One of the first questions an early stage company willing to raise money asks itself are how much to look for (“As much as possible!”), and which level of dilution is acceptable (“as low as possible!”).
The “how much are you looking for?” question is important because its answer, while being traditionally more a matter of intuition than reason, can be difficult to modify once investors are anchored at a specific level.
The company’s interest being the top priority, it is better to focus the discussion on the amount raised and to consider valuation as an output. This can be done by (1) Assessing the timeframe separating the current round of fundraising from the next one, (2) Considering the amount the company is able to spend within this timeframe while maximizing the utility of funds, and (3) Adjusting the amount raised in function of the market-offered valuation.
1) The duration that separates the current fund raising from the next one
Unless your Business Model is one in a million (e.g. gift cards, lottery, central bank) or your company has been around for some time, the goal of the fund raise is to cover the burn waiting for the next fund raise. The longer the duration, the higher the amount raised has to be. Contradictory factors have to be taken into account to determine this duration:
a) A short duration allows raising a small amount and consequently getting a smaller dilution. But it also implies that the entrepreneur must spend a significant share of his time and energy raising funds. This option can be wise if the company is poised to quickly encounter an event that could significantly increase its valuation, as a product launch or a large contract. It is however a dangerous game that is more often sustained (e.g. bridge round following a fail in larger fund raise) than chosen.
b) A long duration allows focusing on execution rather having to spend a lot of precious time in roadshow. It’s also an insurance against the risk of cash exhaustion in case of a hiccup or market downturn. But long-term is difficult to predict, and investors may not be able to value the company based on what it could be at the end of the period. They will want to base their assumption on a closer future, a smaller valuation and, consequently, a more important dilution for the entrepreneur.
The commonly accepted golden mean is of about 18–24 months, roadshow beginning 4–6 months before cash-exhaustion (which implies that the entrepreneur spends c. 25% of his time raising funds).
Now that we set the duration between the current raise and the next one, let’s define how much the company will be able to spend on the period.
2) The amount the company is able to spend efficiently
The more a company matures, the better it is able to deploy a lot of capital efficiently. But even for the most mature company, there will be a level after which the capital marginal utility decreases (=the cake size stops increasing while your slice keeps decreasing).
- In seed, the goal is to iterate towards first versions of the product and Business Model. The funds raised consequently have to cover the (preferably small) team wages and the few other expenses (e.g. offices, marketing tests). If the fund raise is more important than that, a portion of the funds will be used in a sub-optimal way (e.g. non negotiated quotations, launch party), which represents a value destruction for both the investor and the entrepreneur.
- In series A/B the fundraise goal is to accelerate on a well-honed model. The car is ready for the run, the road is straight, and the only thing missing is fuel. But the fuel volume able to be injected is limited a) from a product standpoint by the optimal development team size (cf. Jeff Bezos’ two pizzas rule) and b) from a product/sales standpoint by the evolution of the marginal Customer Acquisition Cost (unless of course if you are Uber, have a crystal clear growth roadmap, and raised $4b in a year).
Within a fixed duration between the raise and the next one, there is consequently an optimal amount to be raised, which is between the moment when marginal utility of the money raised begins to decrease, and the one when it becomes almost non-existant.
So far, we defined this amount with an interval. Confronting it to offer and demand will allow us to precise it.
3) Offer, demand, and the entrepreneur sensitivity to dilution
Theoretically, the company valuation synthesizes future profits forecasts. But a fundraising is also a confrontation of offer (companies willing to raise money) and demand (investors willing to put capital at work).
This confrontation builds a valuation, which dictates the dilution the entrepreneur will have to sustain. The entrepreneur consequently has to determine his sensitivity to dilution, or the level above which she consider that the dilution disutility is too important for her.
In a bullish market offering a high valuation, the entrepreneur will be able to go closer to the moment when marginal utility becomes non-existent than to the moment when it begins to decrease.
The optimal amount raised is the maximal amount which, in a given period, allows the last dollar raised to be more useful to the company than it is harmful to the entrepreneur.
Or, alternatively, 1)define the maximum amount accepted by the market 2) negotiate 20–30% dilution :)