The Next Round

There is a lot of advice on the Web about how to raise venture capital.  Much of it comes from VCs telling you how you can convince them you are attractive -- the VC form of  Elaine’s interview “Are you spongeworthy?”   

Some of the counsel is written by consultants, business development people, company evangelists, and others who think they understand the process because they have been circling around it a long time.  This seems to me like taking medical advice from your doctor’s receptionist.  Watching isn’t doing.

All these advisors have an agenda – to get the attention of the neophyte for some self-interest. What you won’t find much advice about is how to raise the second, third, or fourth rounds.  Why?  Because the venture process bifurcates after you raise money.  Heads - Life is Good and raising the next round is relatively easy. Tails – not so much.

If you are an entrepreneur raising money, now may feel like the Best of Times.  Valuations are rising in private equity.  Fund raising cycles are shorter.  Terms are better. 

If you think this will be true the next time you raise money, think again.  Markets have cycles.  And if you think “just this one round is all I’ll ever need,” think yet again.  Venture capital is like crack cocaine. "Just try a little..."   Once you relieve the pain of making revenues actually cover expenses with the palliative of Other People’s Money, it is hard to shake the addiction to OPM.  So the odds are there will be a next round and it won’t be as easy as this one.  So plan for it now.

What’s the Worst That Could Happen?  The Inside Round
As you go to raise that next round of venture capital, you may find one of two undesirable scenarios happening.  First, no one wants to invest at any price. Alternatively, the “whisper price” at which the market is willing to invest is unacceptable to your existing investors.  Either of these can lead to an Inside Round – a new round of investment where only your current investors participate.

If no one wants to invest at any price, it is usually because new VCs are thinking the probability of an exit is zero.  It may be because the potential acquirers are all focused on things other than acquisition, e.g. their own survival, or because VCs think your asset is unattractive relative to other private companies competing for the same limited exits. Either way, your only alternative is Buy Time because your company has just become worthless in the eyes of the Market.  (You may be thinking “Yeah, but the Market is VCs and they are dumb.”  You create The Market. The Market is whomever you presented the Company to.  If you chose dumb potential investors, don’t blame the Market.)  The only alternative to Buy Time is the Inside Round.

A less disastrous and more frequent occurrence is the Down Round.  Your VCs will often get some signal from potential new investors that there is a price that clears the market, but it is potentially a little to a lot lower than the last round.  Now you have a three way negotiation.  New Money wants valuation of $X.  Old Money wants to avoid writing down its old valuation as much as possible. And Management wants to avoid getting washed out to sea in the process.   This can get very arcane with all sorts of mechanisms (preferences, warrants, voting rights, management carve-outs) getting thrown into the mix, mostly to help the Old Money not feel so badly about its loss of value.  Everyone knows these mechanisms distort valuation and corrupt the alignment of incentives.  Therefore, the greater the disparity in valuation between last round and this round, the more incentive there is to do an inside round and keep it a two-way negotiation. 

Of course, the problem with the inside round is the lack of a disinterested party.  The investors have one piece of knowledge that no outside investor has. They know they are the only potential buyer right now.  This is the problem and the paradox. The Market is saying “your current investment is (nearly) worthless” but inside investors may believe there is hidden value will be revealed with some future events.  Management usually feels this way, too. The paradox is both parties agree there is value no one else can see, but the investors have to be both the pessimist and the optimist. 

The problem is that the future is uncertain.  Sometimes bad things continue to happen and even this new investment ends up being worthless – the Market was right and the VCs lose.  Sometimes the situation turns around and good things happen making that new investment exceptionally valuable – management was right and the VCs get sued by management for self-dealing. The inside round can be a lose/lose for the VC.  That’s why they hate them.

Avoiding the Down Round – What Can You Do Now?
While the Inside Round is the worst outcome, no one wants even a Down Round – a round where the price per share is lower than before.  Down Rounds are de-motivating to everyone, especially employees.  Despite the secrecy of private equity, somehow your competitors always hear about the bad news and use it in the market to increase your perceived risk with customers, partners, and recruits.  This loss of reputational momentum lingers long past the reality of any speed bump in economic or technical momentum.  Bad news always has a longer half-life and higher velocity than good news.

There are two levers to you can pull now to avoid the Down Round.   “Down” means lower than prior valuation.  So the first lever is to avoid an overheated valuation the now in this round.  This may seem counter-intuitive because you are focused so much on your dilution. But taking the most money at the highest price leads to the highest post-money valuation.  This sets the bar highest for the Next Round.  At Series A you are raising money almost exclusively on intangibles – personal reputation, hope, imagination, and some promise to deliver.  At the Next Round the prospective investors have two new sets of data.  They have another year’s worth of observations about customers and competitors, They also have the promises you made and what you actually accomplished.  Reality rarely exceeds expectation.   Getting the highest post-money valuation sets the highest investor expectations. Promising less, raising less, and at a lower valuation leads to more modest hurdle to clear the next time.

The obvious second lever in avoiding the Down Round is execution.  But what kind of execution?  Adding executives or just building the product generally doesn’t buy you much with new investors.  This, too, may seem counter-intuitive because it feels like progress.  But remember new investors also have that year’s worth of data about the market and competitors.   If you are only making this progress on your infrastructure while new entrants are appearing, the real size of the pie is getting more defined and your potential slice may look smaller.  So soft progress is risky. 

The best progress is to prove out the critical assumptions from the first round – how you will find customers (distribution) and how you will get paid (pricing).   Often this means scaling back your vision to ensure you can deliver a meaningful subset version of your road map.    Don’t swing for the fences, lest you strike out.  Concentrate on getting on base.  Getting on base means proving there are buyers for what you have to sell.  This shifts the fund raising conversation from Will They Buy? to How Many Are There?  If you haven’t sold anything (and by this I mean to a few customers [not 1] and at in a repeatable fashion [not with heavy customization]), then the fund raising conversation is much more existential – we code therefore we have value.   If new investors are focused on how big the market is for the first product,  it’s like that George Bernard Shaw quote where we both agree what you are, but are just haggling over price.   That’s a much stronger place to be.

Stay Attractive
So as you listen to the siren song of VCs and consultants advising you on how to raise this round of venture capital, think a few moves ahead.  Don’t assume the wind will always be at your back.  If this feels like a downer point of view about fund raising, that’s good.  It’s easy to find a lot of happy talk about why now is the time.  You are not in the business of raising money.  You are  in the business of business. Fund raising is sometimes a necessary evil.  Just because it is easy now, don't assume it will be again. There are steps you can take now to make the next round be a constructive exercise. You may be spongeworthy today, but you want to be spongeworthy tomorrow, too.

Comments

[Don Geddis]

Re: raising less money than you could (at lower valuation). Yes, this makes the next round easier. But on the other hand, you have less cash in the bank. And when the cash runs out, the game is over. It's very hard to tell ahead of time which will cause the bigger headache: being short on cash just a little too early, or having a high valuation but underperforming. At least in the latter case you have an option of a down round. Whereas running out of cash seems like an insurmountable problem.

[Peter Rip]

Don, of course. The #1 cause of failure in startups is running out of money. My argument isn't do same with less. It is do less with less. If you are going to run out of cash doing x with $y, you'll likely run out doing X with $Y. That's a different problem of planning, not scoping.

PS.thanks for the edits, as always.

[Andrew Fife]

Peter:
so what do you think of a hybrid strategy of maximizing of cash but not necessarily valuation? This of course dilutes the founders more heavily but it should also mitigate some the risk of raising the next round and possibly focus the team more strongly on increasing the size of the overall pie. Founders have trouble with dilution so I'm not sure the strategy is realistic, but do you think it is rational?
-Andrew

[Dan Cornish]

It all comes down to aligning the interests of the Entrepreneur and the VC. If you do an A round with the idea that it is the last money you will ever get, then a down round, inside round question is moot. BUT, the interests of a VC diverge here because of their inherent investment diversification. A VC never invest an A round with the idea that it will be the last money in. They want the company to grow as quickly as possible. The fight a Entrepreneur should have is to keep expenses low enough so that a down round is never an option. Once you take VC funding, that becomes a very tough fight.

[Dharmesh Shah]

From an entrepreneur's perspective, the "now is a good time" arguments are often misunderstood.

Though indeed terms are better and valuations are higher, the one fundamental thing that doesn't change all that much is the probability of raising money (in a Series A) in the first place. This continues to be relatively low. Too many entrepreneurs think the "now is a good time" argument is a reason to believe that it'll be easier and/or more likely to raise capital. This is often not the case.

[Peter Rip]

Andrew - WRT to you comment, it is unrealistic to expect entrepreneurs just to take more cash and suffer the dilution of a low valuation. And VCs don't want this anyway, because we want founders to have enough incentive to make it worth their while.

Dan - No VC will argue to raise the burn rate. They may argue to attack a bigger opportunity that requires a higher burn rate. But that's the conversation/contract you need to have BEFORE the round, not after. Transparency of expectations is fundamental.

Dharmesh - The probability of a SW entrepreneur raising money now is higher than any time in the last five years. Incontrovertable fact. The base rate remains low, less than 5%. But it is up, most definitely. That said, there are more bozo ideas now than any time in the last 5 years, too. But the same is true for the good ideas. The ether is fertile.