I am not (yet) active on a startup of my own but I have been trying to read and educate myself in that arena so that I can at least coherently talk and ask the right questions of the people who I'll be working/negotiating/etc with.
One resource I read is Chris Dixon's blog. A post of his at http://cdixon.org/2011/04/20/financing-risk/, says this in the last sentence:
A rule of thumb is a successful SeriesHow is that supposed to be interpreted? I mean, I (think I) know what Series A is... your first round of funding... but what the heck is pre-money/post-money really referring to and why would pre-money need to be 2x better than post-money?
A is one that is led by quality VCs
with a pre-money at least 2x the
post-money of the seed round.
Why? Because the company still owns everything it owned before the investment, only now, it also has one million dollars more in the bank, so it's worth a million dollars more.
The x here is called the pre-money valuation or, for short, the pre.
The x + 1,000,000 is called the post-money valuation, or, for short, the post.
What Chris is saying is just a jargonny way of saying that you should double the value of the company between the seed and Series A rounds.
Why? That goes back to the definition of value.
The value of a company is simply what the last buyer is willing to pay for one share, times the number of shares outstanding. It's whatever number is necessary to make the investor and the company do a deal.
How can you put a value on a dinky room full of three smelly 22 year old programmers who haven't made a penny and are just spending a lot of money on EC2 instances and Jolt Cola?
Well, you have to estimate. And the more risk there is, the lower the value.
In particular, if a company with a 10% chance of success has a value of x, how much would it be worth if it had a 20% percent chance of success?
Answer: 2x. Why? Because it has twice the chance of success.
So really what Chris Dixon is saying is that a company should double its chance of success between the seed round and the A round.
The best way to do that is by eliminating risks. Example:
Etc., etc. The more risk you eliminate, the higher your valuation is going to be. And at each stage in the funding process, you want to eliminate risk in order to increase valuation in order to insure that the new money coming in buys a smaller percent of the company so that you don't have to give away 100% of the company before you even launch.