How much money to raise, when, and on what terms is, IMHO, the most difficult discussion between entrepreneurs and investors. Perspectives are different and interests can be misaligned. Often the discussion happens under great pressure. And, the consequences of getting getting it wrong are extremely painful.
Entrepreneurs usually see it this way:
• They have great faith in the future and value of the business, and they sell this every day. So it makes perfect sense to them to raise a lot of money at a high price to accelerate success.
• They worry most about missed opportunity: running out of cash before break-even, inability to capture a customer opportunity, or losing the market to a competitor. More money in the bank always increases the chance of success. CEO's have often said to me: "I know I can do this, it's just going to cost a whole lot more."
• They see their competitors and entrepreneur friends raising big rounds (especially in today's market) and naturally want to do the same.
• They want to move past the "Raman noodles and doors-for-desks" stage and become a real business with a decent office, some support staff, competitive salaries, and less time on
• Founding entrepreneurs with high ownership are also very conscious of dilution, so they are quite sensitive to valuation and amount raised. Entrepreneurs who were hired to the company or whose equity has been diluted down to industry-standard levels have less incentive to avoid raising money. They expect to have their equity refreshed back to standard; one CEO told me point blank: "I expect to get 5% of the value of the company, regardless of how much money I raise." Additional investment has little cost to them.
Investors' thinking is partly aligned with entrepreneurs:
• Funds and reputations are made by big hits [which it is trendy to name after mythical beasts], so investors want to identify their highest potential companies and back them strongly.
• Companies are sometimes made by market-preempting investments: once the market and the model are proven, a big slug of marketing money can produce an unbeatable leading position. E.g., I have heard Zenefits' success explained this way.
• Write-ups are a volatile currency, but in the early years of a fund they are the best objective measure of progress, so definitely a good thing to have.
But, investors have additional issues and concerns:
• Later money dilutes early money and piles liquidation preference (1) on top. The best outcome for early investors comes when a company scales based on internal cash flow, with modest additional investment, even if that happens more slowly.
• Investors are at risk for loss of capital, and entrepreneurs mostly are not. If a company raises a large amount of money and spends it before the market and model are proven, the result is a write-off or a re-start, and all the early money is gone. All too often I have seen companies raise, spend, retrench, and have to raise again in distress. The early investors have to choose between buying their shares again or watching the last investors take all the value.
• Investors have experience with many companies, and this perspective helps them recognize the temptation to over-spend. From my own experience, I'd say that there are at least five companies that build up their infrastructure and spending too early -- badly over-estimating revenue -- for every one that invests too late and loses out to a competitor or inability to serve customers. At some point these companies have to cut cost abruptly, damaging their reputation and morale as well as the lives of laid-off employees and the net worth of investors. And it's common for a well-funded company to overbuild its product -- following its vision -- and lose out to a leaner competitor who is adding features quickly in response to customer feedback. I'm going through one of these expand/retrench events right now, and it's very sad, painful, and wasteful for all concerned.
• I and many other investors think that attractive offices and big cash bonuses rarely make sense until a company is solidly profitable. Before the cash-positive point, incentives should be mainly equity; this puts entrepreneurs and investors in the same boat (recognizing that entrepreneurs need enough current income to make their lives work). And sometimes spending gets to be just silly: recall the super-bowl ads and vanity billboards on California 101 that were de rigueur for aggressive start-ups at the height of the 2000 bubble.
I hope I have stated both sides of the issue fairly. This is no easy or clearly right answer here. In these heady times when the mythical beasts are romping in golden pastures of hype, it's good to remember that the path to glory is steep, windy, and strewn with pit falls. The big winners, be they smart or lucky, get most of the media attention, which makes it look easy. It's not. It's all about balancing upside with downside, and reconciling the risks and perspectives of the parties at the table, at every major decision point. If we take risk wisely and execute well we have a good chance to win. If we get carried away by hubris or shallow thinking we are quickly lost. As Bill Gurley put it succinctly, venture capital today isn't in a valuation bubble — it's in a risk bubble.
Notes:
- Securities purchased in later rounds of investment in private companies typically have the right to be paid out first; this is referred to as "liquidation preference".