Devil's Bargain: When Investors Get Too Low a Series A Valuation

I see a lot of posts these days about startups raising huge early-stage investments at ridiculously high valuations. What no one talks about, and what I think is equally dangerous, is the opposite: startups raising small early-stage investments at low valuations.

When startups in New York City, especially ones with teams of three or more founders, raise low amounts like $500,000 on sub-$3 million valuations, it ends up undermining the success of their startup. Why? Because there doesn’t end up being enough incentive for the founders to stick around.

The first problem is that $500,000 generally isn’t enough for a startup to show any significant progress over the course of a year. In New York City, it barely even covers the cost of living.

Let’s say you have four co-founders who decide to live on a very conservative $40,000 a year. That’s $160,000. And we’ll assume they hire four more employees at $60,000 a year (because only a founder would be incentivised enough to work for $40,000 a year). That’s another $240,000.

On top of all that there are costs associated with raising money, as well as overhead, which can run upwards of $100,000. Before they know it, the founding team has burned through $500,000 in a year and has to raise more money.

But most companies need 2-3 years to really see product-market fit. After one year, their business model isn’t firm. They need to gel, pivot, and truly study the market. That takes time and money. And $500,000 doesn’t give you enough of either.

The second problem is that when founding teams are too large, no one founder owns enough equity to stick around. Let’s say your four co-founders from before sold 25% of their company and set aside a 15% options pool for employees. At this point, each founder only owns 15% of their startup. After subsequent rounds of funding, any one of them can expect his share to get diluted down to 5-10% if he she is lucky.

But because the startup has run out of money after a year, the founders now have to reevaluate whether they should raise more money. Each one says to himself: I just made no money for a whole year. I worked really hard, but we don’t have traction yet. Do I want to go raise more money, deal with existing investors (and the headaches that go along with that), all to have my ownership diluted down to 5%?

This is the point at which at least one of the founders usually bails. And when founders bail, everyone loses.

I’m seeing more and more of this happen in New York City and it’s a dangerous phenomena. We’ve seen tremendous growth in the New York City tech scene over the past few years, but if we want to compete with Silicon Valley, it’s important that we make sure entrepreneurs are incentivised to stick around for the long-term.

We need to educate entrepreneurs to be wary of investors who want to give you small investments at low valuations. What’s the sweet spot?
  1. Raise an amount a startup can actually show progress with, around $1+ million, or 18+ months of burn.
  2. Keep the founding team smaller than three people.
  3. Preserve cash and be liberal/generous with option grants.
If founders follow these rules, they’ll be able to show more progress before they need to start thinking about raising another round and what’s more, they’ll own more of their company when they do it.

That keeps founders happy, investors happy, and ensures the sustainability and viability of the New York City venture community.

Somewhere lies a golden mean of start-up valuation....