Why Conventional Wisdom On Runway Is Wrong
When raising a round of financing, conventional wisdom in startup land is to raise enough money to cover 12–18 months of burn. Whether it’s because founders don’t think they can raise more or because every Google search on “how much should I raise?” seems to yield some form of this advice, almost every entrepreneur I talk to gives me this 12–18 month time frame for how long the current raise will last them.
Personally, I think this is one of those cases where this has become the norm and very few actually think about what the optimal timeframe should be. I believe 18 months is typically too short and most startups should raise enough money to cover 24–30 months.
Why is 12–18 months too short? Well let’s work backwards.
It takes the majority of startups at least 3 months to raise a round. In addition, you don’t want to be closing your round right as you are running out of money. For one, it puts you in a position of weakness if you are about to run out of cash and some investors will take advantage of this. Second, if things get delayed at all in the closing process, which is fairly common, you want some sort of cushion. So add another 2–3 months to the timetable. This means you need to go out, at the very latest, 6 months prior to running out of cash. This means you have, at most, 1 year of execution to build the company and hit the next set of milestones and metrics.
And that’s under optimal conditions. What if you only raise for 12 months or if the markets turn and it takes longer to get deals done (like in the first half of 2016). You may actually want to budget more time before you run out of cash. And make no mistake, as a founder your number one job is to make sure you don’t run out of cash.
All this compresses the time you have to execute on your business. Startups are rarely, if ever, always up and to the right. What happens if it takes longer to reach product/market fit than you expected? What if you are delayed in shipping product or the sales cycle takes longer then you anticipated? What if unexpected expenses come up? Now you have even less time to get to the point where your company meets the criteria needed for the next round of investment. I have seen numerous companies right back out raising money 6 months after closing their last round and very, very rarely can you make enough progress in 6 months to warrant raising another round.
I believe this is partially causing in the recent rise in seed extension or seed prime or seed whatever-you-want-to-call-it rounds. We will tackle some dilution implications of this later, but back to my original point.
Every minute spent talking to investors about raising money is time not spent on the product or talking with customers. Yes, as a founder, raising money is part of the job but it shouldn’t be the part you spend the most time on over the course of a year.
This is why drip-feeding companies, otherwise known as tranching, doesn’t work. Whether it’s explicit (term sheets that specify additional funding based on milestones hit — which is a good idea in theory but terrible in practice) or implicit (purposefully raising smaller rounds to “prove” something before funding the next round), it doesn’t work. And by the way, investors shouldn’t invest in this manner in hopes of “de-risking” their investment (aka — put in a little and see if it works). VCs should invest with conviction and be willing to give the company the resources it needs upfront.
But here is the real kicker, the bar to raise next round is ever increasing. Because of the explosion of early stage companies over the last few years, later stage investors seem to continuously increase their expectations and requirements, not lower them. If the time you give yourself is too short, even if you execute well you might not be as far as you need to be for the next round of investment. So you end up going back out in a weak position and raise at a worse valuation then you should have or in a worst case scenario, not able to raise at all.
Hence, this is why I think companies should raise enough for 24 months of burn at a minimum, potentially even closer to 30. Give yourself at least 18 months to execute heads down and make real progress on the business. Give yourself a little flexibility in case you need to pivot or it takes you longer to zero in on product market fit. Give your company every chance at getting to product market fit, hitting those higher traction numbers the next stage of investors require, and getting to point where raising your next round actually makes sense.
Let me stop here to clarify something. I am not advocating for raising as much money as you possibly can. I do believe that constraints force creativity and companies are better off because of that. But founders often do need the necessary time to figure out that creative solution. Note that I’m NOT suggesting that a founder raise more and increase burn. No, no, no. I am instead advocating for extending the time you have to experiment. Maybe it’s a slightly larger amount but same burn per month, perhaps even cut your burn per month. In other words, raise the minimum amount needed for 24–30 months.
I can hear the wheels turning in every founder’s mind right now. “But what about dilution? Shouldn’t I raise a little now and more later at a slightly higher valuation (or cap in case of a note) to minimize my dilution?”
Making the simplifying assumption that your business requires a specific amount of capital to succeed, the dilution argument for raising smaller rounds does not work. It also introduces risks that I will discuss later. Lets work through an example. Let’s say Company A and Company B both need to raise $1.5m but decide to take very different strategies. Both companies start with the same cap structure in which the founders own 90% of the company.
The founder of Company A raises $1.5m in a seed round priced at $5m pre money. The founder ends up with 60.2% of the company after the close of the round, including a 10% option pool that was added, and now has the runway needed to go execute.
The founder of Company B, who is dilution sensitive, decides to raise a smaller amount now and the rest at higher valuations in a few months. She starts by raising $500k at $3m pre, another $500k at $6m pre (already higher valuation than Company A founder), and the last $500k at a $10m pre (twice the valuation of Company A). And yet, after all of that and raising the same amount of money and same option pool, Company B’s founder only owns 0.5% more of her company then the founder of Company A. By the way, this example is even more exaggerated if this founder decided to do notes instead of priced rounds due to extra shares that Company B would be obligated to distribute to investors because of interest accrued, valuation caps, and discounts.
What little the founder of company B saved in dilution, she lost far more in terms of time and headache. Not only is the founder of Company B having to spend significantly more time out talking with investors, time that the founder of Company A is spending with customers or building product, she also has far less certainty in strategic planning. Does she test a new marketing channel? Not if she isn’t sure that she’ll have the necessary capital.
And this small bit of percentage save in dilution is if everything goes well. What happens to Company B if the toll of continuously fundraising affects the performance of the company? If the founder of Company B is unable to raise another round because of this limited progress, the company goes under. Yes she will own more, but it will be worth zero. If she is able to get a bridge round either from her internal investors or by bringing in new ones, she is likely to get lower valuations then previously expected.
In this case, Company B raises the $500k at $3m (same as before), $500k at $5m (same as Company A) and $500k at $8m (still higher than Company A but lower than before). The result? Company B’s founder actually gets diluted more than Company A’s founder. The exact thing she was trying to avoid in the first place.
This is a simplistic example but the takeaway should be that founders who optimize for dilution, rather than considering the best cash strategy for the business, tend to fail at both. One of the best ways to provide your company with the greatest chance of success is to give yourself enough runway.
