Apr 19, 2016
*note: originally published on Amit Mukherjee's personal blog
There are few variables that impact a startup’s trajectory as profoundly as the size of its Series A. Raising $10M versus $3M will fundamentally alter a company’s growth. Hiring, product development, and the number of customers the company acquires are all capital-constrained activities.
Despite how critical the size of the Series A is, few seed-stage entrepreneurs have a deep appreciation for how large a Series A they can raise until they are halfway through their fundraising process, and that’s a problem for both entrepreneurs and investors. Asking for $10M when the market is only willing to provide $3M can make an entrepreneur look uninformed, and result in VC firms passing. Those same VCs might have leaned in if the size of the ask was different.
Why is the Series A unique?
As a comparison, why does the same level of uncertainty not exist for a company’s Seed Round or their Series B raise? The factors that determine size at the Series A are far more enigmatic than in either of these two other rounds.
For a Seed Round, both round size and valuation are fairly standardized; a $1M - $2.5M round is standard, with valuations typically falling in the $4M-$8M range.
For a Series B (or Series C, D, etc.), companies are almost typically generating revenue, and an entrepreneur can quickly grasp an expected round size by triangulating on (1) a new VC’s requirement to own 20% (2) his/her company’s next-twelve-month revenue projections and (3) valuation multiples for the company’s space.
Which brings us back to the Series A. Why is it that some companies can only raise $3M when others can raise $10M or more? After analyzing 41 of NEA’s Series A deals over the past ~4 years, I came up with 3 broad buckets for Series A round sizes:
The $3M deal: The investor is thinking “This is an experiment. I like the team and the concept, but one or more critical hypotheses needs to be proven out, or the business will need to overcome a few hurdles”
The $6M deal: The investor is thinking “I see a path to generating real revenue over the next twelve months, but it’s early. There is not enough data to give me 80%+ confidence that the company will hit its projections
The $10M deal: The investor is thinking “This is a HOT deal. I need to win it! I expect the company will get multiple term sheets based on the uniquely good team / traction / unit economics / product”
While the above characterizations are helpful archetypes, keep in mind that they are rough guidelines and don’t always paint an accurate picture. That is, when you see a funding announcement for a $3M Series A, you can’t simply assume it wasn’t a hot deal (and you also can’t assume that every $10M Series A you see is the hottest thing in the world).
Ultimately, this breakdown boils down to two factors: risk and competitiveness (to win the deal)
When evaluating risk, an entrepreneur can ask, “how many points of failure/uncertainty does my business have between now and 18 months from now?” If the company needs to prove out several hypotheses (e.g., (1) investor hasn’t seen a finished product, (2) product-market fit hasn’t been proven due to a lack of purchase data), it will likely fall into the $3M deal category. Conversely, if the company has launched and has proven unit economics, much of the risk has been mitigated; execution and competition in the market become the bigger factors. In this scenario, the investor will be more comfortable writing a larger check.
The other factor is deal competitiveness. When an entrepreneur has multiple options, the main avenue upon which investors end up competing is often round size. As an entrepreneur considers multiple different term sheets, they are likely focused on valuation. In reality, though, investors tend to be very strict about ownership requirements, so check size might end up driving valuation (particularly in a Series A). Most VCs focus on owning 20%. As such, when a deal gets more competitive, the amount of capital the VC offers may increase, and the valuation will increase in lockstep. Entrepreneurs then realize that they will suffer roughly the same dilution in each scenario, but all else being equal, would prefer to have more cash in the bank!
But wait, why did [X company] raise way more than your framework suggests?!
While risk and deal competitiveness are two factors that broadly explain round size, an investor will ask herself/himself a number of other questions that can impact round size:
How much capital does the business need to hit the milestones necessary to successfully raise a Series B?
How proven is this founder? Has (s)he previously built a $100M annual revenue, venture-backed business? (Example: Jet.com’s $30M Series A)
Will there be a number of copycats / fast followers? How fast does the company need to move to establish itself as a market leader? (Example: DoorDash’s $17M Series A)
Does the company represent a black swan opportunity? (Example: Snapchat, Cruise)
Conclusion: Ask for less, but be open to more
Startups should be cautious not to overshoot on their Series A ask. In any environment, asking for too much can scare an investor off, but particularly in the current market, large demands could lead to a sub-optimal outcome.
By asking for less, it’s more likely that more VCs will be interested, hence creating demand, hence creating an opportunity for a larger sized round.
Also consider the timing of the raise. Having a $500k monthly revenue business versus half of that can make a massive difference. In some cases, waiting 6 months to raise can allow an entrepreneur to raise more capital, more than compensating for the lag in-time.
However, raising at too high of a price/too much money can cause its own set of challenges. In downside scenarios, it’s ugly. Companies shy away from M&A talks, and other investors are less inclined to follow. A down round can also crush company morale.
Ultimately, the most compelling round size comes down to what milestones a company expects to accomplish between the Series A and how much capital it takes to achieve those milestones. At the end of the day, our entrepreneurs are capital allocators, and it’s hard to argue with an entrepreneur who has thoroughly thought through his or her game plan.
*Thanks to Sameer Bhalla and Andrew Schoen for reviewing earlier drafts of this writing