The most important thing to understand about raising capital is this: fundraising is not the end game. It is the bus that gets you to the end game.
That might sound obvious to some, but in the current environment, the media fawns over companies raising large amounts of capital, rather than the ones that don't need it and thus avoid having to give away ownership in their company.
The best way to be successful is to focus on customers, growth, and cash flow. Fundraising should be used to accelerate item two at the short-term cost of item three. This often makes a lot of sense, particularly in "winner-takes-all" type markets where it is important to quickly get to and maintain market leadership.
But fundraising comes at a big cost. If your company is running great without funding, and you don’t have a clear plan for the cash that will create long-term value, you probably shouldn’t be raising capital.
The two biggest costs are dilution and time.
Let’s say you raise $2 million in exchange for 20% of your company’s equity, and spend it on accelerating product development. The true cost to you may end up much higher. If your company sells for $100 million in five years, the dilution from this fundraising cost you and your existing investors $20 million, which is 10 times the cash you raised. Of course, that might be worth it. But you should know the potential cost.
The impact of time spent fundraising is harder to measure but can be just as problematic. Finding investors, meeting investors and following up with them is incredibly time consuming and distracting for a founder. However long you think it will take, double it and add one month.
Fundraising is a not something you can do half-heartedly. You are either all in or not playing. If you can, dedicate (sacrifice) one team member to the fundraising process and keep everyone else out of the vortex. If you don’t, you will pay the price in productivity. There is limited benefit in having more than one person involved in the process, and plenty of downside.
Assuming you still want to raise capital – the next question is, how?
Break that question down further, and tackle each individually:
The worst time to raise is when you have a gun named insolvency pointed at your throat. If you are running out of cash in the next couple of months and you aren’t already well into the fundraising process, you are probably in trouble.1 You need to start now.
The best time to raise is when you have plenty of buffer and a viable fall back plan. If you don’t, investors will smell your desperation. Investing is a bit like dating. You need to have other options or at least convince others that you do.
How much buffer should you have? A typical Series A investment round takes around three months to finalise. But that is just a rough median – which means around half the time, it takes longer. There are enough risks in early-stage companies as it is. If you can reduce one at low cost, especially a fatal one, you should. We recommend you commence fundraising no later than six months before you are projected to run out of cash.
Sometimes, even great businesses struggle to raise capital. The founders of Airbnb had difficulty raising money for years. At one point, they resorted to selling cereal boxes to make ends meet.2 If you believe 100% in your business, but investors don’t, you need to have a plan in mind. This is much easier if you have stayed lean, in which case you may be able to ride out the storm by cutting back all unnecessary expenditure. If not, make a detailed disaster plan that ranks expenditure from most to least critical. Yes, it may hurt.
Everyone has a different opinion on how much you should raise. There are two parts to the formula: projected monthly cash burn X desired months of headroom. The thing most people disagree on is the months headroom.
Cash burn simply means net cash outflow. A quick way to estimate future cash burn is to take your current cash burn and add to it the number of new employees you want to hire multiplied by an industry average monthly salary (plus 20% to account for other costs, taxes and benefits). Try to stay lean. Only add employees where you believe the dilution impact and resultant reduction in firm flexibility (larger firms are less agile) makes sense.
Opinions on how many months headroom you should target vary from 12 to 24 months. Fred Wilson from Union Square Ventures (one of the most respected venture capital firms in the world) recommends 12-18 months headroom for small companies, and up to 24 months for larger firms valued at more than $50 million. Other venture capitalists advocate taking as much as you can possibly raise.
If you raise too little, the problem is obvious. If you assume it takes 6 months to close a round, raising less than 12 months gives you only 6 months to demonstrate company progress before you have to kick off the next round. Given existing investors will expect you to raise at a significant premium to the last round, and new investors will expect you to have shown significant progress to justify that valuation, this is an issue.
If you raise too much, the temptation to spend it is high. Companies can get themselves into trouble by hiring too many employees too early. They become wholly reliant on future fundraising to stay afloat. They may also hire the wrong types of employees and hamper the culture that led to their initial success.
Every situation is different. If you are making rapid progress, growing monthly revenues at double digit rates, and have demonstrated an ability to close out fundraising rounds quickly and with minimal disruption, you will probably get away with slightly less than 12 months of headroom. Otherwise, you are better off playing safe and giving yourself at least 18 months leeway.
If you can reduce a fatal risk at low-cost, do it.
Finding investors can be a daunting task. We built Fundcomb to help founders quickly find the most relevant potential investors for their company. Investors come in many varieties, and inevitably there is overlap between the categories.
Startup accelerators and incubators like Y Combinator and 500 Startups help fresh startups build a viable product. They typically receive a small amount of equity (5-10% is typical) in exchange for a modest cash contribution ($50-150K). Over a period of one to three months they offer the startup facilities, advice, networking and other benefits.
Seed or angel groups like Sydney Angels specialise in providing small amounts of capital to help a startup get to the product stage. They may comprise either a group of angel investors that work in a syndicate, or institutional funds that have raised money to focus on early stage capital.
Individuals and family offices tend to have the most flexibility. Whereas funds tend to raise capital under a specific mandate, individuals and family offices can theoretically invest in whatever they want. Angel investors such as Chris Sacca fit into this category. They are a key part of the venture industry, and help to bridge the gap until a startup is large enough to interest venture capital funds.
Venture capital funds vary widely. The large, well-known firms such as Sequoia Capital tend to get involved when a startup is already producing significant revenue. Given their multi-billion dollar fund sizes, they generally want to invest large sums in each deal. Smaller, more flexible firms such as Blackbird Ventures participate in all stages, from $50K seed capital cheques to multi-million dollar later round raisings.
There are other types of investors to consider also. Many corporations have significant venture-investing arms, such as Telstra Ventures and Intel Capital. Certain hedge funds, growth and private equity funds will also participate in later-stage venture rounds.
Our search engine, FundComb, provides an easy way to find investors. You can narrow your search to target a particular type (e.g. venture capital), product type (e.g. software), funding round (e.g. seed funding only), geography (e.g. startups that focus on Australia/NZ), deal size (e.g. only include funds that can participate in a $200K round) and fund size.
We provide contact details on each fund page, however the best way to approach these investors is to try to find a warm introduction from someone you know. How do you do that? Time and networking.
Go to startup conferences, industry events, coffee-catchups. Investors can receive hundreds of pitches a week. They need a way to filter these pitches. One of the most important attributes in founders is perseverance. Founders can show this by taking the time to find introductions to a curated list of investors. On the other hand, anyone can mass-email a pitch to hundreds of investors.
When you finally get in front of investors, you need to have your pitch perfected. Investors form impressions quickly, and especially in early-stage ventures, do not have much to go on other than the founding team. If you go into a pitch disorganised and with no compelling vision, you are no chance.
You will quickly work something out about investors and fundraising. The less a startup needs capital, the easier it is to obtain.
The reason is simple. Investors are human. They are driven by fear. Fear of making a dud investment, and fear of missing out on a great one. They are subject to herd mentality. If others like it, maybe they should too. And they crave what they can’t have.
Given this, many founders think they need to come across as hyper-confident. They do their best impression of founders who have built hugely successful businesses. Do not do this. A certain level of confidence can be beneficial. But if you push into arrogance, that will put off 99% of investors. And if you aren’t naturally confident or a skilled actor, it can be very difficult to dance on the right side of the confidence / arrogance boundary line.
Not all investors want to see a pitch deck, but some, like Andreessen Horowitz explicitly state that they do. In our experience, more than half of investors want to see a deck, and so we highly recommend that you produce one. Investors that don’t want to see one won’t mark you down, providing you don’t insist on dong a page-turn of the pitch.
You don’t have to talk to investors about valuation immediately, and it is often better to get feedback from investors first. There isn’t much science behind early-stage valuations.
It ultimately comes down to supply and demand. That is, how much capital you are trying to raise versus how much capital investors are willing to commit. What affects demand?
Sentiment is one factor. In some years, such as those following the year 2000 dot-com collapse, investors are sceptical, capital is in short-supply, and valuations are low. Sometimes, such as the late 1990’s and early to mid-2010’s, investors pile into the space (usually after seeing other investors make large returns), and valuations rise.
The other factor, of course, relates to your startup. The factors that will influence valuation include the strength of your product, your team, and the sector you are operating in. The biggest factor, however, is often who else is investing – how many others are interested, and the quality of those that are interested.
Valuations differ so much between time periods and sectors that it is hard to generalise. Unless you are a rockstar founding team, expect to raise at valuations in the order of US$2-3m pre-money for a seed or angel round, and multiples of that for subsequent rounds.
When we talk about pre-money valuation, we mean the implied valuation of the company before the fundraising. Post-money valuation is the implied valuation after factoring in the cash from the fundraising. An example will help.
Let’s say a company has 100 shares before fundraising, and issues 50 new shares to an investor for $5 million. To calculate post-money valuation, take the share price of the new shares ($100K) and multiply it by the total number of shares on issue post the raising (150). The answer is $15m. To get to pre-money valuation, subtract the amount raised ($5 million) from the post-money valuation. The answer is $10 million.
Another method to quickly calculate post-money valuation is to divide the amount raised by the ownership the new investor has in the business. In this case, $5 million divided by 33% (50 shares divided by 150 on issue) equals $15 million.
Don’t spend too much time worrying about valuation. It will be set by investor demand. Be wary also of the trap of accepting a valuation that is too high, especially if you will need additional capital in the next 18 months.
Startups are expected to lift their valuation during each subsequent financing round. In the real world, the valuation of everything goes up and down. But in startups, if valuation doesn’t go up (or worse, a "down-round’), both new and existing investors become suspicious. They start to wonder what is wrong with the company. And that can spell death for a company reliant on these same investors for funding.
When setting valuation, you need also to consider the deal terms. There is an old saying in investing:
You set the price, I will set the terms.
A high headline valuation might look good on paper, but it can come loaded with all sorts of confusing terms that effectively reduce the risk and improve the returns of the new investor. The only way to reduce the risk to one party is for another party to take on that same risk. You are the other party.
The media will often report that Company X raised $100 million from a group of venture capital investors at a $1 billion valuation. If the founders own 10% of Company X, you might conclude that their shares must be worth $100 million on paper. Usually, that is not the case.
The shares held by the founders are not the same as the shares held by new investors. Here are some common rights that new investors may ask for:
A liquidation preference means investors can realise a multiple of their own investment prior to other shareholders receiving anything. If this multiple is set at 1x, the new investors of Company X would receive $100m in priority to other investors. If the multiple is set at 2x, the new investors of Company X would receive $200m in priority.
Note that if a new investor triggers their liquidation preference, they do not also participate in the remaining proceeds. In the above example, assuming a 2x liquidation preference, they would choose to trigger their liquidation preference if the total sales proceeds were less than $2 billion (10% of $2 billion is $200 million).
Things get complicated when a company has raised multiple financing rounds with different liquidation preferences. Often, the most recent capital raised ranks above the raise prior, and that raise ranks above the one prior to that, and so on.
Let’s say Company X had three other prior rounds:
Let’s assume that there are 100 shares on issue at Company X, and that Series B holders hold 30% of these, Series A holders have 30% and Seed investors hold 20%. Recall that the new Series C investors hold 10%, and the founders have the remaining 10%.
Again, if the company sells for more than $2 billion, things are easy. Everyone takes their cut according to the above percentages.
What happens if the company sells for say $400 million?
First, the new Series C investors trigger their 2x liquidation preference and take out the first $200 million, leaving $200 million for everyone else.
The Series B guys now make their decision. Note that because the Series C investors gave up their shares (by triggering their liquidation preference), the equity ownership of everyone else actually increases. The Series B investors hold 30 shares of what is now 90 total, or one third. One third of $200 million is about $67 million. However, they have a 2x liquidation preference that works out to $100 million, and so they trigger that. This leaves $100 million in the pot for everyone else.
Over to you, Series A.
These guys hold 30 shares of what is now 60 in total. 50% of $100 million is $50 million. That compares favourably to their liquidation preference, which is only $25 million, and so Series A takes their $50 million and scurries away.
The Seed and Angel investors hold 20 shares of 60, or one third of the equity pool. This equates to $33 million, well above their $5 million liquidation preference.
The founders hold the remaining 10 shares, which equates to $17 million proceeds. They don’t have a liquidation preference (and virtually never do), and so the decision is an easy one. The net effect of the preferences here is that the founders only received $17 million of $400 million in total. That means their share was about 4%, much less than the 10% they notionally owned.
Still, not a terrible result. At levels much below this, however, the situation is much worse for the founders.
If the company sells for $300 million for instance, the Series C investors take the first $200 million, the series B investors take the next $100 million, and everyone else gets nothing.
Participating preferred works just like a liquidation preference, except the investor also gets a share in the equity pool. If that sounds like double dipping, that’s because it is.
Our Series C investor in the Company X example above would first receive his $200 million, and then 10% of whatever was left (a further $80 million in the $1 billion sale example).
Whilst liquidation preference clauses are common and widely accepted, participating preferred clauses are much rarer.
These clauses are designed to protect investors from the dilution from down-rounds, subsequent capital raisings completed at a lower valuation. The mechanisms vary, but the most common way this is done is by issuing the existing investor additional top-up shares to make up for the loss in valuation. For example (and we are simplifying here), if a subsequent raising was completed at a 10% lower valuation, the existing investor would receive a further 10% shares.
These clauses allow the investor to force the company to buyback their shares upon a given event (whether it be passage of time, or something else). This makes the equity more like debt. If the investor triggers their redemption right and the company does not have the cash on hand to make the payment, the company can end up in bankruptcy if they are not able to raise additional capital to meet the demand.
Given companies are understandably reluctant to agree to such a term, often the language will be watered down. The investor may have the ability to require the company to pursue ‘best efforts’ to complete an IPO or fundraising, for instance.
If someone offers you a fair deal on valuation and terms, take it. Don’t drag out the process in your quest for the perfect deal. You don’t have the time. The small dilution benefits you might receive if you wait are outweighed by a) the risk that the first investor pulls out, leaving you with nothing and b) the fact that your time is almost certainly better spent getting back to the business.
Fundraising is hard. It isn’t meant to be enjoyable, and if it ever becomes that way, you are probably doing something wrong. Do your homework, do it right, and get back to building a great business.