There’s a strange phenomenon in the startup world where entrepreneurs work hard to justify a valuation for a pre-revenue seed round based on the team, market dynamics, etc.. In the end, seed round valuations are often in the $1.5 to $3 million range, and there’s little rhyme or reason from one to the next.
Now, that same entrepreneur who was able to raise a $500,000 seed round at a $1.5 million pre-money valuation goes out to raise a Series A round. Only, this time it’s different. This time the investors look at the startup’s metrics. Things like annual recurring revenue, trailing twelve months revenue, daily active users, growth rate, renewal rate, etc. become the main discussion points for valuation.
Say, as an example, the entrepreneur has $1 million in annual recurring revenue with strong growth and renewal rates. For an institutional investor, the valuation would typically be 4-8x run rate. Competitive deals with multiple investors fighting to lead the round ultimately lead to higher valuations. So, that same company 18 months earlier with little-to-no revenue raises money at a $2 million post-money valuation now has a million dollars in recurring revenue and raises $3 million at a pre-money value of $5 million for a post-money valuation of $8 million. While $8 million is dramatically more than the $2 million from 18 months prior, in reality the business is worth many times more than the seed since it has serious revenue and customers, and is much more likely to be successful long term.
There’s a valuation disconnect between seed rounds based on dreams and A rounds based on metrics. As an entrepreneur, it’s important to understand this and understand the psychology of investors.
What else? What are some other thoughts on the valuation disconnect between seed rounds and A rounds?