For many people starting their first startup, venture capital is like some kind of "black box" that operates according to frustrating, sometimes complex rules that are designed for industry insiders, not first-time entrepreneurs. With this post, I'm going to try and lay out a simple system, based on real data, that will help first-time entrepreneurs (and first-time startup investors) make sense of venture capital, do deals at reasonable valuations, and establish some reasonable goals for the future. I call this system the "Rule of Five X".
First, the disclaimers: the numbers in the diagram differ according to the source (we're using a combination of publicly-available PitchBook data and our own Hatcher+ data) - and everyone these days has a differing view of what "Series A" and "Seed" mean*. That said, the numbers and the time between rounds (5 quarters, plus one for legals) are about right. It's the labels of the funding rounds you need to take with a grain of salt - a Series A in San Francisco might not directly equate to a Series A in Istanbul. They might call a "Seed" round an "Angel" round where you live. If the labels look wrong, just ignore them, and look to the stages instead - and the numbers.
Here's how the Rule of 5X works: If you're an early-stage company looking for venture funding, you can safely assume that for every 5x level of growth in your core business metric (usually revenue), you may demand 5x more capital, at a 5x greater valuation, for your first four rounds. You can also safely assume that it will take you five quarters to get to a term sheet for your next round of funding, and one more quarter to close, once the term sheet is signed (PitchBook's 2017 Valuation Guide says the median amount of time between early-stage round closing dates is almost exactly 1.5 years.) And you can further assume that you will have to give up 1/5 (20%) of equity, regardless of the round you are closing.
Re valuation, if you look at the latest valuation data from PitchBook, you'll see an interesting fact: the median post-money investment between round rises roughly 5x from angel to seed, and from seed to Series A. We know from our work with accelerators and angel groups that the jump from formation to the next stage is equally predictable. If you squint a little and choose the right sector, you can even draw a line beyond early-stage, which, for some historically high-growth companies continues along the 5x growth / 5x valuation path.
What does this tell us? It tells us that there is a system at work here. VCs are not arcane "black boxes" after all. Consciously or subconsciously, the venture capital industry is playing by rules that can be easily dissected and understood - and leveraged - by startups. Grow your revenue 5x in 5 quarters - and your starting point for negotiations for your next round becomes 5x the capital you previously raised at 5x your previous valuation for 1/5 the equity in your company.
Yes, I said "5x the capital". Sounds great, right? But just because I said that doesn't mean you're going to get it. In San Francisco or New York or Boston, if you show you're able to grow 5x in five quarters, I think there is a high possibility that that these rules will apply. But this isn't often the case in tier two cities or emerging markets. For one thing, while investors in the Valley (and the Village) largely understand that "momentum follows capital", many venture investors in less-developed markets often require entrepreneurs to "demonstrate traction" far beyond their capacity to do so.
This factor sometimes has the effect of removing high-value startups from the ecosystem, as the founders in these countries, realizing the system is stacked against them, take their Seed or Series A funds, buy a handful of tickets, and jump a plane for SFO airport - with the objective of raising capital from people that understand they need to be adequately funded to hit their revenue or user acquisition targets of 12.5% per month compounded, or 5x in 5 quarters.
Note: I personally know of many, many examples of companies (and investors) that didn't play by the rules above. Finding exceptions isn't the point - what I'm trying to do here is simply provide some clarity, using some useful medians derived from some pretty massive data sets. My aim is simply to provide entrepreneurs with a set of guideposts they can use so they know what to expect in the coming years - and in their coming financing rounds.
*Leaving aside any obvious differences in shareholder rights, "Seed" seems to us to be the new "Series A" in many locations - and "Series A" the new "Series B". Based on the data, it could be argued that the average time from formation to closing of a seed round is similar to that of Series A a dozen years ago (at least in the US), and that these rounds sizes appear similar also back then, when adjusted for inflation. In any case, the fact that almost all companies do a Seed round now (and that Series A is pushed later by up to 1.5 years) should be taken into account when comparing current and historical data.