Raise the right amount of money for your opportunity

This morning I read that Paul Graham told a conference yesterday that VCs are pushing companies to take bigger rounds than they need, and then after that I was explaining to one of our portfolio company CEOs that the size of the opportunity should determine the amount of money a company raises. Simply put, a company should aim to get to exit raising only a small fraction of the value that it hopes to exit for. Otherwise the investors won’t make the multiple on their investment that they want and after liquidation preferences are paid the amount left for the entrepreneur may well also be disappointing.

An example to illustrate:

  1. Company exits for £20m having raised £1m for 33% of the company in a 1x liquidation preference – the investor gets £8.3m back making 8.3x (£2m off the top and then 33% of the remaining £19m) and the entrepreneur makes £12.7m. Everybody is as happy as they are going to get with a £20m exit.
  2. Company exits for £20m having raised £15m for 50% of the company in a 1x liquidation preference – the investor gets £17.5m back making 1.15x (£15m off the top and then 50% of the remaining £5m) and the entrepreneur makes £2.5m. Nobody is happy. 1.15x is way below a VC’s target and the entrepreneur hasn’t made much in the context of the size of the exit.

The upper limit on the exit is determined by the size of the market opportunity. The acquirer of a business will look at how much profit they will be able to extract, and that profit is a function of total available revenues, market share, and profitability, all numbers that can be estimated with at least order of magnitude accuracy from very early on. There are occasional cases where a product impacts adjacent markets and then the function breaks down and valuations soar – Instagram is a good recent example – but these are rare.

The sequence, therefore, is market opportunity determines likely exit which in turn determines the amount that should be raised. Companies which operate within these guidelines will have a happy time. Those that operate outside them often don’t. The problem is often worse than simply not making as much profit as initially expected because investors and entrepreneurs don’t want to accept that they won’t make as much as they hoped and spend too long chasing the dream, frequently raising more money and exacerbating the problem.

So when I read about VCs making companies take more money than they need it makes me … a little unhappy. In the first instance the amounts are unlikely to be as large as in the example above, but when a company starts raising too much money it starts down a path that can be difficult to change.

  • Hi Nic,

    So for example, let’s say a startup is currently burning $5,000 per month, planning to raise money to grow the team and business. The new burn rate will probably be $15,000. How much money should this startup raise for this new round?

  • You should work out what the next major value milestone will be and raise enough cash to get six months past that. Value milestones include revenue threshold, big product releases, distribution deals and reaching cash flow break even. I can’t work out a number from the data you’ve given me.

  • Yeah I agree, and usually it will be a mix of targets with one major milestone during a period of 12 to 18 months. I like to use the way Fred Wilson put it in this post:

    As he mentioned “raise 12-18 months of cash each time you raise money”. I think it’s a good way to estimate the amount of the round considering you know what’s your next milestone and how much you’ll need to burn monthly to reach it.

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