Ask a VC: how much money to raise?
In this series of articles “Ask a VC”, I’ll try to answer questions entrepreneurs ask me all the time.
“How much should I raise on this round?”
“what is the right number for my business?” “Should I raise the same amount or more than my direct competitor or than other companies in the tech space, so that I look important on the market” (“This startup for example raised over 100m€ last week; if I only raise 10m€, will I look insignificant or not serious enough”)? take any variation on that: for example, a couple of years ago, many Y Combinator startups were raising $2m on a $8m pre-money valuation in a convertible note (and all the ones I talked to there in San Francisco had 2–3 co-founders, just a POC or MVP, and sub-$50K revenue). The amount had nothing to do with their needs, the entrepreneurs were just playing market dynamics…
First, it is always good to remind yourself that money is NOT free. No one will give you free money. Investors give you money in exchange for
- either interests (instruments: debt, convertible notes, SAFEs, BSA AIRs, etc.); this means they get their money back (the principal) and some extra money (the aggregated interests)
- or against a piece of the equity of your company because they believe that piece of equity will be worth more in the future (we call this capital gains).
Taking on debt means you have to pay it back at a given date (we call this date the maturity, often 2 years), which means you will have had to make enough available money in that timeframe with the company operations to pay it back. Most startups run out of cash in that timeframe and keep on raising the next round. So it’s not a great idea to “borrow” money because you won’t be able to pay it back. Some companies keep raising new convertible notes to pay back the previous one, which creates a nightmare in the waterfall calculations for future investors. I’ll write a post one day on why I dislike this instrument. There was also this super famous case in California of an entrepreneur who raised a convertible note without maturity (and famous and sophisticated investors trusted him), and then his company became highly profitable: he had no incentive to ever pay back his early investors…
It’s also called a convertible note because instead of paying back the debt, you can exchange the payment for a piece of your equity at a FUTURE price (supposedly higher). Let’s assume here that we never pay back debts, and that all fundraising is just equity.
This means that, when you raise money, you are actually selling a piece of your company early, ie. when you sell 100% of your company in the future, a piece of it was sold early for a much cheaper price to someone else (the investor), for the money you needed then. The problem here is that by definition you can only sell 100% of your company. If you give anywhere between 10% and 40% on each round, then this is money you and your co-founders will not get at the final exit (we’re assuming an exit here; for a going concern, it's the pro rata of dividends if you distribute any). Let’s assume 3 rounds of equity at 25% dilution each time (seed, Series A, Series B). Let’s say you are 2 confounders, owning 50% each. Then your personal ownership becomes 50% * (1-25%) * (1–25%) * (1–25%) = 50%* 57,8% dilution = 21% ownership left. You just lost 29% of the equity you owned, ie 58% of your future wealth…
So think hard when you raise money. If the valuation is fixed, you will be diluted more if you raise more. Less if you raise less money. But you don’t want to get stuck halfway in the development of your company and not reach the milestones necessary for the next round of financing if necessary. Because yes, you should raise just enough to develop the company to the next stage, ie. reduce risk significantly for the next investor to jump in. Depending on the stage, the next stage could mean building the MVP and the core team, getting to product-market fit, or reaching profitability on one market or one product, etc. However nothing ever happens like planned in our entrepreneurial world, so a margin of security of extra money is a wise move.
So how much should you raise?
You should of course have done a P&L projection over 5 years. Why? Because that financial modeling will take into account all the cash in (revenue, subsidies, grants, investments, etc.), and all the cash out (direct costs, fixed costs such as HR, offices, lawyers, etc.). It also helps structure your thinking and build a model that you can execute against, significantly increasing your chances of success and of reaching the next milestones.
Once your P&L model is built and has taken into account all cash movements, it is trivial to sum up all cash in since today and to sum up all cash out since today. You can graph both curves per month. You can then graph the difference between them, and get a J-curve. The lowest point on that curve will tell you exactly how much you need to raise to execute your plan. It will also tell you WHEN that low point will happen. If it is beyond 18–24 months, then you should probably raise in tranches of money necessary for each 18–24 months. More typically, that low point happens between years 3 and 4. This means you will be cash breakeven, not BURNING more money, meaning you won’t need to raise more money after this. The use of proceeds in % is now trivial. Just sum up the costs since today, and create a percentage of each major expense vs total expense. You then get how much will be used for technology, HR, marketing, etc.
Remember above: I said that nothing ever happens according to plan. So, you should raise a bit more than this. There are techniques to assess this in greater detail, but you can use a rule of thumb of 20–30% more money, or create a worst-case, target-case, and best-case scenarii, calculate the necessary money in each scenario, and weigh each according to some informed probability, to get a weighted required money for this round. Or use a Monte-Carlo simulation with tools such as Crystal Ball.
And here you are.
Just by adding 3 lines of sums (cash in, cash out, difference) to your pre-existing P&L model, you know when you’ll reach cash breakeven, how much you need to raise, and whether you should raise in tranches. Add some uncertainty and you know the final amount to look for, and the split of the use of proceeds. Great insights to have before talking to investors.
— -
I consult with corporates and startups and help them address issues like this and many more. Don’t hesitate to reach out at www.rodrigosepulveda.com or book a video call with me on intro.co.
