I recently wrote about the dangers of "taking as much as you can get" in a series A. Shortly after that, Dick Costolo wrote an absolutely amazing post about raising too much money.
Nonetheless, I don’t think it makes sense for most entrepreneurs to raise big A rounds, because you don’t want to price yourself out of interesting opportunities in the first year or two. By raising too much money, you force your hand on the kind of company that you have to build, whether you want to or not.
That was exactly my point. It creates certain expectations for an exit, and you're making that commitment very early in the life of the company. This may not be as big of a deal for a seasoned (and well-off) entrepreneur like Jason or Marc, but it can be a big deal for the rest of us.
Let’s look at two scenarios for a very promising startup with technology that may be of strategic interest to several profitable public companies:
Scenario 1: You raise 1 on 3 pre in an A round, so you’ve sold 25 percent of your company for a million bucks and you have a co-founder with whom you’ve evenly split equity, and you have a 15 percent options pool from which you quickly allocate 5 percent that fully accelerates on a change of control.
Scenario 2: You raise 10 on 40 pre in an A round, so you’ve sold 20 percent of your company for 10 million and you have a cofounder with whom you’ve evenly split equity and you have a 15 percent options pool from which you quickly allocate 1 percent that fully accelerates on change of control.
Six months into your post-A round, you are approached by Awesome Corp and they would like to buy your company for $20 million. Company that pursued Scenario 1 is in the following situation: founders each own 35% of the company. Founders each make $7 million dollars, investor takes out $5 million for a speedy 4x, and the options holders pull out the remaining million dollars. Ignoring taxes for the moment (much like ignoring friction in freshman physics, this is impossible and problematic, but humor me), this is a nice outcome for everybody. Your investors, it might surprise you, won’t be particularly thrilled, because it’s important to keep in mind that they are not in this business for IRR, they are in it for multiples, and a 4x on a fantastic new company with only $1 million invested is not that exciting. Still, at a 4x after six months, they’re probably not going to block the deal. It’s nice to make 400% returns in a short period of time. Now let’s look at the same offer if the company pursued Scenario 2. Ruh-roh. Do you think our founders are going to be cashing in any Awesome shares anytime soon? No, they are not.
You may very well be building something big - very few of us are trying to build something small - but you need to ask yourself whether you're committed to being big even when a medium-size exit presents itself. And you need to ask yourself whether you're willing to make that decision now, before you've really had a chance to build to that point.
I would suggest that there are some very nice middle ground areas for the entrepreneur that hasn’t previously made a bundle of money, and many of these middle ground areas are still large enough to provide venture returns to institutional investors. By overcapitalizing your company, however, you can put yourself in situations where a potentially huge personal outcome is made impossible.
Even if you're just looking for a home run, Dick cautions on raising too much because "you will spend what you raise".
I hope that this post isn’t interpreted as “you should raise as little capital as possible” or “make sure you don’t invest too aggressively in your company”. Undercapitalizing your company is just as dangerous as overcapitalizing your company, with the added tragedy that undercapitalized companies sometimes miss out on their opportunities to be the gorilla in a huge market. You want to be capital efficient while making sure you are funding the growth of the business.
In other words, like in all things in life, raising venture capital is best done in moderation.