Why Startups Should Avoid Raising More Than They Have To
Without a doubt, the most frequent question from early-stage startup founders preparing for their first raise is: how much money should we raise?
They’ve heard the stories of startups doing huge raises before their product is even finished. Sometimes before it’s even started.
My reaction when I hear their plan to raise $2M is: don’t do it.
If you need to ask, you’re not ready
If you need my advice on how much to raise, then you’re not on your 3rd big startup, able to walk into Sequoia or a16z and walk out with a big check. Fundraising won’t be easy.
You might expect if you’re doing all the work to raise $1M, then raising $2M isn’t much more effort.
My experience, though, is raising $2M at the earliest stages is not 2x harder than raising $1M, but 4x or maybe 5x.
- Bigger investors won’t invest yet, so investors will be small fry like me.
- Investors increase their check sizes as companies progress.
- The valuation will be too low to support a large raise.
A small raise is better
Even if the fairy venture godfather appeared and offered you $2M with a wave of his check-writing wand, you’d be better off not taking it.
Huh? Why would you not want as much investment as you can get? The more money you have, the more you can accomplish, the faster you can grow. Let’s pile it up and cart it off and put it to good use!
The problem is the fairy venture godfather, or the savior angel, isn’t your friend. He or she is an investor. And that money isn’t free.
Giving up equity may seem like free money, just numbers on a cap table, but it isn’t. Investors are taking something in exchange — a big chunk of your business.
How much do you want to give up? As little as possible!
Your goal is to make yourself, and your cofounders, and your employees rich, not investors. As long as our incentives are aligned, we’re just along for the ride. You don’t want to be handing over more of business than you have to. That’s not even good for investors anyway, because you need to keep as much in reserve as possible for following rounds.
But if you’re going to raise big gobs of money eventually, why not take it now and build faster or have more runway?
Because the first money is the most expensive money.
As the company reaches milestones, its valuation increases. That means for the same amount of money, investors take a smaller percentage of the business.
A $1m raise at a $5m valuation (post-money) means giving up 20% of your baby. That’s literally an arm and a leg. $1m at a $20m valuation is only 5%, which is only a kidney and appendix.
What’s the right amount to raise?
How much to raise is a balance. If you raise too little, the company will struggle to make it to the next milestones. You don’t want to run out of cash in the middle.
But if you raise too much, you’ve sold off more equity than needed, leaving less to sell to later investors.
So what’s the right amount?
One answer is to raise the amount needed to make it to the next major milestone when the valuation will jump.
Talk to potential next-round investors now and find out what targets the company will need to meet. Then raise the amount needed to reach it.
Of course, be sure to include a safety margin because everything always takes longer than planned, and raising the round will take time, too.
This approach works best when there are well-defined stages and targets. There could be an FDA approval pending, or the results of an important customer trial, or the completion of critical new features that might only take a few months,but substantially change the risk profile of the company, and therefore the valuation.
The other answer is to raise enough for 18 months of runway. Less than 12 months and you won’t be able to show enough progress to raise another round. More than 24 months, and you’re both giving up too much now and not showing confidence in the ability to grow quickly.
But we need $2 million!
After doing a careful analysis, founders often come back and claim they need the full $2 million. They need to hire more engineers, hire sales people, invest in marketing.
Sometimes it’s true — they have a product and are ready to scale. But usually not.
Usually they have an MVP, which is good for customer testing and experimentation, but it’s not a finished product. They have customer interviews, maybe a handful of users, but haven’t really validated product-market fit.
Raising too much now can actually be detrimental. The company goes full speed ahead on hiring and building out, only to find they need to make substantial adjustments to everything. All the money was wasted rather than invested.
As much as founders want to go fast, and investors want them to go fast, there’s no point in going fast if you’re going in the wrong direction.
Start with a smaller raise, just the amount needed to complete the product and validate product-market fit. Then come back for that $2m raise at a much higher valuation.
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