Should you raise venture capital for your startup? If so, how much?
At first blush, the answer to these questions seems fairly obvious — raise as much money as you possibly can at the highest possible valuation in order to grow your business. John Doerr famously compared fund-raising to attending a cocktail party. When the waiter comes around with the tray of mini hot dogs, you should always take one. The reason being that you never know when in the course of the remainder of the cocktail party the waiter will make it back to you. In similar fashion, the right time to raise capital is when the capital is available; who knows if the fund-raising waiter will ever make it back to you when you decide you are in fact ready to raise money. But that only works if you’re at the right cocktail party.
Let’s start with the decision to raise money in the first instance, and specifically, the decision to raise from VCs. Just as with product-market fit — where VCs care about how well your product satisfies a specific market need — you need to determine whether your company is appropriate for venture capital.
The cardinal rule of VC investing is: Everything starts and ends with market size. No matter how interesting or intellectually stimulating your business, if the ultimate size of the opportunity isn’t big enough to create a stand-alone, self-sustaining business of sufficient scale, it may not be a candidate for venture financing.
Rules of thumb are overgeneralizations and crude ways to simplify complex topics, I admit. But, as a general rule of thumb, you should be able to credibly convince yourself (and your potential VC partners) that the market opportunity for your business is sufficiently large to be able to generate a profitable, high-growth, several-hundred-million-dollar-revenue business over a seven-to-ten-year period.
Your business might be helping people, enriching lives or even saving them, and still not be the right fit for raising VC.
There is no magic to any of these numbers, but if you think about what it takes to become a public company, these financial characteristics (at least in today’s market) could support a public market capitalization of several billion dollars. Depending on the VC’s ultimate ownership level of the company at this time, the returns to the VC on this investment should be meaningful enough to move the needle on the fund’s overall economics.
So, what if the market opportunity just isn’t of that scale? That doesn’t make you a bad person or your business a bad business. It’s unfortunate how many founders can feel that way. You could be running a multimillion-dollar business with great profits and be living a happy, wealthy, influential life. Your business might be helping people, enriching lives or even saving them, and still not be the right fit for raising VC. All that means is that you might need to think differently about where and how to raise capital and come up with a different approach.
For example, there are smaller VC funds (often with less than $100 million fund sizes) that do invest very early in companies and for which the business model is to exit companies largely through acquisitions at lower ultimate end valuations. That type of firm might be more appropriate for your opportunity if the market size can’t support a stand-alone business. Not every small fund adopts this strategy; there are many angel and seed investors who, despite their smaller investment amounts, are also playing the home-runs-per-at-bats game. So make sure you understand the core strategy of your potential partner up front.
The point is simply that venture capital may not in all cases be the right source of capital for you. It might not be the right tool for the job.
What does that mean? VCs are people, too, and they respond to the incentives that are created for them. Those incentives, simply put (and boiled down to financial ones only), are:
1. To build a portfolio of investments, with the understanding that many will not work (either at all, or will work only with constrained upside) and a small number will generate the lion’s share of the financial returns for a given fund; and
2. To further turn those large financial returners into cash within a 10-to-12-year period so that the cash can be paid back to their limited partners, with the hope that the limited partners will then give that cash back to the VCs to play the game again in the form of a new fund.
And even if your business is appropriate for VC (because of the ultimate market size opportunity and other factors), you still need to decide whether you want to play by the rules of the road that venture capital entails. That means sharing equity ownership with a VC, sharing board control and governance, and ultimately entering into a marriage that is likely to last for about the same time as the average “real” marriage. (It turns out that eight to 10 years is about the average length of real marriages in the U.S. …make of that what you will.)
Now, assuming you made the decision to raise venture capital in the first place, how much money should you raise? The answer is to raise as much money as you can that enables you to safely achieve the key milestones you will need for the next fundraising.
In other words, the advice we often give to entrepreneurs is to think about your next round of financing when you are raising the current round of financing. What will you need to demonstrate to the next round investor that shows how you have sufficiently de-risked the business, such that that investor is willing to put new money into the company at a price that appropriately reflects the progress you have made since your last round of financing?
In general, most entrepreneurs at the early stages of their business raise new capital every 12 to 24 months. Those time frames are not sacrosanct, but they do reflect the general convention in the startup world and also reflect reasonable time periods during which meaningful business progress can be made.
Thus, if you are raising your first round of financing (typically called the Series A round), you will want to raise an amount of money that gives you enough runway to get to the milestones you will need to hit to be able to successfully raise the next round of financing (the Series B) at (hopefully) a higher valuation than the A round.
What are those milestones? Well, it varies significantly by the type of company, but for the purposes of our example, let’s assume you are building an enterprise software application. The Series B investor is likely to want to see that at least the initial version of the product is built (not the beta version, but the first commercially available product, even though the feature set will, of course, be incomplete). They will want to see that you have some demonstrated proof in the form of customer engagement and contracts that companies are in fact willing to pay money for the product you have built. You probably don’t need to have $10 million in customer business, but something more like $3 million to $5 million is likely sufficient to get a Series B investor interested in providing new financing.
If you posit that set of facts, then the decision you need to make at the A round is how much money you will need to raise to give yourself a realistic chance of hitting those milestones over the one-to-two-year period before you try to raise the B round. This, of course, is partly a spreadsheet exercise, but also includes a gut check from you as CEO to build in some cushion for things that just might not go according to plan (because nothing ever goes exactly to plan).
A fair question to ask here is why not just raise all the money you need for the company, all at once, and forget this idea of staging out capital raises by round? Well, first, a successful enterprise software company that makes it to an IPO is probably going to raise at least $100 million (and, in some cases, a few multiples of that), so there aren’t too many VCs who are going to write that size check up front.
If you accomplish the objectives that you laid out at the time of your A round, your B round investor will pay you for that success in the form of a higher valuation.
More likely, even if you could raise that amount of money, the terms on which you would raise it — in particular, the valuation you would receive and thus the amount of the company you would need to sell — would be prohibitively expensive. Spreading out your capital raises allows you, as the entrepreneur, the ability to get the benefit of increases in the valuation of the company as you de-risk the opportunity, and provides the VC the ability to right-size their total capital exposure to the business based on the achievement of these milestones.
In other words, if you accomplish the objectives that you laid out at the time of your A round, your B round investor will pay you for that success in the form of a higher valuation. This means that you will have to sell less of the company per dollar of capital you raise. In that case, you and your employees are all better off — you have the capital you need to grow the business, and the cost of that capital is less than it would have been had you raised more money than needed at an earlier stage.
The other consideration regarding the amount of capital to raise is the desire to maintain focus for the company by forcing real economic trade-offs during the most formative stages of company development. Scarcity is indeed the mother of invention. Believe it or not, having too much money can be the death knell for early-stage startups.
As a CEO, you may be tempted to green-light projects that might be of marginal value to your company’s development, and explaining to your team members why they can’t build something or hire that next person when they know you don’t have financial constraints is harder than it may seem.
Nobody is suggesting that everyone live on ramen and sleep on the floor, but having a finite amount of resources helps to refine what are in fact the critical milestones for a business and ensures that every investment gets weighed against its ultimate opportunity cost.