Valuation / ownership is one of the key subjects for negotiation between VCs and start-ups, especially at the seed stage where technology validation, go-to-market and commercial risks are high.
The relevant model that includes the figures discussed later is attached in the link below:
This model can help founders get in the VC’s shoes!
Now, let’s explore the reasons why VC funds require substantial ownership at the seed stage.
Dilution
Imagine the scenario where a seed fund invests $1M at a post-money valuation of $4M, thus receiving a 25% ownership. Assuming that everything goes to plan and the series A round of $5M is raised at a post-money valuation of $20M with the seed fund participates with $1M. It’s ownership goes down to 23.8%. Then a series B of $20M is raised at a post-money valuation of $80M (no participation by the seed fund) and 2 years later a series C round of $35M at a post-money valuation of $140M (again no participation by the seed fund). At series C, the seed fund has been diluted to 13.4%. This means a dilution close to 50% since the initial investment at the seed stage.
If the initial ownership was 10% instead of 25%, the fund would be diluted to 5%. This means that a fund size of $50M needs a unicorn exit (i.e. exit of at least $1B) to return the fund. According to CB Insights, only 1% of start-ups reach unicorn status. Therefore, a $50M fund needs 100 bets to produce 1 exit that will return the fund. But the number of bets of a $50M fund is closer to 20-30 rather than 100.
As a result, a higher ownership at the seed stage ensures that the fund’s diluted ownership post-series C is meaningful and an exit much lower than $1B would still generate significant returns (both in terms of multiples and IRR).
Risk
Pre-seed and seed are the riskiest investment stages. Technology has not yet been validated, product-market fit has not been achieved, team has not yet been expanded (‘managerial risk’), and the company is far from commercialization. Therefore, the only way to “mitigate” (if the company fails shareholding level does not matter so this is not exactly risk mitigation that is why I am using ” “) the risk is to gain substantial ownership at the seed stage. Think about this: a $40M seed-stage fund will probably make 20 investments with an average investment (initial + follow-on) per company of $2M. To achieve a return multiple of 2x of the fund size (i.e. proceeds $80M) you need 2 fund returners (i.e. 2 companies that achieve an exit which each bring proceeds of $40M to the fund).
Therefore, a VC ownership of 5% or 10% at the seed stage is not sufficient vis a vis the technology and commercial risk that the fund is taking.
Modeling the returns (for funds and start-ups!)
Take the numbers discussed above and assume the start-up exits at 2.0x the series C post-money valuation i.e. $280M. The seed fund’s proceeds is $37M. The multiple of investment is 18.7x. An amazing result right? However, looking at the big picture how many of the 20 companies that the fund has invested in will actually reach an exit of that level or an exit at all? Very few. That is why a probability-weighted approach is more suitable. Applying a 10% probability of achieving such a return yields in a probability-weighted multiple on returns of 1.87x and probability-weighted proceeds of $3.7M. Multiplying this by the 20 investments made by the fund results in returns of $74.8M which means a (fund) return multiple of 1.87x.
For many Limited Partners (i.e. investors of the fund) such returns can be viewed as mediocre. On an IRR basis this is close to 10% which hardly beats returns that can be gained by instead investing in the stock market. Factoring in the increased risk and the illiquidity (as opposed to public markets, an LP cannot simply withdraw or sell their VC commitment) involved in VC, such returns do not seem ideal.
Conclusion
Seed VCs try to negotiate down the valuation not because they think the investment case is not strong enough but because they want a larger piece of the pie as they know they will be diluted significantly in late stage rounds. It is very common for founders to be confident about hitting the necessary milestones to move to the next round, but the reality is that very few companies actually progress in that manner. Therefore, such risk needs to be “hedged” by the VC and the only way to do this is through higher shareholding at the seed stage.
