Possible Insight

How Could Funding Possibly Be Bad for You?

with one comment

I have posted quite a bit of analysis that is (hopefully) useful to startup investors. But as someone noted to me privately, I have not provided much direct advice for startup founders. This post is a first step toward reducing the imbalance.

Face-to-face, the number one tip I give to founders is: think very carefully before taking any round of funding. No, not because of dilution. Because funding closes off exit opportunities. “What?” you say, “But an investment will give me the resources to make my company more attractive for an exit.”

That’s true, but it will also raise your asking price… by a lot! And as basic economics tells us, demand drops with price. In this case, it drops a lot! I’ll actually work through the detailed math and data for Series A in my next post. But here I want to make the more general point.

Remember that investors want a return. They have mental anchor points for exits they consider a “win”. This anchor typically varies from 5X to 10X.  Professional investors usually get legal stock preferences that allow them to block exits that they don’t like, i.e., that are out of line with their anchors. Now, they also have mental anchor points for how much of the company they want to buy in the round. This anchor typically varies from 20% to 30%.

Let’s consider the midpoints of those two anchors, 7.5X and 25% to do a quick estimation of how taking a round of funding reduces exit opportunities. Say your company is worth Y today.  If investors want to own 25% of your company, the post-money will be 1.33Y.  If investors want a 7.5X return, the required exit price will be 10Y.

Every round of funding you take increases your required exit price by an order of magnitude!

So if you take an angel seed round at a $3M pre-money, you now need a $30M exit.  Not too bad.  Then a Series A at a $10M pre-money pushes that up to $100M.  Pretty steep.  Series B at $25M means $250M. Whoa. How many $250M exits happen per year?  About 50 to 100.  There are about 1,000 early stage VC investments per year.  Not good odds.

As we’ll see in the next post, there’s a huge cliff at Series A.  But in general, the number of exit opportunities goes down exponentially with each round of funding.  So consider whether an exponential reduction in the number of prospects is worth the progress you’ll make.


Written by Kevin

July 2, 2013 at 9:43 pm

Posted in Founder Advice

One Response

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  1. […] my last post, I showed how taking a round of funding logically reduces the available exit options. As a rule of […]

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