Top ranked sell side investment analyst turned angel investor shares thoughts on startups and early stage investing.
Friday, September 11, 2015
Founders: 5 considerations when you size out an early round
What is the "right size" for my raise and why do I get so many conflicting opinions from investors on it? What am I missing and what am I doing/saying wrong?
Having had many conversations with early stage startup entrepreneurs along these lines of late here are some thoughts from me on the subject. I suspect that I will be accused of giving a long non answer ... but I am strongly of the view that founders need to adopt the policy of:"Taking advice, not following advice." As an entrepreneur, realizing that you will get as many views on your raise as there are investors, means that you need to reach your own view and pursue it based on at least five key considerations:
How much you "need"
The trade off between value creation and control
Location: where you are based and where you will be pitching the most
Whether are you focused on securing angel or VC investment
Sorry, it's complicated
I will start off by saying that this dilemma reminds me about the old saw about economists: Ask five economists their views on something ... and you will get at least six different answers!
In early stage land investors (individual angels, angel groups, seed funds, early stage VCs) have so many different opinions on raise size that there is little if any consistency. Hence my first point to entrepreneurs - no, don't worry, you are not going crazy! The center of gravity of all these voices is indeed hard to discern and is influenced by self interest too. For example and totally understandably a VC will look at any proposition through their own lens - including their usual ticket size. So they might favor a "bigger" raise than an entrepreneur had in mind since that would equate to the minimum ticket size they prefer to invest.
This contrasts with the public markets where the capital markets desks of investment banks pricing deals have at least some chance of consistent price and size discovery. This because of the volume of transactions, more substantial financial data and much more consensus around valuation methodologies and metrics. (Although from from time to time they do get pricing badly "wrong" with resultant often gleeful cheap shots from the media and other commentators.)
Recognizing there is no one "right answer" is at least helpful to maintaining an entrepreneur's sanity. The five factors listed above seem to me to be the key ones that might help you, as the entrepreneur seeking to frame your thinking and head towards as good an answer as you can get. I will tackle these five points in more detail shortly. Also note that I am not making a call here between convertible notes (which duck or at least defer the issue of valuation) and a priced round - that is yet another discussion. But see my post "Startup Convertible Notes - Enough Already" for my take on those vexing instruments!
To further complicate the entrepreneur's thought process ... you need to be prepared to be flexible. Entrepreneurs need to due diligence investors like they due diligence you. All money is fungible but good advice and relationships are not. So if you get talking with an investor or group of investors where you see a good fit and relationship developing but where there is some angst on the other side of the table around the size of the raise it makes sense to be prepared to be accommodative to the extent you are comfortable. So have ready an answer to the question: "If we funded you with $1.5mn not $2mn ... could you make that work?" In fact this can go both ways because the question might well be: "We really like what you are doing ... if you raised $5mn not $3mn how would you put that to work and how much more quickly could you grow!?"
And what about gender?
Some women entrepreneurs struggle with this challenge more than men, in my experience. But to the extent that gender comes in to play it seems most acute at the first time entrepreneur/first raise level. In part that might be a confidence, some might say integrity, issue borne of a lesser willingness of women to self promote, indeed exaggerate. As one (female) founder politely put it to me: "there are a subset of male entrepreneurs who just make it up and are comfortable with that" pointing out the bravado shown by the RapGenius founders. This is a Silicon Valley classic: How Rap Genius Raised $1.8mn in Seed Funding Without Knowing What We Were Doing
However I have heard from (women) VCs on both the East and West Coasts that they see no difference at all in terms of their dialog. They note that the choices that need to be made, as I outlined above, apply equally based on their experience. ie they report no obvious gender based differences in the way entrepreneurs handle them. With that in mind my suspicion is that, by the VC/Series A level, every start up has been through the pain of pitching and iterating their message more times than they care to remember. And having got early angel/seed funding they have built up a network of investors, advisors and entrepreneur contacts that means that they are all better placed to "play the game" ... as best it can be played.
Here is more detail on my five key factors:
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 this 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. Angelist is a good resource here with the ability to compare valuations against a variety of filters.
For any investor the amount you raise will have some connection with her/his 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 around the $2mn level might be all you can hope for ... and raising more than say $1mn on top will be next to impossible. $1mn new money would mean the founders are giving up a third or more of 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 up to $500K say on $2mn 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 even afiduciary Board) and have some initial traction ... heck, perhaps even customers paying real money! In that context if say a $5mn pre-money is achievable then the raise size debate/dilemma really kicks in. Per the prior scenario yes a $500K convertible note works, but now a $2mn priced seed round might be viable. So other factors come in to play ...
2. How much money do you need!?
Seems obvious but since financial models at the early stage are 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 more likely 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 yet 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 your sanity 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)? Sodo 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 proportionate ownership. As Guy Kawasaki points out in his great presentation on the top ten mistakes of entrepreneurs, owning 51% or more of your company does not mean having control. As you take more money from strangers the constraints on you add up.
In my view 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: in the current jargon its all about finding Unicorns. 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. Meeting over!
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 can be pretty location specific ... they prefer to invest in companies they can drive to. (Or get to on the subway in New York City!) Angels are the same - the quarterly Halo reports from the Angel Research Institute indicate that some 80% 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 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 (much bigger) 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 smaller 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 takes longer to scale larger. Plus the stats are clear - you will be much less likely to stay King/Queen for long. (And meanwhile us Angel investors will be diluted away fast and soon lose any hope of influencing the exit process through a Board seat.)