Part I: Fireside Chat with Dr. Dan Gebremedhin – Flat rounds, super-sized Series A’s, and what happens next?

by Sanaz Cordes, MD

This is the first of a two-part Fireside Chat series with top industry experts in the health tech startup space.  Today we sat down with Dan Gebremedhin, MD, a Principal at Flare Capital Partners and a practicing Internal Medicine Physician on the Faculty of the Massachusetts General Hospital and Harvard Medical School.  Flare Capital Partners is a venture firm focused on improving the quality and delivery of healthcare through technology.

At Value Prop Shop, we are hearing from an increasing number of startups who are feeling the aftermath of premature large A rounds as they face the challenges of raising a Series B in today’s shifting venture climate.  We asked Dr. Gebremedhin to share his thoughts about the factors that led to these large Series A valuations and the increase in flat rounds that are occurring as a result.  

Q:  Are you seeing more flat rounds and add-on deals today? 
Yes, these are more common now as compared to before. 


Q:  In your opinion, what factors have led to this?
A:  To put it simply, it comes down to a lack of traction that does not support the post-money valuation of the last round, and thus it is not realistic for an entrepreneur to expect a step up in their pre-money valuation for their next round.  When a company raises a high-priced Series A, usually it’s a function of an inflated pre-money valuation. These pre-money valuations were often driven up by a bidding war between interested investors and entrepreneurs solving for highest near term “price” and not thinking about the implications on the next financing round if the story does not go according to the aggressive plan.

The entrepreneur gained traction and excitement around their product, and started telling a compelling story around the market size and their product as a differentiator and projected very high near term revenues with lots of customers. Essentially, it was over-promising. This led to increased investor excitement and a bidding war for the Series A round, in most cases. Many investors who were interested, presumably at more realistic prices, were not able to participate in the round as companies will only raise a finite amount of money in each round with the lead investor having specific ownership threshold goals.  

So, the Series A deals closed at a high price and resultant large post money valuation, yet the startups weren’t fully prepared for the unexpected consequences of overshooting what the market would truly bear, the inability to convert pilots to contracts, and inadequate sales and marketing plans.


Q:  What kind of valuation and revenue numbers are we seeing as a result of this scenario?
A:  Some entrepreneurs were raising Series A’s at pre-money valuations in the mid to high teens, and some even north of $20M range, which resulted in very high post Series A valuations. Yet, many couldn’t even hit $1M in revenue by the time they had exhausted their Series A capital.  They would need to show top line revenue in the $3-5M range to support a Series B pre-money in the $30M+ range.    


Q:  Were there other factors, in your opinion, that contributed to inflated projections and “overpromising” by entrepreneurs raising their Series A?
A:
  I think there are a lot of factors at play. Entrepreneurs are, by nature, competitive, and if their peers – specifically peers in their specific market – are raising large amounts of capital at high prices, there is going to be a tendency to start an arms race to raise large amounts of comparable capital. It’s a self-fulfilling prophecy. In order to raise a large amount of capital, you need to tell a big story to get investors excited, and so on.   Recently we’ve heard entrepreneurs share that recruiting pressures contributed to the some of the decisions they made about chasing large valuations.  They are competing for the best talent, and to attract great employees, the recruiting message often included the expectation of a “large" exit.  


Q: If the startup can’t reach the necessary revenue milestones for a true Series B, are there other factors that would compel new investors to participate in a flat or add-on round?
A:  Yes. Sometimes you have the opportunity to add world class investors or highly strategic corporate entities who can become large customers or distribution partners; these circumstances may prompt an entrepreneur to add them to the last round of financing, to “just get them in.” If a startup doesn’t have the numbers to support a Series B, they can still raise at their previous valuation if they have other assets with “perceived value.”

Examples include a solid installed base or a large number of consumers using their platform (for B2C products).  In these scenarios, an investor will overlook the lack of hitting the promised 3-5X revenue increase and still invest.   Without these assets pointing to long term value, an investor is not likely to participate in a flat round.  Venture capitalists are generally not in the business of “bargain investing,” because if an asset is at a discount, you have to ask yourself “why is there a discount, and why am I so lucky that I have this unique opportunity to invest at a discount?” Usually there is something fundamentally wrong with the asset, and the chances of exponential growth given these impairments is unlikely.


Q:  How much of a red flag is it to potential investors if a previous investor, with available capital, does not participate in the flat raise?
A:  It gives pause.  Again, investors don’t want to feel they are getting a bargain that comes with risks.  So, I’d call it a “yellow" flag, at the least.   It signals that the investor ought to do very deep due diligence.  They should talk to the investor that is not participating, the other investors, the company's team members, and even customers.   


Q:  Can you share your thought around flat round deal structures and the potential risks around dilution, liquidation and future rounds?
A:  This is a style of investing question and you will see different approaches in the market. The nature of a flat round is that existing shareholders (team + investors) will experience dilution without increase in share value, and no one is excited by this scenario. But, it is required for future growth and sustainability of the business. A not uncommon scenario and challenge faced by investors joining a flat round is an existing participating preferred stock structure negotiated by existing investors.  Incoming investors typically have three reactions to this structure: (1) secure participating preferred stock for themselves, (2) secure participating preferred stock with more lucrative protection options for themselves, (3) work with the existing investors and the entrepreneur to remove participating preferred stock and restructure into a clean, new model.

In my opinion, option #2 misaligns incentives the most.  It greatly impacts earlier investors who took risks at an early stage with the expectation of liquidation benefit.  Both options #1 and #2 have downstream dilution and liquidation consequences for the existing investors, the entrepreneur and the employees.  Option #3, although difficult to negotiate, creates clean restructuring that can best align all 3 parties’ interests and sends a positive message to future investors.


Q:  What advice do you have for entrepreneurs facing a flat or add-on round, post Series A?
A:  Entrepreneurs often feel that flat rounds are a calamity or signify some form of failure.  This perspective is decidedly a short-term mindset, whereas good investors and entrepreneurs think about the long term and the valuation of a company at the exit – not at intermediate rounds of financing. As investors, we advocate a focus on the long term and doing what’s best for the company in the near term to increase chances for long term success. 

It’s understandable for entrepreneurs to feel pressure about dilution, liquidation risks, employee retention and recruiting. It’s also understandable to have concerns about signaling to the market and future investors. But often these concerns are overblown and focused to the echo chamber that is venture capital and venture-backed companies. These things matter much less to customers, which, in all honesty, are probably the most important stakeholders in a venture-backed business. I would encourage entrepreneurs to think of a flat round as means to secure more time to gain traction and keep moving towards the long-term plan and true value creation for all stakeholders around the table.