Friday, January 27, 2012

How much money should I raise?

I get this question a lot. The answer is easy--take as much as you can get.

Why? Let's think this through.

Entrepreneurs resist raising more than they think they need because they are worried about dilution. There are two fallacies here. (A) They need more than they think they will. (B) Dilution is an illusion.

The result of this behavior is that entrepreneurs radically improve their chances of failure. Instead of optimizing for how much of the company you own, you should optimize for the company's success. This is the old saw of owning a small piece of a big pie instead of a large piece of a small one. The additional corollary for startups is that, usually, there is no pie when the music stops.

Let's talk about the fallacies. You will need more money than you think. Entropy is the most powerful force in the universe, and it guarantees that most surprises are unhappy. Also, your business plan is wrong, almost certainly to the downside, because as an entrepreneur, you are blind to risk and more enamored of your baby than others. If you weren't, you would never embark on such an adventure.

Most of the software companies I know do not hit their milestones as quickly as projected. That is not to say that they will not ultimately be successful. But shit happens, and many companies raised money assuming merely imperfect execution, as opposed to one or two complete shitstorms along the way. They run out of money just at the point where there is some visibility that they are getting traction. But, they do not have enough traction to convince a Series A investor to take the risk.

This will get even tougher in the current funding environment, where there is a glut of seed financed companies chasing a shrinking pool of Series A investors. This makes the Series A process longer, and you are competing against a lot more companies for that money, some of whom will have better evidence of traction. You end up trying to do an inside round, which is tough at the seed stage.

Taking less money because you are worried about dilution is just dumb. Very few startups succeed to achieve significant returns to founders and investors. You should do whatever it takes to maximize your company's chances of success. That means choosing the right investors, even if it means a lower valuation. That means taking as much money as you can get with a reasonable amount of effort--there are declining marginal returns here as you divert time to raising money instead of executing.

In the current environment, where seed is relatively easy to get and Series A is hard, it means getting as much as you can in the seed round. You generally don't get a second chance to do more seed funding, because most seed investors will not re-up for an inside round.

So, if you did not raise enough and are running dry before hitting real milestones, you are toast. If you did execute like a rock star and hit the plan, there is good news. You have more money in the bank than you thought you would need. That means putting off the A round for a few months, during which time you will continue to improve and your Series A valuation will be higher as a result, countering some of the "extra" dilution you took in the seed round.

Most importantly, your company still exists, and you still have a chance at eating some pie.

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