The Basics of Equity Part 2 – How Much?

As mentioned in the previous column, the valuation for an early stage tech company depends in large part on how much its entrepreneurs are looking to raise. The obvious next question, then, is how much capital should you raise?

When it comes to fundraising entrepreneurs need to focus on getting enough money to keep the company moving forward. Startups die because they run out of money before they are able to raise the next round.

But what exactly does it mean to “raise enough money to keep moving forward”?

There are two schools of thought here. One says, “Raise the amount you need”. The other says, “Raise however much you can get.” There are pros and cons to both approaches. Let’s have a look at them.

First, “Raise What you Need”. This is the approach that a lot of Israeli entrepreneurs and VCs (well, most Israeli VCs and some entrepreneurs) prefer. It says that you should raise enough money to allow you to reach a significant stage of product and business development.

The major advantage of this approach is that it allows you to raise your next round at a higher valuation. While valuation tends to be subjective in the early stages, the more developed a company is with regards to product development, market traction, and strategic partnerships the higher valuation it can command.

Therefore, if you raise a round at a lesser valuation that allows you to build up your company, during the next round you can command a higher valuation and give up less equity.

The cons to this approach, of course, is that you don’t know what the fundraising atmosphere will be like when you start raising your next round.

Which brings us to the “Raise What you Can” approach.

The big plus of raising a lot of money from the get-go is exactly the big minus from “Raise What you Need” approach. In other words, you don’t know what is going to happen in the future, so it is safer to take the money now when you can.

Given the situation with world financial markets at the moment, this approach certainly has its appeal. In the past couple of months, we’ve begun to hear the term “nuclear winter”. It describes a possible scenario where the economic situation will become so precarious that all fundraising activity will grind to a halt. There is a fear that it will become impossible for any company, no matter how promising, to raise fresh money.

So, what’s the problem with “Raise What you Can”? First, raising a lot of money means that you will be giving up a lot more equity.

Remember the examples from last time. When you are looking for $2M you can often do it with only one VC fund looking for a 25% share. When the fundraising jumps to $5M, then you will likely be looking at two funds and you will have to give up 50%. At later stages, with more progress and a higher valuation you will be giving up less equity and the equity that remains in your hands is worth more.

But that’s not the only problem with this approach. When you have more than you need, you tend to spend more than you need.

Many investors and entrepreneurs still remember the days of the Web 1.0 bubble. Many companies overstaffed, partly because they could and partly because there was a belief that you needed a large headcount before you could go for an IPO. An inflated headcount often means that development goes slower (due to the overhead involved in managing a large R&D team) while your burn rate goes up. Thus it becomes harder to control the situation if you run into problems.

The other danger of having too much money is that you tend to lose focus. If you have the manpower to do five different things at the same time, you will be tempted to do those five different things instead of concentrating on doing the one thing you really need to do and execute on it properly.

So there you have it: two approaches, each with its own pluses and minuses.

The advice we like to give is to raise enough money to reach your major goal and then some. Make an honest assessment of the time and manpower that it will take to attain your desired milestone, and then assume that it will take at least another quarter to achieve it. Be sure to factor in the time you will have to spend raising the next round, always a process which takes more time than you might think.

The other piece of advice is to consider different financing options. For instance, many angel investors and some funds (including Giza when we invest as part of an Ofek project) are willing to provide seed-stage financing as a bridge loan. Instead of fixing a valuation and taking equity, the investors will loan you the money to reach a predefined milestone, assuming you will then be able to attract an additional investor during Round A. The new investor will then decide the valuation. In return, the seed investor will ask for a discount on the equity shares for the next round. The attraction of this setup is that it allows you to raise the money you need to get where you want to get without having to give up equity straight away.

Next time: Dilution and how to divvy up equity

Comments

[amit]

shai,

excellent series. you are not saying anything we don't know or that is new, but you are compacting it in a clear and concise manner which is very clear to grasp.

thank you