Fundraising and Risk

One of the most frequent questions I get from entrepreneurs getting started is, “How much money should I raise?”  In the imaginary world where startup pro formas originate, it is clear how much total capital will be needed to build the business to breakeven, but not when each portion of that capital should come in.  And how you answer that can have a significant impact on the amount of dilution you take over time as a founder.

One extreme would be to just raise all the money up front.  While this approach greatly reduces the total cost of fundraising, it will almost certainly be a worst-case scenario for founder dilution, assuming your valuation goes up over time (which it always does, right?).  So, raising all of that cash at the beginning is obviously not the solution.

Perhaps you could try to raise cash just-in-time, as you need it.  By never raising more than you need, you would minimize the dilution that you’d take overall, again assuming your valuation continues to increase.  But there is a cost to fundraising, including things like your time and effort, out-of-pocket travel and legal expenses, and so on.  And the more times you do it, the more times you disrupt your business and put needed growth expenses on hold.  Definitely not an effective way to grow a company.

So where’s the happy medium?

 Your valuation is essentially a measurement of the risk that investors perceive in your business.  High risk ventures require high rewards – otherwise, I’d just put my money in a savings account.  Conversely, the less risk there is in achieving a particular outcome, the lower the expected return an investor requires.

Risk takes many forms: the risk that you can’t actually build your product; or that after you build it, no one wants to buy it; or that customers don’t pay their bills on time, or that your office burns down.  When you first imagine your company, you have all of these risks circling around.  When you sell your company, you have cash in hand and all the risks are gone.  Every time you take a risk off of the list, the value of your company goes up – sometimes a little (you signed a lease and now know what your rent cost actually is) and sometimes a lot (you signed your first customer).

Reducing any given risk increases your valuation but costs money, and so your mission becomes clear.  At each stage, you want to eliminate the biggest risks you can for as little money as possible.   As you approach each round of financing, try making a list of the risks your company still faces.  Maybe try plotting them by size/impact vs. cost to eliminate.  Identify the large risk/low cost group, add up their costs plus some cushion, and you’ve got yourself a financing size, as well as the beginnings of an operational plan.

Obviously, it’s not quite that simple, but by having a general framework, you can at least start to wrap your arms around whether you should do a seed round of $250,000 or $1 million, or whether your Series A should be $2 million or $5 million.  Then all that’s left is, you know, actually raising the money and building your business.  Easy, right?