With the size of fundraising rounds going through the roof, it was kind of surprising, or not so surprising..., to see a couple of founders and operators coming out over the last weeks with a somewhat contrarian statement: 'Beware of raising too much too early...'. Among them the founders of Twitch and Shyp.
Raising lots of capital looks excellent, of course, but there are no freebies in this world. I always spend some time talking to entrepreneurs about this topic, and I thought I'd share some thoughts with the OE community here. Let's have a look at some of the strings attached to the big dollars.
Let's start from the beginning: The Rationale of a Funding Round.
The key reason why a startup is raising capital in exchange for equity is to develop a product and/or fuel growth. Companies are reaching out to Venture Capital (or 'Capital Risque' in French) firms because there is substantial risk involved in the future development of a product and the aggressive business plan. Otherwise, one might want to consider raising (venture) debt to finance her or his venture as the dilutive impact on equity will be less (but let's leave this topic for another post for now).
But, when your company is planning to grow really fast, double employees year over year, add users and customers rapidly, you don't want to raise too much money. This is because, if you raise three or even four years of cash, there is a very good chance that, by your second year, you will be sitting on cash that you raised when your company was worth considerably less. That's bad for most stakeholders involved, besides the investors: It's too dilutive to you, your co-founders, angels, and, of course, your employees.
Now what? The Revenue Valuation Crunch, aka 'The Cap Table Crunch.'
I recently met a great founder who just raised a small seed round and launched a minimum viable product (MVP) in a hot space. He had a couple of hundred users and even one paying enterprise client, a fast-growing startup itself. When I asked him how much he wanted to raise, he told me EUR 10-15M in a couple of months. This seemed a lot given the stage. And I didn't understand why he would put his company under that much pressure. Not only would this amount of capital most probably be too dilutive for everyone working on the venture right now, but it would also lead to big expectations for the next funding round... to avoid a 'Cap Table Crunch'. Speaking with fellow investors, I realized that many of them were seeing a bunch of, especially pre-Series C, companies that hit the revenue valuation crunch now. These startups raised on a vision, market, opportunity, pre-product, pre-revenue, high price. They get to EUR 1M+ annual revenues but not (yet) explosive growth and scalable product distribution. So their valuation does not change enough, and everyone involved suffered. While it is easier to raise on vision than small revenue if you are a great pitcher, the potential risk is significant. I had to think of this video 🙃.
So, before you pull the trigger on taking on venture money, let's understand why people are raising too much capital first and then what an ideal funding round could look like.
For starters. 'Peer or Competitor Pressure' is really hard...
It is, of course, hard as a founder to see your peers or competitors raise massive rounds and not do it yourself. Shyp's founder calls this 'a trap unless you have product-market fit', meaning you have clearly engaged users and scalable distribution channels. 'Taking on lots of capital at big valuations just forces you to hire faster, spend more on S&M, build more product features, etc. But if you haven't validated you have something your customers love, and you can scale to produce the expected venture return (on the previous funding round), this can be (and was for me) one of the nails in your coffin...'
Twitch's founder Justin Kan puts it differently: 'Build something you believe in and love, not for your ego. As with most founders, after a big sell, my ego kept nagging me to think faster, 'bigger.' My dreams were full of insanely large numbers. A ten-billion-dollar company. A hundred-billion-dollar company...' As a result, I raised a ton of capital and scaled an organization before producing a product that worked. But I built a leaky bucket that I tried to push to the market. I kept banging my head against the wall, but it didn't work out. I shut down the venture.
Avoiding the Cap Table Crunch.
A couple of challenges keep coming back when talking to founders and operators who went through this experience of raising too much capital. Here some thoughts:
No well-defined Mission: 'We weren't clear about our mission early on. It is tough to write the mission after the fact. You should start with a clear reason to exist and filter early hires for believers. Without clearly defined goals between co-founders, huge frictional costs can arise. Not figuring out our intrinsic motivation made it impossible to stay resilient in tough situations. Personally, I also had no passion or real interest for the space we were in...'
Hiring too quickly: 'We hired too fast. Hiring too quickly - especially before PMF can be a fatal mistake. We hired too many people too fast, and we failed to set a cohesive culture early. This is incredibly hard to change later on.'
Growth over Product: 'We raised a $10M series A with just an idea. We focused on growth over everything else. While we successfully grew our customer base, we couldn't retain them. We simply hadn't spent enough time to figure out our product.'
Less Focus: 'We didn't define our 'who' early on. It wasn’t clear who we served. Without making the distinction, we fell into the pit of trying to be everything to everyone. In contrast, early on in Twitch, we decided that we would serve only streamers and iterated till we could serve them in the best possible way.'
What is the DNA of a good funding round then?
There are two basic rules of thumb. First, try to dilute in the 10%-15% (angel round), 20% (seed and series A), and 10-20% band post-Series A whenever you raise money. If you can keep it lower, that is great for you. You might have to do more, but try hard to keep your dilution below 25% each round. If you do two or three rounds at north of 20% each round, you'll end up with too little of the company. And always remember that having a quality investor on board is more important than less dilution.
Second, raise 14-20 months of cash each time you raise money. Less than a year is too little. You'll be raising money again before you know it. Longer than 18 months means you may well be sitting on the cash you raised when your company was worth a lot less.
These rules are most applicable in the early stages. When your company gets above 100 employees and valued at north of EUR 100M, things change. You may need to have more cash on your balance sheet for working capital reasons, and you may not be increasing value at quite the same rate as you were when you were smaller. You might want to raise 24 months of cash or more at that stage. But for the seed, Series A, and Series B rounds, I think 10-20% dilution and 14-20 months of cash are ideal. It's what I advise our portfolio companies to do, and it is what I advise other entrepreneurs to do.
Ask your investor to be transparent.
Make sure to have an open discussion with investors on the fundraising amount and dilution / valuation of a prospective founding round. I usually work this out with the founders, so we get to a deal that makes sense for all stakeholders. My question usually is the following: 'How can we 3x the valuation of your company in the next 12-18 months? What do we need to get there?' By answering this question, the size and valuation of the funding rounds become very clear, and there is no need for much discussion. All stakeholders are aligned, and everyone can focus on building a great business.
Two weekends ago, I enjoyed the sunny weather with some friends in one of Paris's beautiful parks. I took pleasure in seeing so many people again out there playing the Pétanque. We are back; I hope the weather will be so as well soon.
Life is awesome,
Other content I have found useful
- A great survey by McKinsey on the future of work: 'Organizations are clear that post-pandemic working will be hybrid. But, after that, the details get hazy...' But, the work-from-home dream might be less dreamy than many might expect, according to HBR: 'Don’t Let Employees Pick Their WFH Days'.
- A great tweet on customer acquisition costs or CAC: Cost of acquisition is one of the most common questions asked in a fundraise & most consistent metric tracked in a company to understand the health of a business. I've had a lot of convos recently about how to track it & I like this method of breaking out "ongoing" & "experimental. Ongoing are channels that you have tested and believe are good growth avenues - you have decided to invest in them at least for now. Experimental are the channels you are testing - they are ones you think *might* be good growth avenues but you arent sure yet.
- A great tweet by my friend Gale on the meaning of a 'clean cap table': Investors always talk about a "clean cap table". Is the issue about the number of investors, the timing of the individual deals being different and potentially creating different terms for relatively small checks, or something else?