Raising Early Stage Capital: A Cautionary Tale

Every startup journey begins with the entrepreneur’s dream and vision for the company. Despite the unmistakable need to raise money on this dream by convincing investors of its potential, raising money is still the most difficult part of building a successful startup. It is difficult for both first-time and serial entrepreneurs due to its time-consuming nature and strategic complexity. Regardless of how arduous the process is, it is absolutely imperative that the entrepreneur ensures their startup will have the ability to raise enough money at each stage. To do so, the entrepreneur must think strategically about the longterm trajectory of the company in every facet, whether it be funding rounds, user growth, or product development milestones. Unfortunately for the entrepreneur, there is one major pitfall to avoid early on in his or her strategic thinking. What is that fatal pitfall you may ask?

The entrepreneur does not raise enough money at the seed stage.

There are two primary reasons why the entrepreneur may fail to raise enough money in the early days of the startup.

1. Lack of Experience. The entrepreneur is perhaps a first-time entrepreneur and therefore does not have the experience necessary to understand to what extent they will need funds to run their business. As a general rule, it is suggested that the entrepreneur raise twice as much money as he or she deems necessary.
2. Avoid Dilution. In this scenario, the entrepreneur is experienced enough to understand that they may need significant funds to run their business, however, they are fearful of getting diluted by issuing a large number of new shares. Rather than get diluted, they prefer to raise less money at the seed stage and spend that money carefully until their A round.

Regardless of the reason for not raising a sufficient seed round, there is a plethora of consequences that can in some cases lead to the startup’s failure. If the entrepreneur does in fact not raise enough seed money, the startup will enter death valley.

The Perils of Death Valley

The entrepreneur does not under any circumstances want to be in death valley for the sake of their startup. Death valley is most often situated between the seed and series A rounds when the entrepreneur is still lacking the experience necessary to make strategic growth decisions. There are two major perils in death valley that will severely punish the entrepreneur:

Stagnant Growth

When the CEO is consumed with raising additional money either in another equity round or a convertible note, he or she is not focused on orchestrating the business’s growth at a pivotal time. Not only may the team miss key growth milestones due to lack of strategic vision from the CEO, but monetary constraints will also kill the team’s moral. In total, while the CEO is scrambling to raise more money (often a difficult task without key milestones to exhibit concrete progress), the business will grow slowly and hesitantly.

Discounted Round

Ironically, when the entrepreneur intentionally raises less in a seed round to avoid dilution (and then runs out of money), he or she gets diluted even more when it comes time to raise a series A round. The entrepreneur must raise a sort of intermediary round to propel the company to a series A round, but does not want to begin the dreaded discussion around company valuation. The discussion becomes difficult when the entrepreneur feels that the company has made significant progress and therefore should be valued higher than its seed valuation. However, due to lack of funds and the inability to run far, this progress can seldom be quantified by commercial KPIs, and therefore does not necessarily present an objective justification for a higher valuation than at the earlier seed stage. Therefore, a convertible note is used to raise money quickly and delay the valuation discussion until the series A round. Unfortunately for the entrepreneur however, the note has a nice cap and discount for the investor which severely dilutes the entrepreneur’s shares in the series A round.

Take the following scenario to illustrate the perils of death valley.

*Note: In this example, a $2 million convertible note is issued with a $6 million cap. The note therefore converts to 25% equity in the series A round.

1. Sara founds StrongBit, a cloud-based data analytics platform that integrates multiple big data sources into one dashboard.
2. Due to her experience as an entrepreneur, Sara is able to bootstrap her startup until she raises a $500,000 seed round for 20% equity, hoping it will take StrongBit to a strong series A round.
3. 6 months later, Sara realizes she does not have enough runway to position StrongBit for a strong series A round. With the $100,000 she has left, Sara knows she will not be able to lead her team to secure those 10 paying enterprise clients necessary to impress VCs for a series A round. This puts Sara in a predicament.
4. Due to StrongBit’s lack of tangible progress and arbitrary valuation, Sara chooses to issue a convertible note for $2 million with a $6 million cap and a 20% discount. The kicker is coming…
5. Finally, StrongBit secures 10 paying enterprise clients, has a valid CAC, and brings on two new advisors. Things are looking good, so Sara decides to raise a $5 million series A round at a nice $12 million pre-money valuation. During this same series A round, the note converts to equity at a $6 million cap, which substantially dilutes Sara’s shares.

In the end, although Sara was able to bring StrongBit to a high valuation, she gets screwed on the terms of the convertible note, which was necessary due to lack of sufficient seed money in the onset. In this scenario, her shares are diluted more than they would have been if she had raised that same $2 million in an equity round.

As the company’s valuation rises past the cap on the convertible note, the entrepreneur’s dilution potential also rises. So if the series A round values the company at $20 million, as opposed to $12 million, the entrepreneur will be diluted significantly more, as illustrated below.

How to Avoid Death Valley — If You Love Your Shares, Set Them Free

In order for the entrepreneur to avoid death valley and the potential failure of their businesses, it is critical that they maximize the value and potential of their dream. Similarly, it is imperative that the entrepreneur maximize their ability to raise seed money on this dream and thereby properly equip the company to reach a solid series A round.