Thursday, July 25, 2013

Go Big? Go Small? Who Knows!? Part II

Why deciding the right size for your early round is so very vexing! 

Part II

Sorry, there is no "right answer"!

In my Part I post on the topic of "what is the right size for my early stage round?" I advised that entrepreneurs can maintain their sanity by recognizing there is no one "right answer". I listed five factors that seem to me to be the key ones that might help you, as the entrepreneur frame your thinking and head towards as good an answer as you can get. This post reviews these in more detail. So here goes:

1. Valuation

As the cliche rightly has it, valuation (especially for start ups) is an art not a science. It is a negotiated answer based on incomplete information, very high levels of uncertainty and, it has to be said, a large quotient of hutzpah. Valuation is a book length discussion but a recent post by Bill Payne for the Angel Capital Association gives a blog length summary as seen from the investor side. Bill cites the VC Method, the Berkus Method, the Scorecard method and the Risk Factor Summation method. I would add that many investors use more seat of the pants approaches. For example looking at comparables (eg by sector, stage, location) they think are relevant, even just high level average seed stage valuations - currently the median is $2.5mn.

For any investor the amount you raise will have some connection with his/her take on your company's valuation. For example, if you are at an genuinely early seed stage (maybe not even an MVP, very small team, no customer traction) then a pre-money valuation at or below the $2mn level might be all you can hope for ... and raising say $2mn on top will be really hard. Plus it will mean the founders are giving up half the company from the get go ... which will put investors off of itself. Why? Well it makes for imminent disincentive effects as further rounds further dilute you down to zip pretty fast. In that context raising $500K say seems more reasonable all around plus means you only give up 20% of the company.

As your idea morphs into an actual business the options multiply.  Say you have an MVP in the market, have built out a team with domain expertise, the right technical talent and others (plus have a good Advisory Board maybe) and have some initial traction ... heck, perhaps even customers paying real money! In that context if say a $4mn pre-money is achievable then the raise size debate/dilemma really kicks in. Sticking with the $500K vs $2mn options for the sake of argument, either "works" now so other factors come in to play ...

2. How much money do you need!?

Seems obvious but since financial models at the early stage a largely works of fiction it can be hard to pin this down. And as your valuation grows there will be a tendency for investors to suggest you raise more because a small raise leaves outside holders with a smaller position and hence lesser influence. Plus rightly or wrongly there is a perception that bigger valuations simply equate to bigger raise sizes.

So you really need to work out what you truly "need" to either get to cash flow break even (and hence be self funding thereafter) or what will get you to the next major milestone that will allow you to take the story up a notch and raise more money at a higher valuation. And "need" means having a well articulated "use of proceeds" that is the best assessment you can make on current information, plus has a cushion built (25%?) to protect you from inevitable startup snafus.

One thing that investors will look at hard, and entrepreneurs should too, is the current and future burn rate. If your raise does not cover 12 or better 18 months of negative cash flow then you have an issue ... because, given how long it takes to raise money, with lesser runway a) there is less cushion for adverse events and b) you will need to start raising money again pretty much when the current raise closes - not good for you or your business!

3. The trade off between value creation and control

The classic Noam Wasserman dichotomy also applies - growth (and thus value creation) vs control. aka Do you want to be rich or King (or Queen)? So do you want to grow really fast and are happy ending up with a smaller share of a much bigger pie? Or does control matter - do you want to run the show and build "your company, your way" for as long as possible? Both are totally valid but intensely personal choices. Wasserman's point is that entrepreneurs need to understand their own motivations from an early stage.

If you want to be King/Queen then take as little outside money as possible ... but if you want to grow fast with a view to a) maximize the pie but b) in so doing give up control and c) most likely in just a few years lose your CEO role then in most all cases you need to raise larger amounts.

Some entrepreneurs don't realize that control has only a loose connection with ownership. As Guy Kawasaki points out in his great presentation on the top ten mistakes of entrepreneurs, having 51% or more does not mean having control. As you take more money from strangers the constraints on you add up.

The trigger point is when the dynamics of your capital raising have created a five person Board (with say the CEO, another funder, two investors representatives and an independent). The moment that happens then, as Founder/CEO, you have appointed your judge, jury and potential executioner. (Because you are "out" on a 3-2 vote if the majority of the Board decides you are performing poorly or are not the right person for the next stage of the company's evolution.)

4. Where are you located? Where are you pitching for money?

The Silicon Valley "Go Big or Go Home" mantra speaks to a culture where all sides are looking for the big wins. And big wins come from aggressive scaling ... and raising substantial amounts to do that. So pitching to VCs and even Angels out West with a dinky small raise sends the signal that you are not serious about the big win, or maybe your opportunity isn't itself big enough to deliver one.

On the East Coast I think there is a generally more analytical/incremental (East Coasters would call it "realistic") approach where a well calibrated smaller raise taking you to the next proof point is more accepted as the way to go.

Important to note that VCs in general are very location specific ... they prefer to invest in companies they can drive to. Angels are the same - the quarterly Halo reports from the Angel Research Institute indicate that 81% of Angel Group investments are made in a group's home state. (But note that this is a partial picture since total Angel investments made outside the context of groups are much bigger in $ terms given total angel commitments of approx. $25bn/year vs. an annualized figure of about $1bn for groups alone as captured in the Halo report.)

One consequence of local investing ... is that your odds of funding go up if you are located where the money is ... angel money, again per the Halo report, is fairly widely available across the US but VC money is much more concentrated. Approaching 2/3rds of VC dollars are put to work in Silicon Valley, the New York Metro area and New England aka Boston. (You can see the full break down in the the latest PWC Moneytree Regional Aggregate data).

5. VCs vs Angels?

A subject worthy of lengthy discussion of itself ... but the motivations of Angels vs VCs are really very different. And entrepreneurs need to understand this. Steve Blank put it well recently when he said: "The day you raise money from a venture investor, you've also just agreed to their business model" Basically Angels invest their own money and like to see it come back before too long, In contrast VCs get paid invest other people's money and are prepared to wait more years for scale.

Angels would be very happy if your plans were to use their money to take the company to a $30mn exit in four years. For them the smaller raise can be seen as less risky, maybe enough to get you to that early exit plus gives them the hope that they can retain some influence (esp. via a Board seat). (Basil Peters book "Early Exits" is the angel investors bible on this topic.)

VCs in contrast (above the small seed level players) have to have a much bigger exit for their business model to work. So they will be inclined to favor bigger raises from entrepreneurs pitching a much bigger opportunity that yes, can make everyone rich. But it means you as the entrepreneur have to wait longer for your personal liquidity and indeed put that liquidity at risk of some adverse economic, market or competitive development as the business waits longer to scale larger. Plus the stats are clear - you will be much less likely to stay King/Queen for long. (And meanwhile your Angel investors will be diluted away and lose any hope of influencing the exit process through a Board seat.)