the market range for your startup based on its current state, (2) your ability to generate meaningful funding options, and (3) the external funding landscape.
I’ve frequently observed that when founders ask for above-market valuations, it’s not due to their savvy negotiation or their abilities to secure a more favorable outcome. Instead, it typically appears as though the entrepreneur lacked an understanding of those three factors above to determine the appropriate valuation.
Said another way, you can quickly and easily turn off investors just by rushing to discuss a high valuation too soon.
This does not mean that you shouldn’t fight for what you believe in or negotiate for a favorable outcome — not at all. It’s more about the need to understand the investor landscape and convey that you understand it too. For example, even once you’ve determined your initial pricing ask, the reality is that different seed investors have varying degrees of sensitivity to pricing.
Angel investors can be the most wildly unpredictable about how they’ll react to differing valuation levels, for instance. Probably the most price-sensitive seed investors I know are sophisticated individual angel investors. This handful of people, through their own admittance, can be extremely and unabashedly cheap, as they’re fully self-aware of their role within the funding ecosystem. They’ll therefore systematically seek to invest in startups at the lowest cost-basis possible.
Yet at the same time, I’ve also seen some high-priced seed rounds come from a syndicate of individual angel investors who were essentially price-insensitive (investing in a convertible note without a valuation cap). At the end of the day, this latter cohort is backing a particular entrepreneurial team and vision no matter what the financing circumstances. So when discussing price with angel investors, it’s important to understand whether they’re price sensitive or insensitive based on investment history and past work with founders.
[Editor’s note: There’s a lot more to know about angel investors, which is a broad label for a nuanced group of investors. To learn more about angels and their motivations, read Understanding the Different Types of Angel Investors.)
After angels, larger venture firms are probably next in terms of how variable they are when reacting to seed pricing asks by founders. This depends on their seed investment strategy, whether stated or implied by the firm. As a general rule, the more seed investments a firm of this profile makes per year, the less price sensitive they are.
With this “option approach” to seed funding, these larger firms worry less about ownership initially and are more concerned about just being investors in the startup in the first place, as this helps to maximize pole position for later rounds of funding — their sweet spot.
On the other hand, if a large firm only makes a small, select few seeds which it treats like its “normal” investments, the same filter and approach for valuation that they take for later rounds will also typically apply during the seed stage. Thus, just like with angels, it’s important to look at a large VC’s history and strategy around seed stage investments.
Lastly, you have firms like NextView Ventures: seed-focused VCs. Institutional venture firms like ours are going to be the least variable in valuation sensitivity. Fundamentally, seed-focused firms are financially driven with their seed rounds, since these are their only (or one of their only) opportunities to invest. So there is a bias to focus on pricing in the seed. (For context, since I mentioned NextView: We have one great product, and that’s a highly engaged seed round. That said, we do reserve capital for follow-ons in later rounds with our existing portfolio. You can learn about our approach in more detail here.)
There’s No Black or White
Regardless of profile and seed strategy, the reality is that all investors have differing philosophies about how to treat valuation.
On one side of the spectrum are those who believe that overall asymmetric returns will be derived from one or two exceptional investments, regardless of entry price. On the other side are those investors who are especially cognizant of the exit market skewing towards moderate-sized outcomes. They’re simply much more likely, so hitting solid doubles becomes the strategy. This latter group will therefore position their investments to be able to capitalize on that reality.
Both profiles are valid because they’re both true; it’s just a matter of how investors translate these factors into their own decision-making.
So What Should Founders Do?
So far, I’ve discussed both sides of the same coin. Working in favor of founders is the fact that sharing valuation expectations early can qualify an investor to ensure they’re worth spending time with as an entrepreneur. And if executed effectively, this can also set a positive tone towards all proceeding discussions with other investors. However, working against founders when they share pricing expectations too early is the fact that the search for investors becomes largely about price, not about finding a good partner for the business moving forward. In this case, it’s almost like opening a job interview by sharing salary requirements. So this early communication may needlessly cause some investors who would otherwise be good partners to shy away from the table.
Over the course of a fundraising process, pricing expectations may actually shift, either downwards or even upwards given demand. But if any initial conversations with prospective investors broke down over early pricing expectations — even if that pricing changes over time, which again, is rather likely — it’s still challenging for those initial investors to reengage the founder. So you may wind up eliminating potential partners by signaling price expectations that, in the end, are no longer reality anyway.
So, think of it this way: Especially at the seed stage, seek a great partner first and discuss valuation second.
As a funding conversation progresses from initial to subsequent meetings, the topics of round structure and pricing become much more natural. Additionally, a good investor relationship is born out of fundamental, mutual interest in the startup itself, not the deal structure. In the end, the foundation of that partnership should begin with a discussion about the shared opportunity, not the details of the arrangement. Approaching initial fundraising conversations in this way can and should yield a much more natural, much more productive, much more collaborative partnership between investors and founders.
Building a startup and currently in the seed stage?
[Editor’s note: This is an updated version of a post that originally appeared on GenuineVC.com.]