Nearly all startups use the same methodology to figure
out when to raise their next round of capital. The founder projects the
planned burn rate and estimates the day they will run out of cash. Then
they subtract a margin for fundraising approximately four months from
the date the company’s bank account will be empty, and declare the
difference the fundraising-process start date.
While logical, this method is highly flawed. It’s predicated on the idea that running out of moneyis the key milestone upon which to base a fundraising. However, running out of money isn’ta milestone — it’s exactly the opposite.
Milestones should
be accretive to the value of your business; they typically come from
key proof points that validate important hypotheses. Milestones can
be based on the product or technology (a great prototype); customer
validation (a key contract); legal (overcoming a regulatory hurdle); or
financial (meaningful revenue growth).
Running out of cash is the opposite of a milestone — it’s the ultimate moment of vulnerability. Running out of money is
Game Over. Some investors will try to take advantage of that moment of
vulnerability with very tough terms, but that worries me less than the
true implication of being vulnerable. Vulnerable companies are simply
unappealing to investors, and often cannot attract capital on any terms.
Investors are motivated to write checks when they feel like your
company presents a great opportunity to return multiples on capital.
Investors believe in the opportunity because of the narrative of the
company and the evidence that the company amasses validating that
narrative. Companies rarely look less likely to return to investors than
when they are about to run out of money.
The cash crisis undermines the narrative. Even if other milestones in
the business are positive and appear equal, it is much easier to
attract capital as a company with eight months of cash than the same
company with two months of remaining cash. As the company runs low
on cash, it starts to smell funny to investors, who start to ask
themselves questions like how did the company get into this situation?
And if this is such a great opportunity, why didn’t anyone else want to write a check?
So what’s an early stage founder to do about the cash vulnerability
predicament? First, I’d suggest leaving more room for error. Ideally,
don’t raise 12 months of capital out of the gate, expecting to go back out raising
in eight months when down to four months of cash. Instead, raise 18
months of capital and start raising again when down to nine months of
capital in the bank.
When debating this with founders, I often hear two arguments for waiting until almost out of
capital to raise the next round. First is that the company’s progress
is so significant month after month that its valuation will be
meaningfully better by waiting as late as possible to raise. We’ve been
lucky enough to experience this situation several times when revenue
doubled by waiting three more months and the growth resulted in a much
more successful fundraising.
This is a fair reason to wait, but the founder must be very confident
that the evidence will make a fundraise easy. Resist the temptation to
believe that by burning cash to the brink, the company will have so much
progress the valuation will appreciate despite the burden of the
impending lack of cash. It rarely works out that way.
The other explanation I hear is that the milestones of the company aren’t particularly
strong and the founder needs as much time as possible to prove as much
as they can. In other words, had the company tried to raise with 6-9
months of capital still on the books, it would have little to show to
prospective investors.
Further, they argue that even with 4-6 months of cash remaining, the company won’t have compelling milestones to share with investors. The company needs to show the progress that comes from burning until almost out of cash to have the best chance of convincing new investors to write a check.
This is usually faulty logic. Companies in this situation rarely
successfully pull off the Hail Mary pass with seconds left on the clock.
Instead, they face diminishing returns, while further damaging the
outlook of the company by being on the edge of running out of cash.
No one wants to write checks for this type of company. If the founder had been out looking
for an extension with 6-9 months of cash, it could have still raised
capital with the halo of promise. In this stage, the company looks more
dead than alive, and the halo has faded.
In this situation, I suggest founders consider early seed extensions.
If the company is progressing extremely well, this is completely
unnecessary and the company should start raising Series A early.
However, without major leaps forward, it is much easier to top up a seed
round when a company still has 6-9 months of capital than with modestly
more business progress but 60 days of cash left and waning inside
commitment.
Some people in the startup world believe that good companies succeed
and bad companies fail. While rare companies find incredible success
right out of the gate, I don’t agree
with this view. Some companies become good companies over time because
they find ways to finance their way through lots of challenges. Other
companies, with great promise, become bad companies because they don’t plan their financing well and they lose the opportunity to live up to their potential.
Let your bold vision and capable execution, not your bank account, determine what your company will become.