Hopefully you are reading this before you decide how much to raise. I’m referring less to very early seed funding just to get your minimum viable product (MVP) built, which in many cases costs little or nothing, and more thinking about raising money after your product is built and/or your initial validation is completed. But the basic concepts outlined in this article apply to later stages as well. This article doesn’t describe the best fundraising vehicles and associated terms to use for seed-stage funding but two common ones are described in related articles: “Convertible Note Basics” and “Reviewing the SAFE Investment Instrument“.
If you’ve already decided and communicated how much you are raising, you might be getting the obvious follow-up question: “Why is that the right amount?” It’s a very simple and justifiable question for the investor to ask but it is commonly met with either puzzled looks or unacceptable responses. Don’t worry, I have some suggestions that might help.
Disclaimer: The concepts described in this article are for a venture-funded company. Many startups don’t have the makings of a high-growth, venture-funded business but can still evolve into a great company. Additionally, there are other forms of financing than just equity investments from venture funds.
How Much to Raise for a Round of Funding
The graphic below summarizes the first major step in the exercise of deciding how much to raise. As you can see, it demonstrates the linear relationship between the amount raised, the time and resources gained and the expected outcomes you can achieve with both time and resources. There are surely exceptions to this basic concept, but this is a very fundamental starting point.
Since you’re trying to solve for the right Amount, let’s analyze the other two variables a little further. In fact, the best way to think about this is to work backwards from Outcomes.
One of the most foundational things to remember is that investors care much less about how you are going to spend the money (activities) versus what you’re going to accomplish with their money (outcomes/accomplishments). What do I mean by “outcomes”? Well, how about acquiring enough customers to gain meaningful market share or to reach positive cash flow? How about securing a strategic partnership that provides significant leverage? How about getting final approval on your patent filing? These are outcomes that reduce the investor’s risk and/or increase their upside potential. So if an investor asks why the amount you’re trying to raise is the right amount, don’t rattle off a bunch of activities but instead describe the expected outcomes you’ll achieve with the money raised.
For a much deeper dive into this subject, see my related article titled “Investors Write Checks for Outcomes, not Activities“.
Time & Resources
A big consideration when deciding how much to raise is the amount of time (aka- runway) and resources it affords you to execute based on a set of financial plan assumptions (new sales, headcount, other expense items). There’s no problem starting with this approach but how much time you should buy yourself with the amount of funds raised? If you truly see an opportunity to get to a positive cashflow state in the not-too-distant future, that might serve as an ideal amount of runway to gain. Even if you decide later to shift into another gear to accelerate growth rather than become profitable, having the choice can be extremely powerful.
The problem I see is that many startups just pick an arbitrary amount of time and figure out how much money allows them to last that long. In fact, the amount of time is often a nice, logical 1 or 2 years. The problem is that’s too logical and I’ve already mentioned that investors care much less about how long your funding will last versus what you’re going to accomplish. So let’s look at the concept of “runway” differently.
The way to think about needed runway relates to the fact that the implied value of your company (valuation) doesn’t increase in a straight line, even if your financial results steadily improve. Later in this article I’ll describe more about how valuation also influences the amount to raise, but for now you mainly need to understand that what typically occurs over time are various events that provide jumps/spikes to your implied valuation. What types of events am I referring to? Well, it comes back to the “Outcomes” category described above. It is those same key outcomes and accomplishments that provide stepped-up valuation, even though your financial results might not be immediately affected. If you want a list of potential pre-revenue outcomes and accomplishments to strive for, see my related article titled “Establishing Valuation Before Revenue Traction“.
Since accurately predicting the timing of these spikes is almost impossible, raise enough funding to get safely past the anticipated milestones, just in case you encounter surprises (you will). How much time past the anticipated spikes is a judgment call based on your level of certainty for achieving the milestone outcomes.
A factor to consider when deciding how much time to gain is the fundraising activity itself. Since it can easily take 3 months or longer from start to finish, and since fundraising is a fairly burdensome and distracting activity (versus running the business), you would not want to gain only 5 months of runway because almost as soon as you close the round, you’ll be on the fundraising trail again.
An exception to this rule of thumb is a “bridge round” mostly or fully funded by existing investors. These are typically much less burdensome and distracting, and are usually done to accomplish some high odds and “within close reach” outcomes. For more information about bridge rounds, see my article titled “Bridging a Gap Using a Convertible Note“.
A final thing to realize is that you can’t wait until you’re 60 days from running out of cash (called the “cash fume” date) to start raising money again because the investors will likely have all of the negotiating leverage. So your timeline needs to account for starting the next fundraising activity 4+ months before you’re expected to run out of cash, including the associated distractions. In other words, if the chief fundraiser is expected to be heavily involved in a significant milestone outcome late in the timeline cycle, you’ll need to account for that in the projections.
If you force me to give runway projections based on funding stage, here is what I see most commonly:
- Pre-Seed: 8-10 months
- Seed: 12-18 months
- Series A: 18-24 months
- Series B: 24+ months
OK, now let’s talk about what many startups mistakenly focus on first when deciding how much money to raise – dilution. Dilution is a mathematical derivative primarily involving valuation and new funds raised (for more information, see my related article titled “10 Basic Fundraising Terms You Must Understand“). The higher your valuation for a given amount of funding raised, the lower the dilution you’ll experience. But, like many things that are negotiated, the valuation must seem “fair” to both sides (investor and company). And to better introduce a potential counterbalance issue, I highly recommend you also read my article titled “Tell Me Your Price and I’ll Tell You My Terms“.
Valuation is driven, to a very large degree by both recent accomplishments and future expected outcomes. This is what I mean by “State of Business” in the graphic below. The state of your business includes recent financial and operational results (if your product is in the market and selling), the maturity of your management system (tools, processes, etc) and also the future potential that is derived by these two things. I know, team, market size/dynamics, business model and many other factors also affect valuation. But those things are mostly unrelated to the amount of money you raise. Instead, it’s their potential positive influence on the future outcomes that help drive up your valuation.
What type of outcomes should you focus on? Try these:
- Prove something (validate)
- Accomplish something
- De-risk something
These are all things that directly affect how investors evaluate the risk-reward trade-off associated with your investment opportunity. And that’s what valuation is mostly about – the risk-reward trade-off.
Reflecting back to the Timeline variable, realize that raising so much money that you get a lot of runway (possibly achieving 3-4 expected valuation spikes) could easily backfire because of the near-term dilution. But hopefully you understand by now the value in looking into the future and thinking about potential step-ups in your implied valuation that are directly tied to outcomes that investors also care about.
Multiple Rounds Over Time
Now let’s project forward to see how multiple funding rounds tie together. With each round of funding, your projected outcomes eventually become the state of your business and that’s what you’ll use to gain a valuation step-up for the next round of funding. This cycle continues again and again until you are either self-sustaining or experience an exit (acquisition or IPO).
A Final Word About Dilution
I find that a lot of fundraising founders get obsessively focused on dilution and make that the focal point for optimization. The problem with this approach is there are only two ways of optimizing for dilution. Either you push for a higher valuation, even if it’s not quite deserved (subjective issue) or you decide to raise less money than originally planned. Pushing for an excessively high valuation will either cause your fundraising efforts to take longer, potentially eliminate investor prospects that could serve you best (provide the most value) and/or create a post-money valuation and future exit hurdle issue (described later in this article). If you decide to raise less money, it will result in less runway and/or fewer and less significant outcomes – which will negatively affect you in the future.
As a result of what I’ve just described, I commonly preach the following mantra: Optimize for Growth, Not Dilution. A great company (culture, management system, etc) with a track record of strong growth has infinite options. That’s what you want and that’s what your investors also want.
Core Principles Covered Thus Far
- Funding yields outcomes (via time and resources gained)
- Outcomes drive valuation
- Raise enough to accomplish milestone outcomes that justify a meaningful future increase in valuation
- Optimize for growth, not dilution
If you’re raising money via a priced/equity round, the amount of money you raise directly affects your post-money valuation (pre-money valuation + amount raised = post-money valuation). Post-money valuation is often forgotten in the process but it becomes extremely important when you’re ready to raise money again in the future. If you don’t create enough new value to exceed your post-money valuation by the time you need to raise again, you’ll have what’s called a “down round”, which is a very naughty word in fundraising because of the significant dilution hit. In fact, your investors probably put in some protectionist terms against a down round, which means the company will take the biggest dilution hit. The amount of money you raise needs to give you enough runway to comfortably exceed your post-money valuation by the time you raise again in the future.
I’ll give a specific example to make sure this is clear. Let’s assume you raised $750K in seed funding at a $3M pre-money valuation and expect it to give you 14 months of runway to accomplish significant milestones. Your post-money valuation is $3.75M after that funding is completed. Approximately one year later when you are raising a $5M Series A (for example), you’ll need to be able to command a pre-money valuation considerably greater than $3.75M. In fact, you should be thinking in the $8M range at a minimum and will be hoping to justify $10M or more. Search for a cap table calculator if you want to model the dilution difference between various scenarios.
Prepare for Surprises
One final thought. The concepts mentioned here are actually as much art as science. You must allow for contingencies because things almost never play out like you expect. It’s impossible to predict how you will perform 9-12 months from now compared to your business plan projections. You can almost guarantee that things won’t work out exactly as planned, but in the early stages of growth it’s extremely hard to predict if the odds are higher of underperforming or over-performing. My fellow Capital Factory colleague, Jason Cohen, wrote an interesting article that suggests that in either case you’ll either want or need more money. It’s titled “More money if you do, more money if you don’t“. Good food for thought and a nice demonstration of both the art and science of deciding how much to raise. The most common surprises I see are as follows:
- Product-market fit
After having some success with early adopter customers, you suddenly struggle to gain traction with your ideal target audience and determine changes are needed either to your product or target market.
- Business model
The way you make money from your product gained initial traction but isn’t helping you scale like you predicted. Some change is needed.
- Go-to-market model
You started selling one way (ie – inside sales only) but later determined that in order to win deals with larger companies using your highest priced offering, you need a field sales team or distribution channel (for example).
Forecasting the Future Cap Table
I previously mentioned my mantra “optimize for growth, not dilution“. However, I do recommend using a cap table calculator to run various scenarios and forecast what the cap table and various equity positions would look like after closing a particular funding round and maybe also the next one after that. You can find a link to one on my Resources Page.
Fundraising is as much art as science (possibly more art). Realize that many of the concepts described in this article are part of fundraising “science”. Every situation is very different. However, based on the core principles mentioned further above and the rest of the information described in this article, below is a step-by-step sequence to consider:
- Decide which meaningful outcomes can and should be achieved next
- Determine the combination of time and resources needed to accomplish those outcomes
- Put a price tag on step #2 to determine the amount of money needed
- Include an extra buffer amount of money to allow for surprises
- Sanity check the proposed amount based on a reasonable range of valuation and the resulting dilution – but while remembering to optimize for growth and building a great company
- Test your valuation assumptions and significance of planned outcomes with real investors
- Refine and repeat
If you are raising money on a convertible note and trying to decide how to communicate the amount you’re expecting to raise, you might want to read my related article titled “Setting the Max Authorized Amount on Your Convertible Note“.