37. The Algorithm for Raise Amount & Valuation (Leo Polovets)

The Full Ratchet Podcast on iTunesNick Moran Angel List

Leo Polovets of Susa Ventures joins Nick to cover The Algorithm for Raise Amount & Valuation. We will address questions including:

  • You’ve outlined three major steps in “The Algorithm for Seed Fundraising.” The first, is the amount of the raise and you cite revenues, expenses and timing as key variables. Can you walk-us-through this step and how an investor can quickly evaluate the numbers and know if the startup is raising an appropriate amount?
  • Step two has to do with price and length of time to raise. Can you first talk about how much time startups should be spending on their raise and why?
  • Can you highlight the four profiles that help determine the appropriate valuation range and what those ranges are?
  • The third step has to do w/ performing a sanity check on the numbers. Directionally, what should be the relationship between raise amount and price?
  • If founders are looking at a fundraise amount and price that cause too much dilution, what options are available to proceed with the raise w/o selling too much equity?
  • Many angels have advocated for using tranches and/or rolling closes at different prices or caps, to incentivize angels to act. You’ve advised against this. What’s your message here?
  • There are some common rights that investors ask for during a seed financing. You mention pro-rata, board seats and Most favored Nations. Can you take a minute to describe what MFN is and why it’s so important for early-stage investors?

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Answer to Last Week’s Brainteaser was the Syndicate.  If you’d like more information on the difference between the two and how they compare, check out the Economics of Syndicate vs. Venture Fund spreadsheet.

Angel List has also included their thoughts on the economics here:  Economics of Syndicates

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Key Takeaways:


1- The three steps to the algorithm

Step 1: How much do you need?
Step 2: What is your target valuation?
Step 3: Perform a sanity check

For step one, Leo advocates to start w/ an 18 month duration. Then the founders must calculate all of the expense-side costs… salaries, office space, infrastructure, utilities, marketing, PR, legal, accounting, etc. And he also suggests to assume that Revenue will be flat over that 18 month horizon, regardless of one’s intent to grow. Once all of the costs are aggregated, he asks a startup to add a 10-20% cushion and this number, over the 18 month duration is the suggested fundraise amount or variable X.

For step two, Leo first thinks about the four stages that a product fits into… and remember that he is often looking at B2B SaaS companies in the Bay Area and the definitions of Seed vs A vs B have become a little fuzzy and are different depending on who you ask. Here are Leo’s four stages:

1. Pre-product or alpha product ($3-$6M valuation)
2. Beta Product, some pilot customers and revenue may be $1k-$20k ($6M or $7M valuation)
3. Mature Product w/ established revenue, but sales are still high-touch maybe in the $25k-$100k range (~$10M valuation)
4. Mature w/ a repeatable sales model w/ $100k+ in monthly revenue (Series A territory or $15M+)

And this step includes Leo’s point about raising a round within 2 months. If significantly faster than that then the startup is underpriced. Significantly longer it’s either overpriced or there may be fundamental issues preventing the startup from getting funded.

Finally, step three for Leo is the sanity check. In steps one and two we calculated the raise amount, X, and the price/valuation, Y. He now likes to assess if they make sense.

So, Y should be about 4-6x variable X. If that’s the case, then it is appropriate to proceed w/ the fundraise. If Y is significantly more than 4x of variable X, then Leo suggests coming up w/ a more aggressive roadmap since more money could be raised w/ acceptable dilution. And if Y is less than 4x, then the founders are probably taking too much dilution. Leo believes that it rarely makes sense to give up more than 20% of the company at the seed stage. His rule-of-thumb here is that dilution should be between 1/6 and 1/4 or 17% – 25% of equity. And this leads us into takeaway #2, which is…


2- Options if you can’t raise enough money at the preferred valuation

First, let’s recap that investors are trying to de-risk their investment by finding out:
-Are the founders good?
-Can they sell the product?
-Can they build the product?
-Does the Market want the product?

So, if the founder is unable to raise the amount they want or raise at the price they prefer, they must do what they can to address those factors and de-risk the investment. This includes:
-Self-funding or taking less salary
-Raise a little less and aim for a bridge round by achieving some near-term milestones
-Implement a less-conservative plan and finally
-The founders can take more dilution


3- Most Favored Nations

Most simply, most favored nations, MFN, protects early investors from getting worse terms than others. Remember that angels often get money in very early, when risk is at the highest. If a VC or other investor comes in later and negotiates for better terms, the angel doesn’t want to be stuck w/ a higher price or worse provisions. MFN guarantees that the early investor, will get upgraded to the best terms, within that round, if better terms come in later-on.
While Leo doesn’t handle the legal docs, his understanding of the way that this plays out is that there is a trigger tied to the MFN, so that if a subsequent cash infusion sets off the trigger (I’m guessing it would be time-related or $ amount of the raise), then it is considered a new round and the early investor does not inherit the new terms. However, if things are going well, then the terms will almost certainly be less favorable in a subsequent round than the previous.

While this may seem like a simple clause, it can have great effect. Especially, when individuals or small groups of angels do not have the bargaining power or deal experience of a venture capitalist. It’s likely that the MFN clause will rarely be necessary, but in the rare case that it is, the riskiest capital should, at the least, be at par with less risky capital.”



Tip of the Week:   The Rolling-Close Gathers Moss