Knowing how much money to raise

A founder recently asked about how much money to raise and when. Specifically, he asks about choosing between splitting a $1.4m, two-year round into $800k for year 1 and then $600k for year 2.

The key issue in splitting rounds is raising enough money (including your cushion) to get you to the next major valuation-bumping milestone. That’s it — that’s the optimal number. This is a number measured using Abe Lincoln’s suspenders (just as long as they needed to be) – the amount of money should be just right, and it’s not a guessing game. More money and you’re giving away extra; less and you’re increasing your transaction costs.


Answer: The question assumes something that it also seems to indicate is not true. And that’s the clue to the right answer.

1. The founder assumes that he’ll give up more equity in a single round than in two rounds. That is only material IF the value of the company appreciates significantly in the interim.

2. But, the founders also says that the company will not be cash-flow positive until toward the end of the period (month 20 – past the middle of the second $600k round). If that’s true, then it’s much less likely that the company is going to hit the sort of major inflection point that equates to a definite material bump in valuation.

3. Why does this sound pessimistic? Because the company has been operating for 18 months and already created great amounts of value — developed a product/service offering, found customers, started a company, and now it is chipping away at execution risk and growing the company. If you as a founder have cracked the code on those earlier stage issues, the value jump between that stage, and that +800k, isn’t as likely to be all that great.

So, listen to the people who’ve seen it happen in real life: two rounds of fundraising are likely to be more burdensome than you expect; do the math on the two-tiered valuation; figure out what you as founders will get years from now from spending the time to fundraise twice to retain a little extra piece for yourselves versus spending the time on growing the business at its rate of return.

Remember, you make vastly more money by running your business than by trying to over-optimize your fundraising.

 

2 Comments

  1. Matt Haley on July 3, 2012 at 10:17 am

    A couple interesting points here from the perspective of a guy that founded and made profitable two VC funded companies…

    1) Calculating $1.4M seems way too exact for a 2 year plan. If the founder was saying $1.5M I would be a lot more comfortable with the estimate.

    2) Perhaps it was written, but I don’t see a solid “use of funds” statement. $1.4 million for 2 years doesn’t cover many people, and obviously a lot less with travel, overhead and other expenses.

    3) The founder seems more concerned with the percentage ownership than with total value of that ownership.

    4) The plan might make sense if there is a significant event that will greatly increase value, such as customer acceptance, Patent approval (always difficult to time), a revenue producing partnership…

    I would always keep the focus on growing the pie, not on the size of the piece of pie. Any time spent on fund raising is time delayed on meeting value increasing operations.

    • admin on July 8, 2012 at 8:24 pm

      Thanks, Matt, for those points. I agree — use of funds (#2) to get you to a valuation-relevant milestone (#4), which is hard to get exact (#1); running the business is how you create value (last sentence) because the value of what you own is almost always what ultimately matters (#3 and second-to-last sentence). It’s clear you’ve thought about this more than once (first sentence).

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