Series A Financing: How Much to Raise?
A Wizard reader writes (or I should say "wrote", as this came in almost a month ago):
“My product is almost ready to go, it will make money in the early going as the model is pretty straightforward, but we need to raise money in order to scale the business. There are three of us right now. How much money should we raise in an A round, how long should we expect that to last, how long will investors expect it to last, and so on and so forth?”
Well, the obvious answer is that it all depends, but on the grounds most people would find that unhelpful, I’ll pretend it doesn’t all depend and address a few specifics.
First, let’s address the hypothesis that the company will make money soon after launch. Irrespective of whether we’re talking about profits or just top-line revenue here, I would caution that it almost always takes longer to ramp your top-line than you think it will. Everybody walks into a venture pitch with their three year financial projections that have a lousy first year, a strong second year, and a monster third year. The truth is that even most ultimately successful tech startups have a slow first year, a slow second year, and then you get your spectrum of third year results ranging from really-taking-off to continued-doldrums. It just always takes longer than you think to launch, grow, ramp sales, close deals, etc.
That’s a good segue for the rest of the question – how much to raise and how long should you expect the money to last. Everybody has different thoughts on this subject, but I would say there are two helpful guidelines. First, raise enough money to last about a year or a good six months after your next big milestone. Some people like to say “raise just enough to get you to
Those of you reading Marc Andreessen’s excellent blog will note that my advice is out of step with his advice to “raise as much as you can”. Now, Marc has co-founded a couple of hugely successful public companies and has invested in countless others and his latest post has the words "my company" and "billion dollars" in the title, so if you find yourself wondering whether you should put more credence in his words or mine, I will repeatedly point you in his direction (you start one monster company, maybe you were lucky, maybe you were in the right place at the right time. You found two billion dollar companies? You officially know what the hell you are doing. Nobody is that lucky.) Nonetheless, I’ll disagree with him on the funding amount question, especially for first time entrepreneurs, for a couple of reasons. Now, if you’re Marc or somebody like him, I don’t disagree that you should raise as much as you can on your first institutional round. Marc isn’t getting involved in a new company hoping he can eventually exit for $60 million dollars, that’s just not an interesting scale to somebody that’s created a couple companies worth well over a billion dollars. I also realize the astute first time entrepreneur in my audience is thinking “but I’m not looking to sell my company for 60 million either! My idea is huge, and I think it’s a home run and I want to go for it!” That’s obviously the right attitude, and it’s an attitude you will need, and it’s the attitude that your investors will want to see from you. Nonetheless, I don’t think it makes sense for most entrepreneurs to raise big A rounds, because you don’t want to price yourself out of interesting opportunities in the first year or two. By raising too much money, you force your hand on the kind of company that you have to build, whether you want to or not. Let’s look at two scenarios for a very promising startup with technology that may be of strategic interest to several profitable public companies (note to self - write a future post about the importance of not planning for or even thinking about exits like this):
Scenario 1: You raise 1 on 3 pre in an A round, so you’ve sold 25 percent of your company for a million bucks and you have a co-founder with whom you’ve evenly split equity, and you have a 15 percent options pool from which you quickly allocate 5 percent that fully accelerates on a change of control.
Scenario 2: You raise 10 on 40 pre in an A round, so you’ve sold 20 percent of your company for 10 million and you have a cofounder with whom you’ve evenly split equity and you have a 15 percent options pool from which you quickly allocate 1 percent that fully accelerates on change of control.
Six months into your post-A round, you are approached by Awesome Corp and they would like to buy your company for $20 million. Company that pursued Scenario 1 is in the following situation: founders each own 35% of the company. Founders each make $7 million dollars, investor takes out $5 million for a speedy 4x, and the options holders pull out the remaining million dollars. Ignoring taxes for the moment (much like ignoring friction in freshman physics, this is impossible and problematic, but humor me), this is a nice outcome for everybody. Your investors, it might surprise you, won’t be particularly thrilled, because it’s important to keep in mind that they are not in this business for IRR, they are in it for multiples, and a 4x on a fantastic new company with only $1 million invested is not that exciting. Still, at a 4x after six months, they’re probably not going to block the deal. It’s nice to make 400% returns in a short period of time. Now let’s look at the same offer if the company pursued Scenario 2. Ruh-roh. Do you think our founders are going to be cashing in any Awesome shares anytime soon? No, they are not.
But wait, don’t the founders actually own MORE of the company? Won’t they actually make MORE money individually? Why yes, they do own more of the company, but that was just a little trick I played on you. It makes no difference, because the investors, who have put up $10 million dollars, stand to take out $4 million dollars, and investors have this thing where their LP’s get very mad at them if they invest 10 and get 4 back after only 6 months. If our founders go look at their Articles of Incorporation and the term sheet they undoubtedly signed from the investors when they raised this round, they will see that the investors have blocking/veto rights, and the investors will veto this deal in a heartbeat. More likely, the company would never even get to this point, because the people at Awesome are going to look at the company cap table and realize that this deal doesn’t get done. The founders have set themselves on a course in which the only two possible outcomes are home run or failure.
I did my math above in 14 seconds and have no time for proofreading these days, so mea culpa if my percentages are off but you get the picture.
I would suggest that there are some very nice middle ground areas for the entrepreneur that hasn’t previously made a bundle of money, and many of these middle ground areas are still large enough to provide venture returns to institutional investors. By overcapitalizing your company, however, you can put yourself in situations where a potentially huge personal outcome is made impossible.
Fine. Let’s say you are only interested in huge home run or failure. The middle ground is for suckers, you say, and you are no sucker. You are an all or nothing hombre. Shouldn’t you now raise as much as you can in an A round? After all, you are in this to rock the world and make a huge difference and build the best damned company you can build.
No, I still don’t think you should raise as much as you can, for several reasons, but I’ll just highlight the most important. You will spend what you raise. If you raise $10 million, you will quickly ramp up to a burn rate of $800k a month, because the investors don’t want their money to sit in a bank account earning interest with 36 months of runway while you hire employees 2 and 3. The amount of money you raise sets you off on a course at a specific pace. Your board will want to know why you aren’t deploying capital. You will hire a marketing team because you can afford to hire a marketing team. You will hire a vp of sales before the product is ready because you can afford to hire a VP of sales. Companies that raise $10 million dollar A rounds don’t raise $5 million dollar B rounds, they raise $30 million dollar B rounds. If you have not accurately predicted how quickly you can grow the top line, you will quickly find that the cap table has gotten away from you, and you will have less flexibility to build the company the way you might like to if the market zigs when you thought it would zag. You want to give yourself the flexibility and room to react to market forces so that you can build the best company possible.
Final notes: It’s possible that by “raise as much as you can”, Marc is implying that the two first time cofounders with an idea that might sell for 20 million in six months will only be able to raise a million bucks. That’s fair enough and probably true. Still, even though I’m putting words in his mouth, I’d just caution that investors will always want to put more capital to work in a great company. Second, I hope that this post isn’t interpreted as “you should raise as little capital as possible” or “make sure you don’t invest too aggressively in your company”. Undercapitalizing your company is just as dangerous as overcapitalizing your company, with the added tragedy that undercapitalized companies sometimes miss out on their opportunities to be the gorilla in a huge market. You want to be capital efficient while making sure you are funding the growth of the business. If customer wins are accelerating and revenue is up 100% quarter to quarter, don’t try to get too cute about finessing growth on the cost side….ramp into growth and hire ahead of demand. More on that in another post.