Over the last year we’ve seen about 250 pitch decks, from teams at differing stages, with wildly differing views on funding amounts and valuations (the question of valuation is inextricably linked to the amount of the raise; I’ll try come back to that in a future article).
We expect founders to come to us with a clear initial idea of what they need. That said, we see this as a starting point for both a negotiation but also, more collaboratively, a proper analysis of the funding requirement. That process takes account of the factors below, and aims to end up with something that supports the business, and at the same time recognises the financial goals of founders, previous investors, and the DSW Ventures.
An old VC acquaintance is fond of saying, in respect of how much of the company will the founders give up, that “the answer is always a third” – regardless of the sum raised. This overstates the case, and there are plenty of exceptions, but in a meaningful fund raise, the investor group will normally want to take a meaningful equity stake – say 15% to 30% of the enlarged share capital. Clearly, the temptation is to raise as much as possible. Which works up to a point, but you can envisage a graph with a y axis showing valuation, and the x axis a decreasing probability of sounding credible and ultimately in closing a funding round. So why do some founders get significant funding, even at a really early stage with limited dilution, and others not? Essentially the drivers are likely return, and risk. Factors like an unproven or limited market opportunity, first time round entrepreneurs, and little evidence of product-market fit, for example, don’t give investors a case for investing say £2m for 20%.
On the other hand, if you absolutely need £2m, but the stage of progress can’t support a commensurate valuation, the investors will dilute the founders / management out of sight. This is an own goal, storing up resentment that will show through further down the line, and likely as not to be unwound in some future round or option grants. So back to the drawing board: can the team deliver real progress in the next year with less investment?
In practice, prior to your first external raise, make as much progress as possible with whatever funds you have – personal capital, work-for-hire income, or friends and family monies – so that you have the file of metrics and evidence to move the valuation along to the right.
Like most business decisions, fixing the amount of your raise is a compromise between conflicting factors. Fixing an acceptable amount of runway – the number of months to cash-out – drives in the opposite direction to the dilution argument above. Investors want to see 12 months plus of core burn covered by the raise. Core burn excludes the contribution from revenues that aren’t already nailed down. It includes current overhead, plus any additions that are core to the business plan to allow the company to achieve real progress.
The reason for the 12 months or more of runway is two fold. Firstly, raising funds is a pain and a distraction. It takes management away from the day job, and without at least a year of committed funding planning is a nightmare; recruitment becomes more difficult. Secondly, most businesses scale up too slowly to be able, within the year, definitively to show progress that justifies a bigger round at a higher valuation.
In practice, taking together the investment plus anticipated growth in revenues, you should be aiming for 18 months or more of runway – and perhaps even getting to cash break-even (although at that point you will probably want to double-down, have another raise and push the company back into investment phase again).
What the business needs
There’s no science to working out the ideal investment to make on any aspect of the business at any particular stage. You can read plenty of conflicting advice – only one chance to create a good first impression versus move fast and break things. By and large, however, the VC industry would rather see you get product into the market (so long as it works well enough, and doesn’t embarrass the company and its brand) than engineer the perfect solution that ends up missing the customers’ needs by a mile. The reasons are practical: – market needs change quickly; only by engaging directly with customers can you truly understand their needs; and early revenues are way cheaper than equity as a source of funding.
So don’t ask a VC for something like:
- two junior developers @ £40k each for 18 months = £120k
We see this a lot. Firstly it assumes that the costs are constant – in practice they build up over time and sometimes you can back them out again (use contractors for the peaks). Secondly – where’s the contribution from revenues? The best advice is to take the peak funding requirement shown in your cash flow forecast, and add a sensible contingency.
An additional pitfall is to try fund everything that you would like to build, or every market opportunity you would like to explore. Remember just how expensive money is at this stage. If a new feature costs you £50k in year one and you give up 2% of the equity by raising just that little bit more cash from investors – then if you exit for £50m in a few years’ time then that feature just cost the founders £1m. Equally, however, the business has to be viable; you need to have a working sales and marketing resource. Like I said, there’s no science in this, but when we ask to have a proper discussion about funding, it’s not because we’re being cheap.
Keep it lean
I started tech investing back in the early Neolithic era. In those days, a start up seemed to need about half a million just to exist – to hire premises with a rent deposit, take on staff all on formal contracts, buy hardware and a bunch of licences, hire auditors and pay pretty big fees just to set up the company. Now….we almost have to stress-test the business plan to see if the team could eventually support paying overheads (because they live for free in the 6 month rent-free period in a succession of workspaces, because the founders live on fresh air by couch-surfing, because they use the free services that we offer through the DSW Ventures network).
Lean works for us, and also for our investee companies. What doesn’t work is for us, isto overfund the company, because suddenly everything costs twice as much. Sure, we know that at some point we need to hire an in-house counsel, HR managers, and to invest in operations and infrastructure – but not at the stage of this first institutional or larger-scale angel round. Equally, this isn’t the time for founders to close the gap between their start-up salaries and usual market rates. So again, don’t beat us up for being mean; we just don’t want you to lose you moral compass.
On balance, ask for less than more; if you succeed in getting a set of excited investors you can turn up the dial, but it’s less credible to reduce your opening bid.
Fund what you absolutely need plus a sensible top-up; if demand and valuation permit, think about what else you could do with more funding – but just bear in mind that the long term cost of that money could be huge.