Why you’re mispricing your VR seed round

I invest in early-stage VR startups via my fund, Presence Capital, so I may be biased on the topic of pricing these startups. But I’ll try to remain neutral here and act as if I was a founder fundraising for my own startup.

I’m all-in on VR and AR and believe these technologies are the basis for the future of computing. In fact, I cofounded my investment firm to focus exclusively on finding and backing VR and AR startups. That said, I’ve noticed that many VR startups have trouble raising their seed rounds due to mispriced valuations and an overemphasis on reducing dilution with their first round.

VR and AR are emerging technologies. Entrepreneurs routinely buy into the hype and fail to set their valuations to appropriately reflect the immaturity of this market and the time needed to reach meaningful revenue.

The reality is that most of the traditional advice on fundraising that applies to mobile, SaaS, or enterprise startups doesn’t necessarily apply to VR because this market is so new and raw. You should raise with that in mind.

My goal here is to help founders optimize for success in terms of building a great business over the long term, not just in raising the first round of funding. Similar to engineering, premature optimization can cause you to focus on items that don’t materially affect your outcome and can divert your attention away from those that do.

I meet with a lot of VR and AR startups. In the last year, my firm tracked 400+ of these companies, had 200+ meetings, and made ~25 investments.

When we evaluate a startup, we look for team fit (grit and sense of urgency), product vision, and round terms that show intellectual awareness of the market and growth trends. Unfortunately, we frequently see founders that have a great background, a strong vision of what they want to build, but trip themselves up over the way they structure their round. More specifically, the valuation/cap they are trying to raise at.

We are often approached by VR and AR companies with minimal prototypes (if any) trying to raise at an $8 million to $15 million pre-money valuation or cap with a dilution target of 15 – 20 percent. As a contrast, a YC-graduated company that likely has the benefit of a launched product, initial traction, a large existing potential market, the YC network, and an investor feeding frenzy on Demo Day usually raises at a $6 million to $8 million pre-money valuation. For early VR companies that are pre-product launch, often a valuation in the $3 million to $6 million range or a higher level of dilution is more appropriate.

(Note that, in arguing for lower valuations, I’m actually arguing against my own interests given that my firm usually commits to investing in a company before a seed round is fully-formed, so we are mostly aligned with founders trying to raise as much as possible while keeping dilution to a minimum.)

As a founder, there are quite a few ways a high seed-stage valuation can work against you:

• Turns off potentially great partners. Strategic and value-add investors are frequently valuation sensitive. Savvy investors are excited by VR but need to be intellectually honest about how quickly the market will develop.
• Sets your initial bar too high. You may be able to raise your Series A and even Series B as up-rounds on the hype around your team and VR in general, but eventually you will be graded on revenue and traction metrics. Not just against other VR startups, either, but against other, more mature industries.
• Creates future round risk. VR is an early market; it’s possible you will need to raise another round before it develops and be priced too high to raise a bridge.
• Takes the momentum out of your process. Raising when your valuation is misaligned with your reality feels like a drag on your fundraising process. A lot of investors will string you along and not give you firm commitments. The opposite of this feels like a ball rolling downhill: You rapidly gain early commitments and are usually oversubscribed much more quickly than you expected. This puts you in a position of leverage to decide who to let into the round.

So given the above, what can you do to make your round go smoothly?

• Be honest with your situation. Your VR or AR startup is significantly more risky than a normal venture. You’re in an emerging market with a product that’s likely pre-launch, with little-to-no traction and few revenue opportunities in the short term.
• Focus on the right metrics. It’s normal to be diluted 10 – 30 percent with your seed round. Your team’s experience, product vision, and how far along the product is determines where you fall in that range. That said, in future rounds, when you are in a position of leverage, you can command much higher valuations and reduce dilution at that point.
• Raise enough capital. You’re going to need time and may not want to be in the position of having to raise again in case the market cools.
• Manage burn expectations. Keep burn low and demonstrate a plan where your seed round gets you 16–24 months of runway. This is higher than normal seed rounds (12–16 months) because of the immaturity of the VR market.
• Look past the current round. Optimize not just for your seed round but for raising a series of rounds with the right partners. Choose an appropriate valuation that reflects the state of your company and how risky hitting your next milestone is. The valuation you have for this round sets the bar for future financings.

When does this advice not apply?

• When you have significant revenue. This is unlikely for consumer VR at this point but may be possible for B2B and enterprise businesses. At that point, standard revenue-based valuation logic applies (you need $1.5 – $2 million ARR to raise a Series A)
• When you have significant traction in the form of retained users. Specifically, D1/D7/D30 retention that mirrors long-term engagement usage patterns you see on web and mobile: D1 50 percent+, D30 25 percent+. Side note: Session length is not an appropriate proxy for consumer long-term engagement. VR also has higher-than-normal session lengths because users need to overcome a lot of friction to begin using a VR device.

I purposefully did not mention a founder’s experience as a possible exception. Sure, you may have a higher chance of success as a repeat founder, but even experienced founders are at the whim of the growth rate of the VR market.

All of the above being said, each situation is unique and every founder needs to find their own path.

[Thanks to Arjun Sethi, Nabeel Hyatt, Justin Waldron, and Daniel Hu for their input on this post.]

Amitt Mahajan is Managing Partner at Presence Capital, co-creator of FarmVille, and a serial entrepreneur. He blogs at Amitt Mahajan. Follow him on Twitter: @amittm.