Guest Post: Beware The Post Money Trap
My partner Albert wrote this a few weeks ago. Since then I have met with a number of founders who are most certainly headed for this problem. As valuations are extended and it feels very late in this cycle, I feel that the risk of this happening to entrepreneurs is quite high now.
In the current valuation environment many entrepreneurs seem to believe that only two numbers matter in a financing: the amount of the raise and the dilution. This leads them to buy into the idea that more money for the same dilution is always strictly better. Combined with a lot of money being available from investors this is resulting in Series A rounds of $10 million and more.
What could possibly go wrong? The number everyone seems to be forgetting about is the post-money valuation. It is a crucial number though as long as a company is not yet financed to profitability. It determines how far the company needs to come to be able to raise money again. It needs to build enough value so that the next round of fundraising can be at or ideally above the current post money valuation.
If you do a Series A with a $50 million post-money, it means you have to build something that people will consider to be worth $50 million when you next raise money. Now if your company hits a great growth trajectory and the financing environment stays as it is then great. But if either of those two conditions are not met you will find yourself in the post money trap.
Again, you can get caught in this trap in two different scenarios. The first one is that you hit a bump in the road. Users or revenues or whatever the most relevant metric for your business wind up not growing as fast as you think or worse yet hitting a temporary plateau, possibly even a small setback just as you need to raise more money. The second one is that the external financing environment adjusts for instance because the stock market drops 20%. Then even if you hit all your milestones, suddenly that may no longer let you clear the hurdle you set for yourself.
Some founders seem to ignore this logic entirely. Others come back and say “but we will have that much more money to and hence time to clear the hurdle.” That too, however, is faulty logic. It reminds me a lot of the problem of getting rockets into space. The simplistic answer would seem to be: just add more fuel. The problem though is that fuel too weighs something which now needs to be lifted into space. Your burn rate is pretty much the same thing. Unless you are super disciplined on how you spend the money you will have a higher burn rate the more you raise which makes subsequent funding harder (instead of easier).
Another, less common, founder objection is: well, if necessary we will just do a down round. This ignores that down rounds are incredibly hard to do. For reasons of founder, employee and investor psychology they rarely happen. And if they do they are often damaging to the company. So when you are in the post-money trap you have largely made your company non-financeable entirely.
Finally, this situation is highly asymmetric from the point of view of funds versus companies. First, funds have portfolios, so some deals with dangerously high post money valuations can be offset — if one is disciplined — with others that are more attractive. Second, when investing in preferred there is a lot of downside protection built in that’s not available to the common shares. Hence a simple test to see just how far you are stretching into is to ask investors (and better yet yourself) how much common they (you) would buy right now and at what price.
Maybe this is a stupid question, but how is this post-money valuation defined or calculated?
Pre-money valuation plus new money invested. So a $10M pre-money plus $4M investment equals $14M post-money valuation.
Thanks Ben, my morning pre-Coffee Googling definitely had me barking up the wrong tree on this one.
the value before the financing (premoney) plus the amount raised equals the post money
I think the pendulum swings to the “right” valuation at the next round, typically. An entrepreneur only finds out later if they were over-valued, under-valued or right-valued. If they were under-valued, the upside is easier to achieve. If they were over-valued, the expectations are tougher, and they need to live-up to that valuation, and if they don’t, the next valuation will self-correct.
Re: “And if they don’t, the next valuation will self-correct”.Yes it might. But the risk is that overpricing can move you farther away from optimizing the original business model, and more towards a business model of selling a dollar for 90 cents.At the point of the next round, it then becomes a case of not just correcting the valuation, but re-working the business model. Thanks.
I don’t fully understand. Are you implying that the startup will re-work their business model because they were over-valued? What I’m saying is- if you allow yourself to be overpriced, that’s your problem, and you only get to find out if you were right or wrong 6-18 months after that happens.
I think (girish correct me if wrong) he is saying that by being overfunded this capital can “subsidize” otherwise unprofitable business models. If that his point, I agree partially, and it really is almost an entrepreneurial “tragedy of the commons” were companies flush with venture capital can price products uneconomically and make “legitimate, sustaining business models” from being well-received by the markets. Mark Suster has talked about similar concepts in past posts. 1 of 2 things happens: The “overcapitalized” company uses funds to bankrupt or drive away competition, gets enough market share, and thus can increase economics and price in the future because consumers have limited options. 2. They don’t gain enouhg power to “monopolize or manipulate” the market and need down round or go bankrupt.
“…can subsidise otherwise unprofitable business models”.Or kick the can down the road re optimizing the business model. Thanks.
It was like someone said (not sure who but I think it was in regards to Fab and how they imploded): “There is no shortage of people who want to buy half-price tvs”. Basically without that insane amount of funding they wouldn’t have been able to selll higher end goods at such dicsounts.. but that also would have kept them from growing so quick
Not deliberately William (although each startup is different, and somebody might).What I said was – ” can move you farther away from optimizing the original business model”.You can end up kicking the can down the road on the process of testing and optimizing the business model when you are pushing hard on only one lever. Thanks.
Define “self-correct”. 🙂
I mean- whoever gives you your next valuation will correct it, because there will be a track record- either you delivered and lived up to your valuation, or you didn’t.
Where i was headed was — either you down-round, you sell, you get profitable, or you die. So really the best you can realistically do at the point do is a sale, under some degree of duress. (Which, of course, has a ‘corrected price’ attached.)
Down rounds are a blast aren’t they? That’s a great set of conversations to have. Really look forward to those…not.
a) Regression to the mean – If some over-evaluation was intended and some just “lucky” statistics says you will most likely be less “lucky” next time.b) Capital efficiency – less money works harder
Really important insights, thanks! Particularly appreciate the point that more money usually leads to a higher burn rate because there’s less incentive to be capital efficient. Since VCs hold the cash, should they take some of the responsibility for over-capitalizing companies? Do you find this happens more with syndicates than with rounds with 1 or 2 VCs where its easier to control total raise?
yes, VCs and other investors are to blame
Where was this post 15 years ago,when I needed it?
#vcsecrets2000 –> #vcprotips2015
Brilliant. Yes. I’m not sure it was as much a secret as not having as thorough an understanding of all the knock-on problems and in my case, how long those problems would last.
You wouldn’t have listened anyway and you know it Steve
Awesome point. 17 years ago, I certainly could not have been convinced that taking a $32 million investment with a $90 million post valuation – with under a $1 million in trailing 12 months revenue – was a bad thing. At that point, it was the only thing we could do. It’s hard not to get sucked in, when it get’s frothy.
Consider yourself lucky 30 years ago there wasn’t even “this” to have a post on (or a place to post “this” for that matter.)
sadly i was part of the problem
OK, so assuming a startup can’t be perfectly valued at a private funding event, what’s the downside of under-pricing? Obviously, entrepreneur ends up giving away more equity than they should have, and with it, perhaps, too much control to investors. What else?
Losing control is a very real threat and should not be taken lightly. Too many entrepreneurs are already in a split board after a single financing.
Yeah, it’s a big deal to lose control. But let’s say you don’t lose control when you close financing at lower valuation than you could have. Other than buyer’s remorse, ego, what’s the downside? Not much, AFAIK, provided you’re not that far below reasonable valuation.
i’ve never done the work, but i think there may be a very positive correlation between returns and the companies where the entrepreneurs have retained control. of course cause and effect aren’t clear there.
ya it’s the egg and the chicken for sure. I know that as founder I want to be the one to decide when I give up control
loss of bragging rights
There is anything else?
Ego / Bragging rights, evidently. 😉
D – U – M, dum.
@JimHirshfield:disqus was fav joke of my 7th grade science teacher, Mr. Johnson… “that’d be D-U-M, dum, wouldn’t it?”
Hahahaha. Now I feel totally stoopid for missing that. #GoodOne
Great post. I never understood how some entrepreneurs were willing to make binary bets on their success so early in the Company’s life cycle (Series A). It is a rare company than needs, or can properly utilize, $8-10M prior to a real growth stage where the business metrics have matured and are reliable. Personally, I can’t imagine building a company that after 2-3 years is worth $50M (if we choose to sell) and everyone being happy and making money. If investors are in at a $30M pre-money and have an exit after two years at $50M – thats not so great. A traditional $5-6 pre and $3-4M Series A would have been a better deal for all since the entrepenur is going to have a much harder time conving everyone selling is best when the economics don’t work.Gregg F
spoken like someone who has done it something like ten times now
Would you advise entrepreneurs to lean towards under or over valuation? Or is that mostly a gut check case by case…?Reason I ask is entrepreneur who’s at Series C told me the other day, get as much money as you can in seed and A, but I don’t see many examples of A where you know you’re on a long, reliable upward growth curve
i think that advice is bad http://avc.com/2013/09/maxi…
Take Goldilocks and the 3 Bears money. Not too hot, not too cold, just right. But, the funding environment in certain locales is really really hard-so instead of taking 12-16mos of runway, you might want to look at 20 mos of runway. If you can’t find product market fit by then, it may be too elusive to find.
Hmm, I wonder, any thoughts on the time frame for raise? We’ve gotten mixed stories from people about setting a short window of a month or two all the way out to someone who said they did a whole year of it, which seems exhausting and focus sapping. (edit: I should say, any thoughts from the VC end, although obviously if you have experience or can point to entrepreneur perspectives on this that’s welcome too)
“But it will be different this time around”
BUT WE’RE DIFFERENT.
Don’t you love the phrase ‘are certainly headed for this problem.’Heads up people whose boss had coffee with Fred in the last 90 days!
“Hence a simple test to see just how far you are stretching into is to ask investors (and better yet yourself) how much common they (you) would buy right now and at what price.” <–brilliant. Save a lot of meetings with that one.
We’ve turned down two (fairly unsolicited) offers in the last 3 months. The normal, typical reasons were there: Investor not a good fit or no value beyond $$ and we like owning it all.BUT– there was a new wrinkle this time.We were uncomfortable with the valuations because we thought them too high. (“DID I JUST FUCKING SAY THAT??!!”, he thought.)I don’t like putting preferred shares on at “high” prices during a raging bull startup/tech/pvt$ environment. It puts common in a tough position, and can hurt the company as today’s post states so well.In fact… you could execute like this http://streamable.com/gcy1 and if the financing market turns south or even just stalls, you’re looking at a down round after thinking you just crushed it! F that noise brother.To me, I think things have gotten frothy in the early stages. You might even call it a bubble.BUT– it’s for good, valid reasons.These startups (ours?) COULD disrupt everything. And I mean everything. Look at Uber– that shit is fo real, dawg. Is $40b too much? I don’t know… their revenue is FOR REAL and they are going GLOBAL in a matter of years with incredible disruption everywhere.in other words, the jackpots are bigger now… and they’re real.Therefore the tickets are more expensive, for good reason.BUT– it sucks to be someone else’s ticket unless you get picked.Unpicked tix are straddled with $$ (sounds weird) that you don’t know how to deploy, OR they need to get more money and that means begging down-round style. All that with a common/employee shareholder base that is like “WTF we have to get to $XXXXXXXXXX before I see a dime?” and everything starts to spiral downwards so fast you don’t even know where your panties are.SUMMARY: Your business is worth present value of its future cash flows. Revenue and profits solve everything. Getting ahead of your value can have VERY negative consequences. Stay real. Unless you’re a moonshot— then grab every dollar you can right this second and light the fuse.EDIT: I just realize I basically rewrote Albert’s post, but worse. I really just wanted to add that there are VALID reasons this shit is happening — good stuff for “tech” and for “startups” but probably not for INDIVIDUAL STARTUPS that don’t want to be a lotto ticket.
Oh plus you’ll never get whacked if you always make money for your partners.
And I mean everything. Look at Uber– that shit is fo real, dawg. Is $40b too much?No sure about the “dawg” I don’t speak ghetto.Anyway, focus on the downside not the upside. Outliers are outliers. Zuck should have taken the 1 billion. You are either a businessman or a gambler. The “family” made money from gambling but not by gambling.  Just don’t make the mistake of having Fredo at the helm.
I don’t believe that for a second, g
We’ve turned down two (fairly unsolicited) offers in the last 3 months. The normal, typical reasons were there: Investor not a good fit or no value beyond $$ and we like owning it all.I like your use of that modifier “fairly”. If you feel comfortable doing so, please define what that means exactly.Is that like “fairly” pregnant? I mean either something is unsolicited or it’s not.
We are not actively seeking capital, but we’ll listen if someone comes to us.
Then you don’t need to use the word “fairly” it is just “unsolicited”.
If she asks me to dance, that’s unsolicited. By the time we get back to my place, it was all “fairly unsolicited”.
Beware the Post Money Trap there as well.
When Investors come to us it is good – they first start to work on a relationship (ideally they come via an introduction but we will accept cold pitches) – ideally we prefer them to form in lines not dots (credit @msuster inverted)
Well said.So simple a true statement:”Your business is worth present value of its future cash flows”Is not always so easy to come to.
To me, many times (not always), that is just financial engineering bullshit brought on by people with the power to make investments to get their way. Which is fine I am not calling them out or whining in any way. No complaints just a comment. After all the stock market doesn’t “work” that way. And no angel typically makes an investment this way either. Real estate investing sometimes works that way but many times it doesn’t. Anyone investing that way in NYC real estate (or even in the area I am in) would miss many opportunities by computing future cash flows and not taking into account appreciation.In any case it’s impossible to predict present value of future cash flows on something with limited history and unknown outcome. Once again, it’s gambling. Besides we all know that VC’s are looking for the big kill anyway. So it doesn’t really matter if they overpay a bit. Which is why I guess they seem to be overpaying. A bit.
.Real estate developers and investors always project incomes increasing forever. Always.I did it for a quarter of a century — never once did I ever forecast a downturn in the rents. Nobody ever questioned me.The pension fund formula — 15 year cash flow projection, sale in year 16, NPV of the cash flows including sale over the fifteen years plus one day — was the way it was done.The logic was always that we were capturing inflation as part of the increases. That often turned out to be very true.It takes about 15 years to really lose your virginity in that business but there has never been a down turn that has been longer than that same period of time.This is why you almost cannot lose money in institutional quality commercial real estate if you hold it for 20 years and maintain it properly.Recently a building I owned was demolished for the dirt in the CBD of Austin, TX. I had renovated it 35 years ago and now it had regressed to land value. In the interim it threw off a lot of cash and it sold for a bloody fortune.Long term ownership of institutional quality commercial real estate is one of the safest and most lucrative businesses in a growing country like ours.JLMwww.themusingsofthebigredca…
Common is better off with high valuation and worse off by amount raised (i.e. absolute liq pref $ and participation features). A high valuation would be harmful if there is a down round and there is an anti-dilution feature. If you get rid of the AD clause you are def better off with a high valuation.
Our AVC bud @JeffFinkle shared a good phrase with me a few years ago: “the physics of the deal fall apart”. That really stuck with me. If you can pull off a down-round, fabulous. But don’t you need to decide yes/no on that pretty darn quickly — because otherwise isn’t your only way out to sell — and sooner is better?
Could you explain this part of your post in more detail, “The second one is that the external financing environment adjusts for instance because the stock market drops 20%. Then even if you hit all your milestones, suddenly that may no longer let you clear the hurdle you set for yourself.”The first scenario makes sense. You needed to build a $50 million company, but you fell short.For the second one, how did the financing environment change the value of the company?
The valuation of publicly traded companies effects the value of privately traded companies. When the bull market ends and we enter a bear market the value of publicly traded companies is going to fall. This is the change in the financing environment that will in turn cause the value of privately held companies to fall.
Okay, I think that makes sense. So the second scenario is where your company ordinarily would have been valued at $50 million, but the 20% drop in markets means its only valued at $40 million?
Let’s see you have a marketing automation startup that is privately held. Your public market comparables would be companies like HubSpot and Marketo. Financial market cools off and their stock price drops. People use public company comps to work back to private company valuations. All things being equal the value of your private company drops.
Correlation Coefficient of 1 between a cyclical pull back of the total stock market and an A round of 2mm?
Not smart enough to specifically answer the question but a seriously doubt there is a perfect correlation. I do think it is high if you take into account the lag between a change in the public markets and what happens in the private sector. Market goes bad, company raised too much at too high a valuation can’t raise an up round with a new lead, VCs start doing less new deals because they want to keep part of their current portfolio alive on life support, limited partners have to reallocate away from VC asset class so less VC funds get raised. I could go on. My primary point is that Albert is right about the dynamic external financing for startups adjusts when there is a big fall in the stock market.
when the markets go bad, they effect all companies, even the best ones facebook did a down round after the 2008 market meltdown, for example
Oy.Nothing gets the rank and file startup employee more excited than a down round.While down rounds are bad for founders they are even worse for the rest of the team. If a company I work for does a down round I am going to need a salary adjustment to market rate because it’s just a job now.
If a company I work for does a down roundThat’s the life you have chosen. You could have worked for General Electric or Dupont.Anyway, for the company, I would imagine that knowing that is the case (reactions) upfront means that they can try to tamper that emotion with the proper words in the proper order. Creative spin and manipulation in other words. For further info, read this: Now that I have brought you up to date, I want to tell you that there was no dormitory fire, I did not have a concussion or skull fracture, I was not in the hospital, I am not pregnant, I am not engaged, I am not infected, and there is no boyfriend. However, I am getting a “D” in American History, and an “F” in Chemistry and I want you to see those marks in their proper perspective.http://citydawn.tumblr.com/…  People who are “better than thou” will have a real problem with the nuance necessary to pull this off and just see it as not shooting straight. They will gag upon just the mere thought of this type of strategy because they can’t navigate around the minefield creatively without fucking it up. So they see it as dangerous and to be avoided. I’ve done things like this, not about grades though.
Exactly — that’s the “physics of the deal falling apart” at the granular level. The team loses motivation. And because it’s just a job, they’re less losing momentum yet further toward the targets. And the good ones are looking elsewhere. Not good.
Some founders seem to ignore this logic entirely. Others come back and say “but we will have that much more money to and hence time to clear the hurdle.” That too, however, is faulty logic.I think one of the qualities of a good entrepreneur is being able to listen to advice that you are given by obviously more knowledgeable and experience people. While it’s ok (and good) to ask questions and to challenge, it never fails to amaze me when someone who knows Jack Squat seems to think that they will be the one to defy the odds and that the person who has all the knowledge cards is the one that is wrong.I remember when I was young and an older more experienced person who did what I was trying to do (and I knew nothing about) told me that the location that I had picked was the wrong location because “there aren’t any tall office buildings”. While I’d like to tell you he was right (because that goes along with my comment in the other paragraph) he actually was wrong and I managed to make the idea work by approaching it from an angle that he hadn’t thought of. However, It took much longer of course to work around the handicap and was much harder.But the reason I didn’t follow his advice was not that I thought he was wrong, or not that I was stubborn, but simply because I didn’t have the money to do what he suggested so I went the path that I could go given the resources that I had at the time.Over the years, and I guess this is obvious, I’ve found that people with more knowledge, intel, and experience are typically right a significant percentage of the time so that it pays to bet in the direction of what they tell you. One of the reasons that people go to great lengths to count cards in poker.
Not commenting today. Busy with the Apple Live event at the site. Looking forward to Apple Watch
But raising enough funds earlier on did help PayPal to survive through difficult economic times and I am writing this knowing well that most of these companies will not turn into another PayPal. What I am not clear about is Fred’s view on whether there is a bubble or not….I saw the recording of his interview at the launch festival and he mentioned the same point on valuation when asked about “bubble”. So are we saying companies are over valued across different stages but it has not yet reached bubble territory because the investor pool is still limited to accredited investors?
i prefer the word “extended” to “bubble” and that’s what i used at the start of this post
Eugene Fama-“Ain’t no such thing as bubbles. Otherwise we could predict them and risk arbitrage them away.”
Keep hearing “when the market corrects, seems rounds will dry up”. Since when is the Correlation value of an A round and the total stock market set in stone as 1?
Perhaps there are some limitations to the series investing model itself, and you could criticize VCs for raising money from LPs when startup valuations are so high. Series investing is a great model to fund rocketships. But not so great for funding companies that are unable to attain exit velocity. The flip side of this — let’s say, value investing, for lack of a better term — is not suited to funding space vehicles but is great for ocean liners. I recently read a bio of Charlie Munger which noted that during a now-forgotten down cycle in the California economy, he and his famous partner referred prospective investors to Sequoia b/c they did not know what to do with the money. When we approach the peak of our current cycle, will VCs turn away money from over-eager LPs? Put follow-on funds on hold? First remove the beam in your own eye, as the saying goes!
Founders who say “we’ll do a down round” have never seen the down round math. Having built those spreadsheet models as a junior VC in 2001, I can tell you the dilution is UGLY. Today’s founders would do well to learn from history. Or from math.
Yeah but part about what you like about “them there ‘founders'” is that they are reckless in their own way and they think that they are different. And that the old rules don’t apply.Reminds me a bit of women who are attracted to “the bad boy” even knowing what they may be getting themselves into. (Same applies to men as well..)Knowing to much, is for sure, a handicap to many forms of success (especially the side that you are involved in..)
It’s terrible for founders but if a company has non-founder executives their options typically get refreshed in a down round
Yeah been through one of those (and joined just after another).Having 90% of your vested stock effectively wiped out and vesting reset when the execs promised it would have “minimal” impact was pretty eye-opening, plus I don’t even know what the %age of dilution on the unvested side was as I was totally clueless in the first one.On the second, having a ton of layoffs + a bunch of critical employees suddenly quit (the week before I started) really didn’t help anything especially as I had to replace two of them at a customer site immediately as the only company income was from a consulting contract they had been servicing.Fun days. Now the next time when the hiring manager walks me through the support department and says “look this is awesome, our product is so good we dont get any support calls” I will read that as code for “We also don’t have any customers”Definitely learning the hard way here.
I lived through this while at BitTorrent. We raised a lot at a high valuation and then the business did not advance as we had hoped. We were then forced to do a down round. Anyone who has ever done a down round knows what that does to a company…it’s catastrophic. It’s one of those rare cases where the company is now very profitable and things are good (I left years ago). However, it’s a (hard) lesson learned…one I’ll never forget. A well respected VC that also has a popular blog once told me, “Only raise for the next 12-18 months. Otherwise you’ll likely dilute yourself or set the expectations too high.” I’ve always remembered that advice.
Definitely walking a knife-edge if you think the market’s going to correct substantially downwards. Options:A) take a below-market valuation and blow away expectations such that even in a bear market you’re attractiveORB) raise at a “frothy” valuation, then choke your burn rate to squeeze every last month of runway (and reach a couple extra milestones) so you can ride out a big bear marketA is simpler but assumes the venture taps are open at all when your account reads $0, regardless of how much ass you kick. B takes heroic discipline (?PayPal) and risks the post-money trap.No easy answers.
I think the psychology of turning down more money for the same dilution (all else being equal) is harder than doing a down round. Especially if a VC is more equity%-sensitive than price-sensitiveIt seems counter-intuitive that taking less money for the same dilution is actually better for the company in case things go south.I think what is really says is that it is extremely expensive to be undisciplined.
Yup. Corporate finance is an integral strategy just like marketing, just like operations for the startup. I am seeing more and more startups that should be $2M-$3M pre money, or maybe even less than that try to raise at $4-$6M pre. I think that leads to a bullwhip effect in later rounds. I am also seeing more and more, “Convertible debt with a $6M cap and a 20% discount” type terms. What the entrepreneur really means is they want $6M, but probably couldn’t get it so they will take a bunch of money and hopefully raise their series A at 6M or better.This is a bigger deal for startups that don’t have revenue. If a startup has revenue, the cash burn goes down and when rough patches hit, at least they might be able to survive. While I disagree with the effects, causes, and potential after effects of the bubble that Mark Cuban cited, he is right on one thing. If you have an app, and it’s non-revenue generating or little revenue generating, when the bubble pops, you are out of business.
another thing I might interject is watch the burn rate. real estate costs in SF are sky high-i have heard $72/sq ft. have also heard startup salaries going up. $100k in some seed deals!
Seriously. I can’t imagine HQ’ing in the Bay, certainly not at seed and probably not at A. Obviously that means more hustle on the fundraising front, but the $ saved and the hot air avoided seem worth it.
I wouldn’t be surprised if begin hearing about a “unicorn curse” within the next 12 – 24 months.
.Let me express a bit of skepticism about this subject.Let’s look at some sample numbers. Company Alpha has revenue of $4MM and a valuation of 10X revenue (purely an example, taken from the online publishing business, just attempting to put a bit of gravitas into the discussion, use whatever valuation model works for you).So company has a pre-money value of $40MM (10 x $4MM = $40MM.)The company takes in $5MM resulting in a $45MM post-money value for which it will likely “sell” a 11.1% equity interest ($5MM/$45MM = 11.1%).Alternatively, the company also has an identical offer of $10MM.In this scenario, the same pre-money value is in place, $40MM.The investment of $10MM results in a $50MM post-money value for which it will likely “sell” a 20% equity interest ($10MM/$50MM = 20%).The obvious conclusion is that the second $5MM investment was marginally cheaper for the entrepreneur — 11.1% for the first $5MM and 8.9% (20% – 11.1% = 8.9%) for the second $5MM. Financiers know this stuff, the marginal money is cheaper than the initial money.If the first $5MM bought 24 months of runway, then the second $5MM may buy another 24 months. (This is slightly over simplified due to the tendency of increasing burn rate when obtaining new funding. Just slightly.)In the 48 month runway scenario, the company may be infinitely closer to actually generating some cash flow — not to cash flow positive but just some cash flow, more than it had at the time of the funding. This is actually quite likely. The runway will therefore be extended dramatically as the company begins to decrease its monthly burn rate.All of the above is just arithmetic which may argue for the notion that getting more may not be too costly.Bring this today — we are in a bubble, interest rates (primarily as a proxy for rates of return in general) are at all time lows, the stock market is at all time highs and the national economy is really not recovering.Given these real world conditions — and with an invitation to quibble on any of them, please do, but it doesn’t much change the notion that there is a future day of reckoning coming in some form or fashion — I would counsel any CEO or founder or entrerpreneur to get as much as they can as cheaply as they can.The cash window is getting ready to close and when it does, it won’t be a matter of messing with different valuations or down rounds, there will be no cash. When that happens, the One Eyed Jack will be King in the land of the blind. Be that One Eyed Jack with money on hand.This is coming from a guy who was building high rise office buildings when the Prime went to . . . . . 80%. [Little joke because every time I check it, it “only” went to 21.5% on 19 Dec 1980. But every time someone tells me the story, it went to 25%.]We had a stable source of funding but believe me, we couldn’t raise enough spit to lick a stamp. I gave up a lot of equity to find that partner and it worked out just fine. Had I not, I would have gone bankrupt. Lots of others did.This is the “risk” part of the equation. Remember one other thing, some 70-80% of the peer investments that are made with the greatest amount of wisdom possible will fail. Many of them will fail because of a lack of money. Any slice of a pie is better than no slice of a pie.Build for the long run when it comes to money. Who cares if you give away more equity. When you make enough money, you can self-fund your own stuff. I have always made my biggest mistakes when I could afford them.JLMwww.themusingsofthebigredca…
Albert’s point is that since it gets added to the pre-money valuation, the extra cash could make raising future rounds at higher valuations harder, and you’re saying that having cash reserves is always useful if the funding environment gets tough.The key element missing from the discussion is: what happens to the cash? In other words what ROI does it generate between the A and B rounds.Let’s take your example, where we’ve raised an “extra” $5mm. Now let’s assume 3 scenarios:1. The $5mm is pissed away with a failed marketing campaign2. The $5mm is stashed in the bank3. The $5mm is employed with a 20% per year ROIIn scenario 1 Albert wins: the money is gone, there’s nothing to show for it — apart from the higher A round post-money valuation it generated.In scenario 2 it’s a draw. For the B round, the higher valuation is perfectly offset by the cash in the bank.Scenario 3 is the interesting one. The $5mm is now worth a lot more than the $5mm sitting in the bank. All else being equal, the pre-money for the B round must surely be higher than the post-money for the A-round because value has been created in the meantime.Of course there’s nothing new here, it’s just basic finance.I’m just saying there’s no right or wrong answer to this question: it all depends on what you *do* with the money.
Help me find this underperforming economy? I keep looking for it in dallas, austin, la, sf, ny, miami, Boise, salt lake, Denver…I can’t seem to find it?
.I want to be there with you but the labor force participation rate (lowest since 1978), U-6, U-7, declining average middle class income, high degree of government dependency, anemic GDP growth rate, high level of new unemployment first time claims won’t let me.Absent Texas jobs, the entire country has created no new net jobs in 7 years. About a quarter of those Texas jobs are energy related and about half of them are going to have to be given back with the current energy outlook and diminished prices.The economy is still pretty damn fragile notwithstanding the great prospects for Austin software engineers.It’s not personal, it’s just the facts.JLMwww.themusingsofthebigredca…
Doing a down round also gives credence to the argument that the investor’s judgement was wrong on the previous round. Most people are uncomfortable with such signaling. And if the new money goes down the drain, you have been the fool twice and that can be lethal to your credibility.As a founder, it is super important to be tuned to this dynamics.Anything done in excess is likely to come back and haunt you. As Fred rightly said, common has no downside protection and you WILL be left out to dry if / when the shit hits the fan.
Nuanced post today by Josh Kopelman arguing for moderation in Series A fundraising, but aggressiveness in raising series seed (to have a little extra time to reach your proof points given an ultra competitive Series A market). http://firstround.com/revie…Note: he’s not suggesting you try for inflated valuations.
Very sad indeed. But I would resist drawing any conclusions. We don’t really know what went down there