Venture capital is often described as a business of pattern recognition - experienced investors pick up on market patterns, management team dynamics, and seemingly random data points to draw powerful insights. While I am still relatively new to the industry, I am struck by a few capital structure patterns that are generally bad omens.
The Too Large "A" Round
Ideal company formation reminds me of agile programming - small teams driving quick, iterative cycles that allow for the most insights, appropriate changes in strategy, and, ultimately, the highest quality "product."
I often say that genius is a function of context, and until a company is fully immersed in the context of the given problem set the best insights and strategies are often not apparent.
Too much money too early and too many people too early interferes with the productive process of iteration. Large teams with lots of resources and a very uncertain sense of direction or purpose are a bad combination.
Too High "A" Round Post-Money Valuations
While a self-serving argument, an equally challenging problem is a too high "A" round post-money. High "A" round valuations are often Pyrrhic victories. High posts and middling execution often leaves a company in a grey zone whereby objective value creating milestones have not been clearly met, yet some qualitative progress has been made. A common result of such a financing is a bridge round that extends the runway and is designed to allow the company a quarter or two to "grow" into its post-money "A" round valuation. More often than not, the bridge becomes a pier and the company and founders suffer from a post-money that proved you can win the battle and lose the war because of it.
"A" round financing strategies should be tied to discrete logic tests and proofs and the goal should be to optimize the validation/dollars ratio. Can we validate the technology and business model on as little as capital as possible? The ratio forces founders to think through the material questions that need to be answered with the use of proceeds. Will the product work? Will customers buy it? Can we sell it? If so, how? How much do we need, with a slight cushion, to answer these questions? Given all the noise in a start-up, what are the real issues and risks we need to manage? The validation/dollars ratio is a measure of efficiency and a quasi measure of return on equity. Start-ups that maximize the ratio are generally rewarded for it.
A reasonable Series "A" raise and post-money combined with realized value-creating milestones generally leaves a company in an enviable position when raising the Series " B". The key hypotheses have been validated and a reasonable mark-up is possible.
To that end, Cooley Goodward's recent report on trends in venture capital reported that the median Q305 valuations for A-D rounds were $5m, $12m, $23.5m, and $41.71m respectively.
Patterns and data suggest that for software companies an $8-10m "A" post appears to maximize the probability of a healthy B round and good optics and pattern recognition.