Time To Raise Capital? How Much Should You Raise

Written by Itay Sagie, a lecturer and strategic adviser to startups/investors. He is also co-founder of VCforU.com, which helps over 17,000 startups with their investor one-pager while hundreds of investors use the platform for deal flow. Sagie is also the Israeli adviser at Allied Advisers, a boutique investment bank from Silicon Valley. You can connect with him on LinkedIn and follow him on Twitter at @itaysagie.

The question of whether raising capital during the Coronavirus epidemic environment is feasible at all is a valid one.

According to Crunchbase, there have been more than 1,000 reported seed and Series A investment rounds from mid March to mid May 2020, which is a 55 percent decrease compared to the same time period last year.1

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Therefore, while it may be even more competitive, fundraising is very much alive. Putting this matter to rest, a common concern for entrepreneurs facing a funding round, is figuring out how much capital they should raise, and for how much equity.

While each company has its own set of unique circumstances, the following may help founders navigate the various considerations.

First, when should you be raising capital?

Having a business idea is not sufficient for raising capital. Investment rounds are normally set to help you achieve a significant commercial goal, which reduces a risk for the investor. For example, a seed round usually funds your move from Proof of Concept (PoC) to initial sales.

Series A rounds fund your sales growth and so on. Therefore, if you wish to raise a seed round with no PoC or raise a Series A with no initial revenues, you will most likely be turned down by today’s investors. In case you are turned down, I advise you to handle rejection in the right way.

Let’s assume you did manage to close a round with an investor, at a very early stage, without showing proof of technology or commercial traction, you will most likely part with 20 percent to 30 percent of your company’s equity, for a very small check size. A small check size means you will not have sufficient funds to reach big commercial milestones, and as I alluded to earlier, these milestones are key to raising your next round of financing.

Therefore, if you have yet to reach your milestones, I would try to reach those milestones first. If you can reach market traction and initial sales, your check size could increase from a few hundreds of thousands of dollars to low digit millions, for the same 20 percent to 30 percent equity. Some companies, such as Braintree, GitHub, MailChimp and Shutterstock, have succeeded in bootstrapping themselves without any external investors, or managed to postpone their initial investment round until reaching massive commercial growth, thus raising tens of millions of dollars for relatively little equity.

Second, your long-term cash need does not equal your round size.

Assuming you are raising a seed round, and you have a financial forecast which is rooted in realistic revenue and expense assumptions, you have all the basic ingredients to assess your estimated cash need. Let’s assume your revenues in years one through three are: $200,000, $500,000 and $5 million, respectively, and your EBITDA in years one through three are: negative $800,000, negative $800,000 and negative $1.4 million, respectively, and assuming year four is already profitable, your “cash dip” will be $3 million.

This is calculated by simply accumulating the annual EBITDA and looking at the biggest negative figure. In this case, many entrepreneurs will wish to raise $3 million or slightly more. In most cases, depending on the entrepreneurs, $3 million is a large ticket size for Seed stage.

If you do manage to find a $3 million commitment at seed stage, it will most likely include a set of milestones to achieve before receiving another chunk of capital. This is also known as a “tranche.” While this method does make sense in certain cases, in most cases entrepreneurs will not reach their milestones to the dot, and will be penalized with heavy dilution.

A second option, which I personally tend to prefer, is to raise a $1 million seed round, (20 percent above year one’s projected cash need, as life is slower and more expensive than your excel spreadsheet) reach initial revenue, and then raise a separate series A to cover the cash need for the next two years.

In this scenario you avoid being penalized (diluted) for missing your revenue projections. The downside of the latter strategy is working on two separate fundraises, each of which takes months of work from the founders and may impact the business itself. I personally believe it is worth it.

Third, sticking with industry norms will help you in your next funding rounds.

Haggling equity with an inexperienced seed investor, giving them substandard equity for a standard check size, will result in a bloated valuation at an early stage. For example, let’s say you succeeded in raising a $1 million seed round for 5 percent equity, this will result in a $20 million post-money valuation.

Your future Series A investors will hopefully be professional and, as such, will require a valuation that sits well with industry standards. If your bloated seed-stage valuation is higher than the standard Series A valuation, that would require a “down round.” For example, a $2 million Series A for 25 percent equity, means $8 million post-money valuation. Such a down-round, from $20 million valuation to an $8 million valuation, means heavy dilution to both you and the previous investor and is generally considered a red flag to future investors. Red flags greatly reduce your chances of raising capital in the future.

Recap

A solid fundraising strategy will greatly impact the success of your company from your seed stage, all the way to liquidation. It could help you become more attractive to current and future investors as well as to buyers for M&A.

Knowing when to raise capital, setting a right valuation, reaching relevant professional investors, knowing what terms to negotiate, and adhering to industry standards, can be the difference between your company’s success and failure.

Illustration: Li-Anne Dias.