I recently wrote a guest post for the Dorm Room Fund‘s blog about the dangers of raising too much money early on. I think this topic is one of the most important for young startups raising seed / series A capital. You can see the post on the DRF blog, but I have also posted it below. Enjoy!
Mo (VC) Money, Mo Problems
If a venture capital firm offers to invest $1.5 million in your startup for a 15% ownership stake and a competing venture firm offers you $3 million for 15%, which would you choose? In both scenarios you undergo the same amount of dilution, but choosing the $3 million option means a higher valuation and more capital resources to work with. This logic is why many entrepreneurs won’t bat an eye and will choose the 3 million dollars even when they only need 1.5 million (or less). Makes sense, right? Not always. Sometimes less really can be more when taking venture capital money.
Let me explain.
A young startup with a high valuation needs to generate significantly more value to continue to attract favorable investment terms. The higher a valuation is, the harder it is to exceed this valuation in future rounds. It leaves a startup more susceptible to getting stuck needing to raise future rounds at a lower valuation than it received initially. This is called a “down round.” A down round is financially damaging to founders and investors. Even worse, a down round can be harmful to a company’s psychology, which impacts employee morale and may ultimately effect the company’s performance. Accordingly, by raising more money than you need and optimizing a round simply to achieve the highest price, you risk setting expectations too high and do not leave any room to recover from the inevitable bumps in the road. And trust me, startups are never smooth sailing the whole way.
Instead, if a startup raises a more modest amount at a lower valuation, it buys itself time to grow and to experiment with its business model without as much pressure or as many expectations. Then, when the time comes to raise another, bigger round, the startup will have more negotiating power to raise a larger sum on better terms without sacrificing as much equity.
When evaluating how much money a startup should raise, Chris Dixon suggested on his blog that entrepreneurs should raise, “enough to get your startup to an accretive milestone, and then some fudge factor.” This rule of thumb makes sense. Raise enough money so that you have sufficient resources to grow, but leave a little wiggle room to hit the milestones you have set. However, be sure not to raise excessive amounts of money just because you can.
Sometimes, in the early stage investing, venture funds will encourage entrepreneurs to raise more money than they need out of the funds’ best interests, rather than capital needs of the young startup. Additionally, when startups raise more money than they need, they usually will find a way to spend it – unnecessarily. But unfortunately, the extra money-spent doesn’t always equate to extra growth. Don’t fall into this trap: think about what you need to hit those accretive milestones and don’t go overboard. It can come back to haunt you.
The great thing about tech entrepreneurship today is that startups need less money than ever to achieve accretive milestones. Startups can do a lot more with a lot less. This means that early stage startups can afford to raise smaller rounds and don’t need to worry too much about optimizing valuations in the short term. Instead, focus on building a killer product and managing the money that you truly need in an effective manner. Look beyond the hype of cash and high valuations and find a partner who supports your fundraising strategies and understands your growth trajectory and capital needs.
Feel free to reach out to me at any time if you have any questions about this!