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, Ill pretend it doesnt
all depend and address a few specifics.
First, lets address the hypothesis that the company will make money soon after launch. Irrespective of whether were 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.
Thats 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 and
then you will be able to do a B round at a bigger valuation, etc., but you want to give yourself some reasonable stretch of time
to be product and strategy focused after the A round before you have to hit the road again to raise more money. Its no fun
having to think about starting to raise money again only a few weeks on the heels of closing the previous round. Second, you
always need more money than you think you need, especially if this is your first startup. You can have a nice detailed
spreadsheet that accurately reflects market salaries, rent, and more, but you will still require more money than you think.
Those of you reading Marc Andreessens 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, Ill disagree with him on the funding amount question, especially for first
time entrepreneurs, for a couple of reasons. Now, if youre Marc or somebody like him, I dont disagree that you should raise as
much as you can on your first institutional round. Marc isnt getting involved in a new company hoping he can eventually exit for
$60 million dollars, thats just not an interesting scale to somebody thats created a couple companies worth well over a billion
dollars. I also realize the astute first time entrepreneur in my audience is thinking but Im not looking to sell my company for 60
million either! My idea is huge, and I think its a home run and I want to go for it! Thats obviously the right attitude, and its an
attitude you will need, and its the attitude that your investors will want to see from you. Nonetheless, I dont think it makes
sense for most entrepreneurs to raise big A rounds, because you dont 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. Lets 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 youve sold 25 percent of your company for a million bucks and you have a co-
founder with whom youve 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 youve sold 20 percent of your company for 10 million and you have a
cofounder with whom youve 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, wont be particularly thrilled, because
its 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, theyre probably not going to block the
deal. Its nice to make 400% returns in a short period of time. Now lets 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, dont the founders actually own MORE of the company? Wont 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 LPs 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 doesnt 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 hasnt 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. Lets 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. Shouldnt 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 dont think you should raise as much as you can, for several reasons, but Ill 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
dont 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 arent
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 dont
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: Its 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. Thats fair enough and probably true. Still, even
though Im putting words in his mouth, Id just caution that investors will always want to put more capital to work in a great
company. Second, I hope that this post isnt interpreted as you should raise as little capital as possible or make sure you
dont 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, dont 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.
Posted by Dick on July 23, 2007 12:29 PM | Permalink
COMMENTS
Why do people think they have to raise tons of money in one round? Because Marc Andreessen thinks its a good idea (yes I saw his
company sold today for $1.6 B). If you have his background you should try it, but most people do not even have the ability to
produce a working prototype let alone generate revenues. I see so many people spending all of their time raising money instead
of getting something useful done.
Raising money is very hard. Make it easy on yourself. Create something that people can touch, hold, and try. If at all possible -
have some sales. Then raise money. It's much easier this way.
Posted by: Roger Anderson | July 23, 2007 09:51 PM
Andreessen's basic concept is that one is trying to build a large company. A flip in six month's to take away $7 million is nice but
not consistent with building a large company. Having only built one $1 billion company (which admittedly may have been luck) I
agree with Marc. My thought's on Marc's post are here http://sophisticatedfinance.typepad.com/sophisticated_finance/2007/07/raise-more-
cash.html
Posted by: Robert Hacker | July 24, 2007 07:32 AM
Dick,
I really enjoyed the article. Given my current position, I found it to be extremely helpful and down to Earth.
I do have a question; I'm currently raising capital for my company. We have successfully locked up a 300k 1st round investment
should we decide it is the right one. We are also in talks with a VC firm who it seems won't invest in my company unless it is
several million dollars. The problem, we don't need several million dollars right now. You're probably wondering, ok than go with
the smaller investment. The problem is th small investor doesn't have any relevant experience or influence in our sector,
whereas the VC firm specializes in our industry. Is there anyway to make my company more attractive for a smaller investment
to the VC firm? Can we offer a smaller 1st round investment to the VC while stipulating that they have priority in a 2nd round?
Thanks for reading my essay here...
Best Regards,
Jeff
Posted by: Jeff | July 26, 2007 08:57 AM
I've been in and out of this dance for two years. How much? when? under what terms? and I've discovered one thing. You must
have real traction in a web business. Real customers who pay Real money. If you waste your time raising money before you have
traction, you have nothing. I spend 100% of my day with customers and we are doing great...we turn away investors. My advice to
an entrepreneur is to roll up your sleeves and work...forget the money.
Posted by: David Armstrong | July 26, 2007 09:52 AM
I posted on the related topic of the risks of taking money at too high and too low a valuation and how they are asymmetric at the
Lightspeed blog recently - click on my name in this link to read if interested
Posted by: jeremy liew | August 7, 2007 12:03 AM
We have been trying to raise capital. There are so many different models out there and so many unscrupulous people, that it is
nerve wracking. We have had tons of people wanting us to give them money to look at our venture with no promises. We had 1
guy ask us to sign a document saying we could not sue him if he commits fraud. We have had some looking for a 10x return in 3
years. We have had some wanting to encumber our personal assets and 100% of the company if we default in any way. Wow. We
are now talking to a supplier that is promising to finance us at 2 below prime for capex if we put them in front of our client to
prospect their services. It is so hard to tell which companies are reputable, which are not, and to know what is the norm for
financing a deal.
I will tell you that I have had people try to force us to take more capital than I saw a need for based on my pro-forma. I did do a
conservative business model (I know, everyone says that). There was no need for the excess cash and all it did was increase the
repayment terms and make the deal less desirable. All I wanted was the funding necessary to get us thruogh to profitasbility plus
15% reserves for unknowns. Was that a good idea?
Posted by: Larry McNeill | August 10, 2007 11:33 AM
Great post! I'm just learning about this stuff and found this to be very informative. The only thing is that I don't quite understand
some of the lingo. What does it mean to say "You raise 10 on 40 pre"?
[editor's note: 10 on 40 pre means that the pre-money valuation (the valuation before you raise any money) is 40 million....you
are adding 10 million to the company, so your post-money valuation is 50 million (40+10) and the investor of the 10 million now
owns 20% of the company (10 = 20% of 50). This is frequently shortened and you'll hear things like "the valuation is 5 on 9" , etc.]