I spoke with a bootstrapping entrepreneur who is thinking about raising equity to keep his explosive growth going. I asked a bunch of questions to help him come up with a dollar figure to raise from angel investors, who were already starting to approach him.
He needs a $140,000 piece of equipment that will dramatically increase his manufacturing productivity. And he wants to attend a bunch of expensive trade shows – maybe another $50,000 to invest in acquiring long term customers. So initially I thought $200,000 was a good number.
After we spoke, though, I was reflecting on what he needs and realized that now would be a good time to get a bit of a cash cushion.
Often the advice for equity fundraising is to “raise as much as you can.” And if your business metrics are showing momentum, it often means you “can” raise more than your financial projections show that you “need.”
In the case of this bootstrapping entrepreneur, he’s got tremendous momentum. He grossed $800,000 in revenue in his first nine months of business, and made a $40,000 profit. I told him that puts him easily in the top 1% of all startups!
And like many entrepreneurs at this juncture, he believes – rightly – that his company valuation will be going up steeply in the next year. So to minimize dilution he wants to raise as little as possible.
Here are the five big reasons he should raise a cushion on top of what he knows he needs.
1. A Convertible Note Won’t Be As Dilutive
A convertible note is a loan designed to convert into equity in the future. But the price of that equity will be determined by the company’s future momentum. The early convertible note investors get a discount on that future price – typically 20%. But if an entrepreneur thinks the company value will go up by 100% or more in the next 12 to 18 months, then they are happy to give the 20% discount off a much higher price.
2. Even A Priced Seed Round May Be Worth It
The average angel investment valuation is much better than what you see on Shark Tank. The pre-money valuation there averages about $450,000. The average angel investment group pre-money valuation is $2.6 million, or almost 6 times higher than on Shark Tank!
In the case of the entrepreneur in question, raising an extra $200,000 on top of the already identified $200,000 increases his dilution by another 6.2% at the $2.6 million valuation. He’d own 86.7% of the company by raising $400,000 instead of 92.9% by raising $200,000.
And there’s reason to think that he could do a bit better than the average angel valuation because of his strong revenue and profit numbers.
3. Raise More Now Before You Hit A Speed Bump
This entrepreneur is in the small group of startups that hasn’t yet hit a big speed bump. But he will. He just doesn’t know when.
And of course his projections are wrong – all financial models are wrong.
Here are some of the possible unforeseen problems that can drive the need for more cash:
- A big customer changes their mind and doesn’t follow through with a big order, for any one of a hundred reasons
- A big customer pays verrry slowly
- There are major delays in the development of a key new product / new feature / new service / extra capacity, for any one of a hundred reasons
- You can’t hire the people you need fast enough to meet your plan, or a key person gets hired away unexpectedly
- A big competitor suddenly appears, and even though they don’t have a great product their intensive marketing slows decision making way down.
Extra cash on hand is very useful for navigating big unexpected twists and turns, which are normal and to be expected even if they can’t be predicted.
4. Raise More To Seize New Opportunities
If you are in a hot market that is growing fast, you may suddenly see some new, unexpected opportunities. These can include:
- A potential customer order that is 10X what you’ve planned, but requires both capacity and inventory increases
- A geographic expansion that suddenly makes a lot of sense but has a narrow window to exploit
- A potential senior team member is interested in joining but you didn’t budget for their function for another year
- A new capability that opens up bigger markets in the future but requires an upfront investment to develop.
Again, extra cash on hand helps you to seize new opportunities that often have an urgency in fast moving markets.
5. Raise More When Investors Are Flush With Both Cash And FOMO
Equity funding goes through up and down cycles. While they tend to be long cycles as a whole, the availability in particular of early stage equity funding in “hot” markets is very subject to dramatic fluctuations.
As this is being written, a strong IPO market has helped bring enormous amounts of cash into venture capital funds. And some markets such as Artificial Intelligence and Cybercurrencies have been very hot for early stage investing.
But these markets can change, as they have often over the course of my career. Cleantech used to be a hot field – it’s much less so now. Apps were a thing for a while but have cooled off.
The Gartner Group publishes annually its assessment of “what’s hot” and “what’s not” in the form of a hype cycle. Interest in new technologies go up for a while, then reality hits and interest goes down. Eventually, hopefully, steady and meaningful growth happens as customers adopt the emerging technologies in a big way.
It’s an important reminder of an investor phenomenon that’s unfortunately applicable in private equity as well as public markets, from which it’s taken:
Buy the rumor
Sell the news
Here’s the thing to remember: investors have emotions, even if they hide it sometimes. If the rest of the world, and your momentum metrics, are screaming that the future potential is huge, they will have FOMO – Fear Of Missing Out.
It’s a good time to raise more money, because they are in a way “buying on the rumor” that everything’s going to be great.
When you’ve been selling product for three years, and you’ve had a chance to hit a bunch of bumps in the road, that’s “the news.” And while they won’t be selling your shares (or selling you short), their inclination to shovel piles of cash at you goes down. A lot. Because reality never entirely lives up to the hype, at least in the short term.
Granite Systems Raised A Cushion And Survived The Dot Bomb
I come by this insight through experience.
My first angel investment was in a software company called Granite Systems, founded by a longtime friend and colleague from my first job. I came in alongside a venture capital round I helped him raise, in 1998.
It was the dotcom boom, and we were selling network inventory management software to internet services providers (ISPs), mobile phone carriers and others. The market was hot.
We raised $20 million in January 2000. That was a big chunk of cash back then.
In March 2000 the dot bomb started. Over the next two years, ISPs went out of business. Funding was hard to come by. Oh, and we had to rewrite much of the software in order to scale.
But we had raised more than enough. The company made it through the tough times, turned the business around, and eventually was sold at a nice profit to investors, founders and employees.
How Much Should I Raise? More Than “Enough”
If you can, you should raise more than what your cash flow statement says you need for the next 18 months. Not so much that your ownership goes down the drain, but enough so you can survive problems, seize opportunities, and weather investment cycles.