What Is the “Right” Amount To Raise?
Imagine you are back in high school at 17 years old. You’ve gotten into the college of your dreams and are now figuring out how to pay for it. You’re probably partially financing your education with a private loan from your local bank. You run the numbers and go in asking for $20k. Your loan officer says “$20k is alright, but you should really take $40k. That will allow you to have more fun, get better housing, afford better food, and go on fun trips with your new friends — all essential parts of the college experience.” …Wouldn’t that set off alarm bells in your head?
Now imagine you’re gearing up for a fundraise for your startup. Things are going well and you have a real business case to accelerate growth with outside capital. You run the numbers and come up with $1M to accomplish your goals. You meet with VCs who say “$1M is alright, but you should really raise $3M. That will allow you to grow faster, hire more people, and have more runway — all essential parts of building a great business.” …Are any alarm bells going off this time?
The purpose of the analogy above is to establish a limiting principle to raising capital. Just like how you wouldn’t take out as much debt as is offered to you, you shouldn’t raise as much equity as is being offered. That’s because the more money you raise, the greater the expectations and potential burden on the company, and the less flexibility you have to operate (see our post on The Opportunity Cost of Capital). Therefore it’s worth considering raising less even when VCs around you encourage you to raise more. Keep in mind that VCs are incentivized to deploy capital (see our post on VC Economics & Why Fund Size Matters To Companies).
So what is the “right” amount to raise? What follows is a brief description of certain pros and cons of raising more and raising less, as well as key laws of physics concerning growth in startups:
- There are only so many people you can effectively hire and onboard while scaling your culture of hustle, grit, and creativity that got you your success to date.
- There is a non-linear relationship between the amount of money you set out to raise and the time investment on your part required to do it.
- Every dollar of incremental capital raised beyond what is “right” for the business is at a higher cost of capital than if you were to raise it later with more traction and less fundamental business risk
Raising More
There are certainly benefits to raising more capital. You can spend more money on more things and therefore increase the throughput of product development and sales. If all goes well, this raises your enterprise value above what you could have accomplished without capital, and beyond the effect of dilution from the raise.
Sometimes raising more isn’t just recommended but is absolutely necessary in a hot market where the competition has raised huge sums of capital. In these situations, capital by itself doesn’t guarantee success, but it can at least allow you to fight fire with fire.
However the benefits of raising and spending more capital are limited by certain laws of physics. The most important law is there are only so many people you can effectively hire and onboard while scaling your culture of hustle, grit, and creativity that got you your success to date.
A common harbinger of doom (or less dramatically, of mediocrity) is when a company has raised too much, runs into growth plateaus, can’t find effective places to spend their money, and the VCs start pushing them to spend money in the hopes it can reignite growth. Soon after, the founders start solving problems by throwing money at them in the form of more hires, instead of using the grit, hustle, and creativity they’d previously used to get them to that point, thereby kicking off the slow death of the startup culture, and eventually of the company’s edge in the market.
This is what it means when people say startups die of bloat more than starvation.
Raising Less
A key benefit of raising less is that the fundraise goes faster, sometimes much faster, and you can get back to building your business sooner. This is because there is a non-linear relationship between the amount of money you set out to raise and the time investment on your part required to do it.
There’s a well-known dynamic in fundraising where few people jump in at the start of a fundraise without social proof, but then everyone wants in at the end when a round becomes fully subscribed, especially if a brand-name investor is leading.
To illustrate, a $500k commitment for a newly opened $1M round is 50% of the remaining amount to raise, while only 25% of the remaining amount to raise for a $2M round. However, psychologically there’s a bigger difference between being half raised and a quarter raised, and that difference could be worth weeks to months of founder time investment in the fundraise. In fact, it’s likely that a company crosses $1M raised faster in a $1M fundraise than in a $2M fundraise (assuming raising from the same type of investors), hence the non-linearity of time investment in fundraising.
If $1M is the “right” amount to raise, then incremental time spent raising the second $1M isn’t just time poorly spent, but is also capital raised at a needlessly high cost. If you are optimistic about the future of your business, then it follows that every dollar of incremental capital raised beyond what is “right” for the business is at a higher cost of capital than if you were to raise it later with more traction and less fundamental business risk. If there isn’t a clear place to invest additional capital with reasonable expectation of ROI, then you shouldn’t raise it.
However, raising too little can be futile if the amount isn’t enough to invest in anything meaningful as a business, doesn’t provide enough runway to see those investments through, or isn’t enough to justify that certain fixed amount of time and money required to do all the legal and administrative things you need to do for any size of fundraise.
Ultimately there is no broadly prescriptive “right” amount to raise. But it’s typically less than what you may initially think you need, and almost certainly less than what most VCs will tell you that you need.
By understanding the pros and cons of raising more or raising less, as well as key laws of physics surround growth and fundraising, you can make an informed decision that feels right to you.
