Angelitis: I will write more on this topic in coming weeks, as it is a trap that entrepreneurs do not need to fall into. We recently had three different angel backed firms run into the same issue with us. We were forced to walk away from all three deals. They had priced their previous angel rounds too high, and did not want to go through a down round.
This situation is, unfortunately, increasing with frequency. I don’t know the exact reasons, but I have some suspicions. First, the cost of building out a platform has dropped significantly over the year. This enables entrepreneurs to get their offerings up and running and in customers hands for fairly small sums of capital (usually $500k-$1M). This is a good thing if structured appropriately. The second is that as the markets continue to flourish, angels are coming back into the market and are writing checks again.
However, the following pattern drives the issue. The company raises the first $500k at a $5M post-$. They grow and need more capital to ramp sales/marketing, so they raise the next $500k at a $10-15M post-$. At this point, the company is probably doing $1-3M in annual sales and growing linearly. The entrepreneur decides it is time to raise a venture round now, and goes to market with a $5M raise at $20M pre-$ valuation ($25M post-$). This is where the disconnect hits.
A company that is growing linearly (say $1-2m going to $3-5m this/next year in revenue) is going to be valued at a $3-7m pre-$ valuation. (I will write about different pricing approaches coming up.) The revenue often does not ramp as quickly as the entrepreneur expects (plans from two years ago had probably shown revenue of $10M vs. the actual $2M). Angels, being less price sensitive, had been willing to invest at the higher valuations. However, when the company needs more capital to scale (and is tired of living off of $500k rounds), it is forced to go to the professional venture community.
What should entrepreneurs do? The simplest answer is to use aconvertible debt structure. This avoids pricing the company too high or too low and also does not create unforeseen deal structure issues. The money converts into the professional round when raised.
Everyone loses when earlier rounds are mispriced. Venture capitalists lose the opportunity to invest in quality companies. Entrepreneurs end up running their business hand to mouth as they get trapped raising one $500k round after another.