Wednesday, September 8, 2010

Party Rounds: How To Get a High Valuation For Your Seed Startup

A major shift has happened in the last year - entrepreneurs have gone from led seed rounds to "Party Rounds".  This shift has non-trivial implications for the venture industry which I will explain in another blog post (in which I will also explain what is causing more and more party rounds to occur).

This blog is focused on:

(a) The difference between a Led Round and a Party Round
(b) How you raise a Party Round

Led Rounds (Old Model) vs Party Rounds (New Model)
  • Led round.  (The old model)
    • Who sets the terms:  A single investor sets the terms of the round in negotiation with the entrepreneur.  Usually the investor is one of the larger $ amounts in the round or a professional investor.  Other investors then co-invest on these terms, often after being pulled in by the lead investor or the entrepreneur (the "syndicate").
    • Board seats.  The lead investor may or may not take a board seat depending on what they and the entrepreneur decide.
    • Representing the investors.  The lead often represents the overall set of investors in the round.  So if e.g. the entrepreneur wants to sell the business, she may often discuss it with the lead investor rather then having to tie in to all investors.
  • Party Round.  (The emerging model)
    • Who sets the terms: The entrepreneur sets the terms, often by bringing on smaller investors with no leverage first to get early commitments for the round.  
    • Board seats.  Board seats are usually not given out.
    • Representing the investors.  There is typically no one investor who represents the overall investor pool.  Or, a "Brand name" investor will tell the entrepreneur what investors in general may want.
    • Valuation: Party round valuations are often 50-100% higher then led rounds.  This is due to the fact that no single investor invests enough to have the leverage to negotiate down the terms.  Similarly, the way a Party Round comes together often precludes the ability to any one investor to negotiate or set the terms (see below).
      • The net impact of this is that an entrepreneur who before would have raised at a $1.5-4 million valuation is now raising at a $3-6 million pre-money valuation.

How to Raise a Party Round and Get a Better Valuation
In the not-so-distant past, there were a handful of major angels or funds who would lead rounds.  An entrepreneur would have to negotiate terms such as valuation with this small set of potential leads.  Once a lead fell into place, other investors would follow on into the deal.  The small number of potential leads meant that:
  • There was higher likelihood of collusion amongst investors in setting price - people were more likely to know who the entrepreneur was also talking to
  • Entrepreneurs had fewer options from which to raise capital - which meant they had less leverage over market cap or other deal terms

Today, it is increasingly typical that the entrepreneur raises a round without a lead investor.  Furthermore, the entrepreneur can get much better terms (e.g. a much higher valuation) in a Party Round as follows:
  • The entrepreneur finds 3-5 smaller angels willing to put in money on terms set by the entrepreneur.  
    • These angels are typically ones who traditionally have not had much deal flow, or do not invest professionally, or alternatively, are investing more for status/to give back than for financial return.   This means they are less valuation sensitive in many cases.
    • These investors do not have the leverage (or in some cases the interest) to negotiate a better deal. 
    • These angels may still be value added money, or e.g. previous entrepreneurs known by more prominent angels (so they may still provide social proof beyond just the money committed).
  • The entrepreneur uses the money committed by smaller angels to set terms with larger angels.  
    • By raising from these 3-6 lesser known angels, the entrepreneur raising the round now has say $200K out of $500K in capital committed for the round.  The entrepreneur can now go to professional investors / super angels (who normally would have had more leverage) and say "I have set terms and have a big chunk of capital committed.  If you want to invest, you need to do so on these terms".
    • Many institutional angels have a model in which they make 30+ investments a year.  Part of their premise is by investing in a large portfolio of company, they will hit the 1 company that will return the fund many times over (e.g. the next Facebook or Google).  The super angels do not want to miss out on a hot opportunity, so may be less likely to negotiate at this point.
  • Wrap up the round.  
    • Once one or two prominent angels agree to the terms, many of the others (both large and small) will follow.   The round is now closed and in many cases overcommitted, causing the entrepreneur who planned say $500K to raise $1 million for their seed.
I will discuss why Party Round have emerged, as well as the pluses and minuses of these rounds in another post.

Thoughts?  Do you think Party Rounds are good or bad for the entrepreneur?  For the investors?  For the tech community?

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