Secure the Bag: The New Rules of Raising Venture Capital
[This is part 2 in a series of 4. Before diving into this one, you may want to read Part 1 of 4: Do I really want to do this? If you’re already sure VC is for you and you want some advice on when and how much to raise, you can just start here.]
Figuring out when to raise venture capital is part math; part gut feel.
In the very beginning when you’re just a few people and an idea, early investors are trying to figure out whether this is a risk worth taking: Is there a need for this product? Is the market big enough? Is this the right team to pull it off?
As the company grows and you cross certain milestones that signal a new stage of life, you’ll be able to share some metrics that show evidence of traction. That’s when you can begin to apply math and aim for a valuation based on expected growth rates and multiples of revenue.
I’m sorry to say that even then, timing and valuations are not perfectly scientific, and every firm has its own process for evaluating and pricing a potential investment. I’ve spent two decades in the industry, first as a company builder and now as an investor, so I’ve seen the process from both sides, and I’ve never seen the same show twice.
Raising venture capital tends to be binary: It’s either really, really easy or really, really hard.
The worst part is how so much of it seems so arbitrary. But if you follow a few simple guidelines, you will find it a bit easier to control your company’s financial destiny.
When should you start fundraising?
The short answer: You should raise when you have product-market fit.
Even before you achieve product-market fit, invest some time to build your network and establish relationships with other founders and investors. When you’re ready, you can hit “play” and kick off your process.
What is product-market fit?
Product-market fit means being in a good market with a product that can satisfy that market.
How do you know if you have product-market fit?
If you’re asking, you probably don’t have it. It’s more a feeling than a science, but when you have it, it’s obvious.
One example: I’m on the board of Women in Product, a community of 16,000 female product managers. We recently held a 2,000 person conference. Within the first 28 hours of listing tickets to the event, we sold all 2,000 general admissions tickets and generated a 1,200 person wait-list. That’s product-market fit. It slaps you in the face and makes you pay attention.
There is one way you can measure product-market fit. I’m a big devotee of Net Promoter Score (NPS). NPS helps you measure how likely your customers would be to recommend your product or service to a friend or colleague. (For more on how to do this, check out this blog post I wrote on why and how to measure NPS.)
The best of the best can reach an NPS score in the 70s. Anything above 50 is amazing and should be taken as a signal of product-market fit. Some of the most successful companies of our generation — Amazon, Apple, Netflix and AirBnB — typically get NPS scores in the 60s and 70s.
Another measure, developed by Sean Ellis, is if 40% of your customers say they would be extremely disappointed if they could no longer use your product or service, you likely have product-market fit.
You could also use the hockey stick method. Chart out your progress in terms of revenue, new user signups and/or engagement. If you can lay it on top of a picture of a hockey stick and it lines up, you’re probably ready.
When *not* to raise
Never raise money in “The Trough of Sorrow.” A term coined by Y Combinator co-founder Paul Graham, the trough of sorrow describes the meandering and sometimes despairing period where founders are still iterating and yet not getting anywhere. In the trough, you’re doing lots of experimentation (i.e. failure and lessons learned) but you’re not getting meaningful traction.
Do whatever you need to do to stay alive during this period, but don’t try to raise money. It’ll be almost impossible, and the memory of insecurity will linger, making it hard for investors to believe in your comeback story later on. Better to stay quiet and keep working on your business. Hit the pause button on the raise and go back to work for a bit longer. Keep learning. Keep making progress.
Just when things start to work and you begin to feel momentum, VCs will come knocking on your door.
How much money should your company raise?
Once you’ve determined you’re ready to bring on outside capital, it’s time to think about where you are in terms of stages of funding, and how much money you should raise. Round names and sizes have been confusing lately because the goalposts keep moving. Think instead about life cycle stages.
Ideation or Concept phase
If you’re in ideation or concept phase, then you are most likely a pre-seed company. You should bootstrap as long as possible in order to build interest and get the best value for your equity. If you only need a small amount of capital (<$1 million), see what you can raise from “friends and family” (this can be anyone in your life with money such as professors or past colleagues). Raise as little as you need to build and launch the product and get a little customer validation.
Minimum Viable Product (MVP) with Early Market Signals
If you have a product in market and things seem to be going up and to the right, you may be ready to raise a seed round from professional angels or micro-VCs. Other indicators that you may be ready to raise a seed round include customer love for your product and strong unit economics.
The details depend on the type of company you’re building. SaaS companies will typically have $30,000-$50,000 in Monthly Recurring Revenue (MRR) before raising a seed round. If you are a consumer transactional company, you may need more monthly revenue than this since the revenue is non-recurring. If you’re a hardware company, you’ll need to show a working prototype to raise $1 million-$3 million on a valuation of $3 million-$10 million.
These numbers are in constant flux, and valuations have been on the rise over the last several years. Assume they will continue to rise a bit each year until the next downturn.
Once you’ve achieved product-market fit, you’re ready to raise your Series A from institutional VCs. Series A is meant to scale a business that’s already working. That means you have a product customers love in a large and growing market; strong unit economics; scalable customer acquisition channels and/or a repeatable sales playbook. For SaaS companies, you will typically have $100,000+ in MRR. Marketplace companies will typically have $5 million+ in Gross Merchandise Volume. Consumer transactional companies will typically have $5 million-$10 million in annualized revenue. If you’re a hardware company, you may have early commercial validation.
Series A raises are typically $6 million-$12 million with pre-money valuations ranging from $10 million-$30 million. How much you need to raise depends on what you believe it will take (such as headcount, marketing spend, fixed costs) to reach the milestones required for your next fundraise. Building a financial model will help you determine the ideal # to raise, but keep in mind that it usually takes longer and requires more resources than most founders project so you may want to also build in a cushion.
If you’re hitting the right milestones and you’re ready to raise, you’ll want to read my next post where I’ll walk you through a step-by-step guide to running your fundraise process in Part 3 of 4: Operationalize your process.
If you can’t wait for my next blog post (a weekly 4-part series), you can watch a talk I recently gave to seed stage founders on fundraising below or view my slides here.