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Series A Investing is Not a Market Driven Pursuit

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Series A Investing is Not a Market Driven Pursuit

Stuart Ellman

“Is your fund crashing?” is the question my mother will ask after seeing the front page of Wednesday’s New York Times.  “Dizzying Ride May be Ending for Startups” is the name of the article. DropBox and Snapchat have both been marked down by mutual funds. Square is going public at a price significantly below the last private round.  Every banker pitchbook now has a page showing how late stage venture valuations are dropping. So, how does this affect Series A investors? My answer: Not as much as you think. 

At first glance this contention may seem counterintuitive. Of course there is a certain frothiness when the late stage markets are riding high. Boundless enthusiasm infects the venture community at large, and people assume that we too are swept up in the hype. The reverse is true as well. Tremors shaking the public markets yields a certain amount of fear throughout the ecosystem. But the truth is this: Series A investing is not a market driven profession, and late-stage pricing fluctuation doesn’t change how we run our business or how our portfolio companies run theirs.

At RRE, we are primarily Series A investors, which means that we lead the rounds after the Seed Round (which is the first money in a company).  Series A funding is usually raised once the product or service starts to ramp and show initial traction.  Usually, the valuation range is between $20mm and $50mm and the amount raised is between $5mm and $15mm.  

This is different from late stage investing in many ways. But one difference is critical when thinking about valuation. Series A rounds are priced up from what the company has achieved since it started (ground up approach) whereas late stage rounds are priced at a discount to what could be in the market (top down approach).  Series A gets a richer valuation, up to a limit, based on the quality and background of the CEO, the amount of traction the product or service has been able to achieve with the seed money, and the market opportunity. 

Late stage is done in reverse. Companies are valued at a discount to where they would be priced in the public markets.  If a company is expected to trade at $3 billion, a late stage round might price at a 15% to 20% discount to account for risk and illiquidity. 

The implication of this is obvious. The share prices of publicly traded companies are variable. Tremendous price fluctuations are common even in stable markets. If late stage venture valuations are based upon constantly shifting public company share prices, then one would expect pricing for late stage venture deals to be highly variable as well. 

Consider Box and Dropbox.  If Box is the publicly traded competitor to Dropbox, then similar multiples must be applied to both.  If Box drops by 30%, it would only make sense that the same should apply to the late stage rounds for Dropbox.

But here’s the thing--this is not true for Series A valuations. While there is certainly some upward price pressure when the markets are very high, as well as downward pressure in times of economic turmoil, we never price a $1mm revenue company off of a discount from public markets.  First of all, there is almost never a publicly traded direct competitor to a Series A company.  But moreover, it would (and does) seem ridiculous when a company says, “even though we have almost no revenues, assume we have $200mm in revenues and price us like our publicly traded competitors.”  It simply wouldn’t make sense.

When I make late stage investment decisions, I pay close attention to public market comparables. But when I do my bread and butter Series A investing, I remind myself that the company I am funding is 5 to 8 years away from a public offering. Rather than worry about the headlines, I focus on what each company has achieved and on what it has the ability to achieve. 

So, Mom, my fund is not crashing.  My job, first and foremost, is to find great entrepreneurs building exceptional companies, to fund them, and to help them grow. If I get that right, the rest will take care of itself. Great companies will cash out when the markets are ready to receive them. And while share prices of publicly traded securities are constantly moving, there will always be market appetite for great new companies.