04.07.2009 20:01:26

Investors Network Team

There really is not minimum or maximum amount that you can or should be asking for. A better question here may be how much money do I want to ask for or how do I decide on the amount of investment needed for my business?

Let’s imagine for a moment that the company will make money soon after launch. Irrespective of whether we’re talking about profits or just high revenue here, I would caution that it almost always takes longer to ramp your top-line than you think it will. Everybody walks into a venture pitch with their three year financial projections that have a lousy first year, a strong second year, and a monster third year. The truth is that even most ultimately successful tech start-ups have a slow first year, a slow second year, and then you get your spectrum of third year results ranging from really-taking-off to continued-doldrums. It just always takes longer than you think to launch, grow, ramp sales, close deals, etc.

That’s a good consideration for the rest of the question – how much to raise and how long should you expect the money to last. Everybody has different thoughts on this subject, but I would say there are two helpful guidelines. First, raise enough money to last about a year or a good six months after your next big milestone. Some people like to say “raise just enough to get you to and then you will be able to do a B round at a bigger valuation”, etc., but you want to give yourself some reasonable stretch of time to be product and strategy focused after the A round before you have to hit the road again to raise more money. It’s no fun having to think about starting to raise money again only a few weeks on the heels of closing the previous round. Second, you always need more money than you think you need, especially if this is your first start-up. You can have a nice detailed spreadsheet that accurately reflects market salaries, rent, and more, but you will still require more money than you think.

 Let’s look at two scenarios for a very promising start-up with technology that may be of strategic interest to several profitable public companies (note to self - write a future post about the importance of not planning for or even thinking about exits like this):

Scenario 1: You raise 1 on 3 pre in an A round, so you’ve sold 25 percent of your company for a million bucks and you have a co-founder with whom you’ve evenly split equity, and you have a 15 percent options pool from which you quickly allocate 5 percent that fully accelerates on a change of control.

Scenario 2: You raise 10 on 40 pre in an A round, so you’ve sold 20 percent of your company for 10 million and you have a cofounder with whom you’ve evenly split equity and you have a 15 percent options pool from which you quickly allocate 1 percent that fully accelerates on change of control.

Six months into your post-A round, you are approached by Awesome Corp and they would like to buy your company for R20 million. Company that pursued Scenario 1 is in the following situation: founders each own 35% of the company. Founders each make R7 million dollars, investor takes out R5 million for a speedy 4x, and the options holders pull out the remaining million dollars. Ignoring taxes for the moment (much like ignoring friction in freshman physics, this is impossible and problematic, but humour me), this is a nice outcome for everybody. Your investors, it might surprise you, won’t be particularly thrilled, because it’s important to keep in mind that they are not in this business for IRR, they are in it for multiples, and a 4x on a fantastic new company with only R1 million invested is not that exciting. Still, at a 4x after six months, they’re probably not going to block the deal. It’s nice to make 400% returns in a short period of time. Now let’s look at the same offer if the company pursued Scenario 2. Do you think our founders are going to be cashing in any Awesome shares anytime soon? No, they are not.

But wait, don’t the founders actually own MORE of the company? Won’t they actually make MORE money individually? Why yes, they do own more of the company, but that was just a little trick I played on you. It makes no difference, because the investors, who have put up R10 million dollars, stand to take out R4 million dollars, and investors have this thing where their LP’s get very mad at them if they invest 10 and get 4 back after only 6 months. If our founders go look at their Articles of Incorporation and the term sheet they undoubtedly signed from the investors when they raised this round, they will see that the investors have blocking/veto rights, and the investors will veto this deal in a heartbeat. More likely, the company would never even get to this point, because the people at Awesome are going to look at the company cap table and realize that this deal doesn’t get done. The founders have set themselves on a course in which the only two possible outcomes are home run or failure.

At the end of the day you know that the more money you have the more you will spend. Unfortunately, money spend does not always equal level of success achieved or whether there will be success at all. What is the absolute least that I can spend to get this business of the ground? Now there is a question that perhaps not enough entrepreneurs are asking of them selves.

I acknowledge the contribution of Dick Costolo this post and take responsibility for my changes and additions.

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