8 ms·

Aaron is very smart, but what this article is missing is that valuation often follows the amount of capital you raise. What I mean is your valuation is determin

Aaron is very smart, but what this article is missing is that valuation often follows the amount of capital you raise. What I mean is your valuation is determined by the demand for your shares. VCs have a specific ownership % they need for their model to work. Whether that is 10% or 20%, large rounds at very high valuations happen because of bidding wars. More VCs are bidding over that 10% or 20% they are looking for and that drives the price up. Many successful entrepreneurs say its not the amount you raise that is dilutive, it’s the number of times you raise. In addition, good seed VCs are happy to give you a higher valuation when you have investor demand, so you can take more capital. This was my personal experience. Before our round closed, we had $X committed at $Y valuation, giving up 20%. When more capital came calling, our lead was happy to raise the valuation so we could take more money and increase our odds of success. Would be great for Aaron to address this point.

bytematic 6y ago
I think Aaron is talking about seed and stage A rounds more so than later rounds
- owens99 6y ago
  I’m also referring to seed and A rounds.
corry 6y ago
I've heard founders say this too. The mentality is "look, you'll end up giving away 20% of your company on the round anyways, so you might as well get more $$$ for that 20%". As if the % is fixed and immovable. In my own experience, this minimum % ownership target is a very real issue and bar to jump over for most "proper" Series A VCs. At least the ones leading the round. If I was in that position, and it was a great fund, it would be very hard to imagine saying "no, I'll value my company less, and take less $$$, for the same dilution." Human nature IMO basically favours taking more $$$ every time ONCE % is fixed. However, Aaron might say that the best companies can easily push back on that fixed % approach, which is the true issue here. And that's a good counter point. But many of us, even as YC-backed companies, don't know how to effectively push back against that dynamic. For me, out of the 5 Term Sheets I got for our Series A, I think all of the funds involved had a minimum % ownership target. Hard to negotiate around that. Normally if there is a term you don't like, and you have multiple sheets, you can just play them off each other. But it seemed pretty universal in my admittedly narrow experience.
- corry 6y ago
  One additional point. If you have existing investors who have pro rata rights, the larger the check from the new round lead investor, the more existing investor money is also being put in. And since all VCs are basically in a "I want to put as much capital into winners as I can", the insiders are likely OK with larger rounds / valuations in general, since they get to place more $$$.
- maire 6y ago
  I was at 2 successful companies that went against the normal VC path. Vitria was able to move the VC % lower because they were already profitable and demonstrated potential before approaching the VCs. They were only using the VCs for their contacts and not for cash. VMware never got VC funding. I am not sure why - but they tried. They finally sold themselves to EMC and were later spun out.
  - avrionov 6y ago
    According to Crunchbase VMmare raised almost $400M https://www.crunchbase.com/organization/vmware/company_financials https://www.crunchbase.com/organization/vmware/company_finan...
    - kijiki 6y ago
      2/4 rounds (and the overwhelming majority of the $$$ raised) were years after the EMC acquisition, and immediately before the IPO. Not really what people think of when they talk about raising VC. The 5 million and 20 million rounds in 2000 were strategic investments from partners who were going to resell ESX, and were done for reasons other than needing working capital. IBM and Dell were the 2 partner investors, IIRC.
- CerealFounder 6y ago
  This is it. These people are money managers that market based on owning x amount of one of the top 50 companies each year in order to raise a new fund. If they take smaller % the model fails both executively and from a marketing perspective.
ghiculescu 6y ago
Optimising for a good valuation (over a good business that you own lots of) is missing the point.
akharris 6y ago
Thanks - at any given round, dilution is driven by how much money the founder agrees to take. No outside party can force a founder to take dilution, it takes an agreement on both sides. While VC ownership targets are part of their business models, founders don't actually have to agree to meet them. From what I've seen, those targets are far more flexible than anyone admits at the start of a negotiation.
- daniel_levine 6y ago
  While I tend to agree with you in principle, I'm curious how often YC is flexible on the ownership target :P
  - akharris 6y ago
    This is part of my point, founders don’t have to accept our deal even though we put it in writing ahead of time. It’s not the founders responsibility to make our business model work, it is their responsibility to build a great company. If we agree on an entry point for us to go along for the ride, great!
    - aabhay 6y ago
      This is exactly the issue though? Investors say “hey you don’t have to raise from us if you don’t want to give up X% of the company”. Which leaves no room to negotiate. The ONLY time you can expect to sell a smaller % of the company in a round is if you go to an investor and say “hey this OTHER investor wants the same % but is paying more, are you willing to take a lower % at a higher valuation?”. However, this seems very rare and the VC driving up the valuation is usually a higher tier VC in a bidding war, so founders are likely to go with them. Long story short, if you want to convince founders to sell less of the company, you have to convince top tier VCs to take less, and founders will follow suit.
- TuringNYC 6y ago
  No outside party can force a founder to take dilution, but unless you are the hot oversubscribed startup, rounds are often just enough money and you find yourself coming back hat in hand to be diluted over and over.
hinkley 6y ago
The first time I read about this topic, the author suggested counter-offering a smaller investment for a slightly higher dilution/$ to soften the blow. As in, “I don’t need $50m (for 20%), how about $23m for 10%?” I have never been to any of these meetings, but it seems like the guy who just skyrocketed your valuation for his 20% is going to be “louder” than the earlier investors who also own 20%. The % of investment versus the % of investors will probably skew things a bit, too.
itsoktocry 6y ago
>our lead was happy to raise the valuation so we could take more money and increase our odds of success. VC is such a strange world. "Valuation" is a measure of the fair-value of an asset. How can a lead investor decide "to raise the valuation"? Why would anyone looking to invest base the valuation on people who already have money in, rather than their own due diligence? Why wouldn't the optimal valuation be as high as possible? This game is kind of confusing.
- daniel_levine 6y ago
  It's a bit confusing but does make sense. Imagine wanting to buy 20% (or 100%) of Apple in the public markets. If you try in normal trading it will either take months based on trading volume or you'll bid up the price as you're buying. People looking to own larger pieces of a business are often willing to pay a premium to folks trying to buy smaller pieces.
- jjeaff 6y ago
  Because in a startup, valuation is generally calculated by the investor rounds rather than revenue. An investor can raise the valuation by putting in more money for the same ownership percentage or same money for less percentage. They wouldn't generally want to boost valuation for their round because that reduces their return. But there is probably some wisdom in hyping up valuations to get customers and future potential investors excited. Additionally, if it is a follow-up round, they probably want to invest at a higher valuation just for their own investor confidence. No one wants to have a "down round" because it throws cold water on the hype train for all the other investors.
  - itsoktocry 6y ago
    >An investor can raise the valuation by putting in more money for the same ownership percentage or same money for less percentage. That's the confusing part, and it seems backwards. The valuation should determine how much money you are willing to put in for a specific ownership share. It should be an input, not an output.
    - 6y ago
datanecdote 6y ago
Worth keeping in mind the principal agent problem literature. Selling equity in a company is vulnerable to “lemon” problems. Startups with product market fit want to minimize dilution and keep executing before raising at a higher valuation in {12} months. Startups without PMF want to maximize runway to maximize probability of finding PMF. VCs know this, and startups know VCs know this, and etc. Unfortunately this can create perverse signaling incentives on both sides.
zeckalpha 6y ago
This sounds like a variant of the winner’s curse. https://en.m.wikipedia.org/wiki/Winner's_curse https://en.m.wikipedia.org/wiki/Winner's_curse

bytematic 6y ago

I think Aaron is talking about seed and stage A rounds more so than later rounds

owens99 6y ago
I’m also referring to seed and A rounds.

corry 6y ago

I've heard founders say this too. The mentality is "look, you'll end up giving away 20% of your company on the round anyways, so you might as well get more $$$ for that 20%". As if the % is fixed and immovable. In my own experience, this minimum % ownership target is a very real issue and bar to jump over for most "proper" Series A VCs. At least the ones leading the round. If I was in that position, and it was a great fund, it would be very hard to imagine saying "no, I'll value my company less, and take less $$$, for the same dilution." Human nature IMO basically favours taking more $$$ every time ONCE % is fixed. However, Aaron might say that the best companies can easily push back on that fixed % approach, which is the true issue here. And that's a good counter point. But many of us, even as YC-backed companies, don't know how to effectively push back against that dynamic. For me, out of the 5 Term Sheets I got for our Series A, I think all of the funds involved had a minimum % ownership target. Hard to negotiate around that. Normally if there is a term you don't like, and you have multiple sheets, you can just play them off each other. But it seemed pretty universal in my admittedly narrow experience.

corry 6y ago
One additional point. If you have existing investors who have pro rata rights, the larger the check from the new round lead investor, the more existing investor money is also being put in. And since all VCs are basically in a "I want to put as much capital into winners as I can", the insiders are likely OK with larger rounds / valuations in general, since they get to place more $$$.
maire 6y ago
I was at 2 successful companies that went against the normal VC path. Vitria was able to move the VC % lower because they were already profitable and demonstrated potential before approaching the VCs. They were only using the VCs for their contacts and not for cash. VMware never got VC funding. I am not sure why - but they tried. They finally sold themselves to EMC and were later spun out.
- avrionov 6y ago
  According to Crunchbase VMmare raised almost $400M https://www.crunchbase.com/organization/vmware/company_financials https://www.crunchbase.com/organization/vmware/company_finan...
  - kijiki 6y ago
    2/4 rounds (and the overwhelming majority of the $$$ raised) were years after the EMC acquisition, and immediately before the IPO. Not really what people think of when they talk about raising VC. The 5 million and 20 million rounds in 2000 were strategic investments from partners who were going to resell ESX, and were done for reasons other than needing working capital. IBM and Dell were the 2 partner investors, IIRC.
CerealFounder 6y ago
This is it. These people are money managers that market based on owning x amount of one of the top 50 companies each year in order to raise a new fund. If they take smaller % the model fails both executively and from a marketing perspective.

ghiculescu 6y ago

Optimising for a good valuation (over a good business that you own lots of) is missing the point.

akharris 6y ago

Thanks - at any given round, dilution is driven by how much money the founder agrees to take. No outside party can force a founder to take dilution, it takes an agreement on both sides. While VC ownership targets are part of their business models, founders don't actually have to agree to meet them. From what I've seen, those targets are far more flexible than anyone admits at the start of a negotiation.

daniel_levine 6y ago
While I tend to agree with you in principle, I'm curious how often YC is flexible on the ownership target :P
- akharris 6y ago
  This is part of my point, founders don’t have to accept our deal even though we put it in writing ahead of time. It’s not the founders responsibility to make our business model work, it is their responsibility to build a great company. If we agree on an entry point for us to go along for the ride, great!
  - aabhay 6y ago
    This is exactly the issue though? Investors say “hey you don’t have to raise from us if you don’t want to give up X% of the company”. Which leaves no room to negotiate. The ONLY time you can expect to sell a smaller % of the company in a round is if you go to an investor and say “hey this OTHER investor wants the same % but is paying more, are you willing to take a lower % at a higher valuation?”. However, this seems very rare and the VC driving up the valuation is usually a higher tier VC in a bidding war, so founders are likely to go with them. Long story short, if you want to convince founders to sell less of the company, you have to convince top tier VCs to take less, and founders will follow suit.
TuringNYC 6y ago
No outside party can force a founder to take dilution, but unless you are the hot oversubscribed startup, rounds are often just enough money and you find yourself coming back hat in hand to be diluted over and over.

hinkley 6y ago

The first time I read about this topic, the author suggested counter-offering a smaller investment for a slightly higher dilution/$ to soften the blow. As in, “I don’t need $50m (for 20%), how about $23m for 10%?” I have never been to any of these meetings, but it seems like the guy who just skyrocketed your valuation for his 20% is going to be “louder” than the earlier investors who also own 20%. The % of investment versus the % of investors will probably skew things a bit, too.

itsoktocry 6y ago

>our lead was happy to raise the valuation so we could take more money and increase our odds of success. VC is such a strange world. "Valuation" is a measure of the fair-value of an asset. How can a lead investor decide "to raise the valuation"? Why would anyone looking to invest base the valuation on people who already have money in, rather than their own due diligence? Why wouldn't the optimal valuation be as high as possible? This game is kind of confusing.

daniel_levine 6y ago
It's a bit confusing but does make sense. Imagine wanting to buy 20% (or 100%) of Apple in the public markets. If you try in normal trading it will either take months based on trading volume or you'll bid up the price as you're buying. People looking to own larger pieces of a business are often willing to pay a premium to folks trying to buy smaller pieces.
jjeaff 6y ago
Because in a startup, valuation is generally calculated by the investor rounds rather than revenue. An investor can raise the valuation by putting in more money for the same ownership percentage or same money for less percentage. They wouldn't generally want to boost valuation for their round because that reduces their return. But there is probably some wisdom in hyping up valuations to get customers and future potential investors excited. Additionally, if it is a follow-up round, they probably want to invest at a higher valuation just for their own investor confidence. No one wants to have a "down round" because it throws cold water on the hype train for all the other investors.
- itsoktocry 6y ago
  >An investor can raise the valuation by putting in more money for the same ownership percentage or same money for less percentage. That's the confusing part, and it seems backwards. The valuation should determine how much money you are willing to put in for a specific ownership share. It should be an input, not an output.
  - 6y ago

datanecdote 6y ago

Worth keeping in mind the principal agent problem literature. Selling equity in a company is vulnerable to “lemon” problems. Startups with product market fit want to minimize dilution and keep executing before raising at a higher valuation in {12} months. Startups without PMF want to maximize runway to maximize probability of finding PMF. VCs know this, and startups know VCs know this, and etc. Unfortunately this can create perverse signaling incentives on both sides.

zeckalpha 6y ago

This sounds like a variant of the winner’s curse. https://en.m.wikipedia.org/wiki/Winner's_curse https://en.m.wikipedia.org/wiki/Winner's_curse