Category: Founder Advice

Have you ever finished an arduous task and thought to yourself, “Argh! I went about that all wrong. Why didn’t anyone warn me?”  Well, if you’re thinking about raising a seed round, here’s me warning you 🙂

When faced with a challenge, most entrepreneurs seek out as much data as possible, then wade in and start trying to make things happen. For fundraising, that probably means poring over TechCrunch, listening to as many “founder stories” as possible, and dissecting the top VCs’ blogs.

Of course, every one of these channels suffers from massive selection bias–only unusual events are noteworthy enough to make it through their filters. And fundraising is one of those processes where, if you optimize for the unusual case, you hurt yourself in the typical case.

At RSCM, we’ve either observed our portfolio companies raise or directly participated in 100s of seed rounds over the last 4.5 years. We are intimately familiar with the typical case and have developed a corresponding “small seed playbook”.  And, should you be lucky enough to find yourself in the right tail of the fundraising curve, there’s any easy upgrade path.

Too Much Money, Obsession with a “Lead”

The most common mistakes in raising a seed round are: a headline amount that’s too large and getting anchored on the concept of a “lead” investor.

Raising seed is rarely easy. But there’s a very steep gradient in difficulty as you move from a $500K to $1M target. In that range, you usually need substantial revenues, a clearly pedigreed team, or anti-gravity class technology. Sure, there’s some chance you could find investors who simply fall in love with you and your idea (most likely if you’re in the SF Bay Area or NYC), but the probability is low and the expected search effort is high.

Even if you satisfy one or more of the extreme requirements, as you get towards $1M, a lead investor becomes more and more necessary. Now, you may be thinking to yourself, “That’s OK; I want a lead!” Hmmm. If you’re an engineer, what would you think if someone said, “I want an architecture with a single point of failure!” Or in marketing, “I want a campaign targeted at users with low conversion rates!” Or in sales, “I want prospects with long sales cycles!” Yes, there are cases where that is in fact what you want, because there are other factors that balance out the obvious drawbacks. But as a rule of thumb, it’s a mistake.

Suppose you plan your round around a lead from the outset. If you don’t end up finding one, you have precisely zero dollars to show for your efforts. Moreover, the universe of lead investors is much smaller than that of all investors, so the prospecting job is correspondingly much harder. Finally, it typically takes a lot longer to get a first serious meeting with a potential lead investor, let alone close the deal. You’re probably in for a much longer fundraising cycle, which has tremendous opportunity cost in terms of building your business, especially at the seed stage.

Unless you truly meet some of the aforementioned extreme criteria, this path is probably not optimal. Our recommendation is that you don’t start a seed raise by looking for a lead unless you have at least $20K in monthly revenues, a dozen professional investors who have proactively expressed interest, or your business simply cannot move forward without a large chunk of capital.

Modest Raise, Brick-by-Brick, Graduated Price

So what do you do if you have zero to small revenues and don’t have a lot of VCs on speed dial? Start with a modest headline amount, $250K to $500K. Your plan will have to show you making decent progress with this amount of money. Make sure your development schedule and cash burn support you hitting a reasonable milestone with that much runway. And be prepared to tighten your belt; fundraising almost always takes longer than expected.

Then get your first commitments from your most enthusiastic supporters and members of their immediate networks. Usually, when I ask a company who is planning or trying to raise if they have anybody close to the company (friends and family, advisor, early customer, etc.) who could write a small check, the answer is yes. When I ask them why they haven’t tried to close the money yet, the answer is usually some combination of, “It doesn’t really move the needle,” and “We don’t know what terms to use.”

At the very beginning of a raise, pretty much no check is too small. You need to get the ball rolling. You also need to show momentum. So use attractive terms that lead to a quick close. I recommend a convertible note with  the standard 20% discount and 5% interest, plus a very compelling cap. If you have an attractive valuation, people will not mind so much that you don’t have a lead investor. The plan is to start the cap low and raise it gradually as you  build momentum.

Now, a lot of founders worry about dilution and lose sleep over getting “fair” value. Don’t. $100-200K worth of dilution at a valuation even 30 or 40% below what you think is market just won’t make very much difference in the long run–I assure you that there are much worse dilution potholes on the road to liquidity. And fundraising is a terrible distraction from operating your business, so an investor willing to move quickly is valuable.

You must make clear that you’re offering the earliest investors the great deal partly in return for moving quickly (the other part is due to the special relationship and/or value-add of the investor). Otherwise, most investors will dither. Sometimes it helps to tie the great deal to some sort of natural deadline like an accelerator Demo Day, a significant software release, or a large customer close. Creating a sense of urgency is much easier said than done, but you need to try.

Somewhere after $100-200K, you bump the cap up. “The great deal” becomes “the good deal”. The size of the bump depends on what the market tells you. If you closed the first chunk really fast and you have a big pipeline of prospects, bump the cap two notches. If the first chunk was still a fair bit of work or your pipeline seems thin, only bump it one notch. But keep the time pressure on to the extent you can. “The good deal” is also a limited time offer, perhaps tied to yet another natural deadline.

Once you have the first two chunks in, you can start to play a little more strategically. Getting half the the round closed often generates psychological momentum. You’ll also have money in the bank, which helps your negotiating position. And you’ll  hopefully have made further engineering and customer progress, which makes you less risky.  You can bump the cap again. You can also start trying to work AngelList and look to bigger geographies like San Francisco or NYC (if you’re not based there already). You can event start seriously probing small funds who lead rounds. This is where the upgrade path comes in.

Sidebar: Process Is Key

Before I get to upgrading a small seed round to a big seed round, I need to make a point about process. Like achieving any other company objective, fundraising works better if you impose some structure on it. You absolutely must track prospects, either in a spreadsheet or a CRM.

I recommend a couple of prospect categories: first checks, second checks, later checks, and round leads. Initially, focus on developing lists for the first two categories. You will also naturally generate names of people within your network that fall into the second two categories, but don’t devote too much energy to extending those lists until you’re ready to actively pursue those categories.

Now, start talking with all the first check prospects, focusing on two initial objectives. First, qualify each prospect. There are three basic qualification states: (1) does in fact appear to be a potential first check writer, (2) doesn’t appear to be a first check writer but may be a second or later check writer, or (3) doesn’t appear to be a check writer at all.

Second, try to expand you lists through the prospects’ networks. Ask class (1) prospects if they know anyone else who is as decisive as they are or investors that tend to follow their lead. Ask class (2) prospects if there’s anyone who they like to follow or people they typically participate alongside. In my experience, members of class (3) rarely make good referrals.

After you work through the first check prospects, move on to the second check ones, with parallel qualification and list expansion objectives.

If you have time during the first check and second check prospecting, do some modest scouting of the later check and round lead prospects. Go ahead and schedule some first meetings. These prospects probably have long scheduling lead times and require multiple stage-setting meetings anyway. The goal here is not to close them (though if they fall in your lap, seize the opportunity). Rather, the goal is gather intelligence on what they’re looking for and start building a relationship. Try to keep detailed notes in whatever tracking system you use.

Oversubscribe, Entertain a Lead, Convert if Necessary

OK, back to upgrading. Please keep in mind this is no longer the base case. Most no-to-low revenue startups never get to this point.

Suppose first-check demand justified a two notch bump in your cap, second-check demand seems strong even at the higher price, and later-check and lead scouting has yielded a promising pipeline. Further suppose that you’ve made good operational progress in the meantime. If all these stars align, you can attempt the upgrade.

In this everything-goes-smoothly scenario, you should be having lots of positive meetings with later-check prospects. At some point, it may look like you’ve got more “soft-commits” from later-check writers than you have room (assuming you stick to your original target amount). Or you may receive strong buying signals from some of your lead prospects. If either of these conditions are true, do one of two things:

1. Force a quick close and oversubscribe if desired. Tell all interested investors that it looks like you might be oversubscribed. Make it clear that you need to get firm commitments so you can figure out if there is any room left. In other words, use scarcity and social proof to get investors to move. You can then decide whether you want to raise a larger amount than your original target.
2. Move to close any viable professional funds as “leads”. The term “lead investor” is confusing. You naturally assume they come first. In $1M+ rounds they usually do, but in seed rounds they often just take everything left at the end. A situation that often arises is you’re talking to a potential “lead” investor that only writes $250K+ checks, but moves very slowly. At the same time, you have several later check writers that you feel you can pretty quickly and you probably don’t have room for everyone. In this situation, you need to force the action with the potential lead investor. Give them a deadline and tell them you need a term sheet in 7-10 days or you will close your existing pipeline. Absolutely do not risk losing other investors  because you want to hold out for the “lead”. When you are a low revenue company, always take the bird in the hand.

The goal in both cases, obviously, is to create a sense of both scarcity and urgency. As a low revenue startup you rarely have leverage when fundraising. Anytime you do find some, use it

Most institutional investors these days are comfortable leading a seed round with a convertible note structure. There are still a few that have a strong preference for priced rounds. If you run into one that insists on a preferred equity financing and you’ve already close a bunch of investors on notes, don’t sweat it. You can always convert all the other notes into the preferred round.

Parting Wisdom

Remember, it’s usually pretty easy to adjust and pivot when things go better than expected. So you don’t need to plan much for those scenarios. This playbook is targeted at the usual case. Oversubscribed and led seed rounds are the exception rather than rule.

Depending on market conditions, I would say only 10-20% of seed rounds are “led” in any meaningful sense and another 10-20% are oversubscribed from a modest original target. So 60-80% are just ordinary, every day seed rounds that take a while to close and have no real lead investor. Which is totally fine. Fundraising is really hard. $250K to $500K is a win. That’s roughly a year of runway and I’m continually blown away at what entrepreneurs manage to accomplish in a year.

I see a lot of pitch decks. Hundreds per year. Almost every one is wrong. Not the startup idea. Not the slide layout. Not the facts per se. But which facts and in what order. Nearly all founders use a structure guaranteed to kill their “conversion rate”.

The common flaw stems from a fundamental mismatch in the way our brains create versus consume content. Each engages a different forms of reasoning. I studied this general topic in graduate school under one of the pioneers in the field. I kept up with the literature over the years. And I observed a huge number of pitches. But it still took me years to realize what was happening (repeating the same mistake in my own pitches, of course). Once I did, I couldn’t help appreciating the ironic beauty of the situation.

First, some background in cognitive psychology. Your brain has two completely different reasoning systems. System 1 is the fast, associative pattern-matching module—good for sitting in the background while you walk the plains and then rapidly determining whether a rustle in the bushes signifies mortal danger or a tasty dinner. System 2 is the slow, logical alternative-weighing module—good for deliberately figuring out whether it’s best to make camp by the river or on the hill. (If you want the full general audience explanation of System 1 and System 2, read Thinking Fast and Slow by Daniel Khaneman, who was the partner of my late professor, Amos Tversky.)

Now, when you build a pitch deck, you have to call on System 2 to develop the content. System 2 is logical so you can’t help but try to construct a deductive proof of why someone should invest in your company. That’s why most pitches have 3-7 slides setting the stage: here’s the problem, here’s the size of the problem, here are the current solutions, here are the drawbacks of current solutions, here are the requirements for a better solution…” I refer to this pattern as “In the Beginning”.

However, when investors consume that pitch deck, either at Demo Day, in an email, or face-to-face, they call on System 1. For most people in most situations, System 1 is the default. System 2 takes much more energy and operates much more slowly, so it only gets called on when something special happens. Thus, unless your pitch quickly triggers investors’ System 1s to recognize your company as a tasty dinner, their System 2s will never wake up and no amount of logic can help you. And then when you use your System 2 to try and improve your pitch, you’ll be blind to the problem.

You may be wondering why none of your advisers notice this problem when they reviewed your deck or watched a practice pitch? Here’s another ironic bit. People who sincerely want to help with your pitch will expend the effort to use System 2, also blinding them to the lack of System 1 appeal.

Perhaps the worst case of “In the Beginning” I’ve seen was at a pitch event several years ago with a brutal schedule of 12 fifteen-minute slots. A company in the last hour really started at the beginning: the last generation of technology, quotes on recent shortcomings of that generation, market sizing for the next generation, the founders’ previous experience designing this type of system, technical architecture of their new solution, and performance metrics versus the primary incumbent. Logical, but not engaging. Ran over his time and had to rush through the last slide, which was something along the lines of logos for 5 blue chip enterprise customers, an average annual contract value of $60K/year, and current $MRR of $35K/month with 20% MoM growth for 6 months.

WTF? By the time that slide flashed on the screen, 80% of the audience members were fiddling with their cellphones or chatting with their neighbors. Talk about a missed opportunity! Better to just show that last slide, drop the mike, and walk off the stage!

Luckily, identifying the problem suggests an obvious solution—focus on triggering System 1 to flag you as interesting. So without further ado, here’s Kevin’s “Hey, tasty dinner right here!” pitch template:

• Title Slide
• Context Slide: super high-level explanation of what you do, 5 bullets max
• BOOM! Slide: the most impressive thing about your company
• Ask Slide: what the next BOOM will be and what you need to get there
• Why Slides: details on how you made the first boom happen and why you’ll make the next boom happen too

Putting the Ask right after the Boom is key. The Boom triggers alertness and primes for action. Then you’ve got to give the investors something to pursue. Otherwise, you may lose their interest. Also, telling them about good stuff that will happen in the future right after good stuff that has already happened in the past naturally gives your good-stuff-forecast more credibility. Your investment ask will seem maximally reasonable at this point.

You may wonder why you need the Why slides at all? Well, once you wake up System 2, it needs to eat too. But keep the Why section as small as possible. The more facts you present, the more chance that System 2 will find a strong objection and dismiss you so it can go back to sleep—remember, System 2 requires a lot of energy. The goal is to just satisfy System 2 and get to the next step in the process. where you can bring other cognitive mechanisms into action. Oh, and when delivering the Why, keep referring back to the Boom as much as possible to maintain alertness. For example: “[Supporting Evidence]… which is why X customer loves us so much and is paying us so much money.”

My guess is that most founders’ pitch decks already contains 80%+ of this content. It’s just in the wrong order and probably too much detail on Context and Why. The big question you probably have is, “What should my Boom be?” Sorry, no blanket advice here. It’s situation dependent. But guess what? By simplifying the problem to one question, we’ve made it amenable to A/B testing. If your Boom isn’t obvious, generate 3-7 alternatives and test them against several investors each. Also, if you can’t come up with a decent Boom, it might be a signal that you haven’t made enough progress to fundraise with much success. So your near term goal becomes to make something Boom-worthy happen.

That’s my preliminary diagnosis and treatment. I’ve given this advice face-to-face to many startups over the past two years and have received a lot of positive feedback. But it’s an inherently limited sample. So if you read this post, try out the approach, and learn anything interesting (positive or negative), please drop me a line and let me know! Maybe someday we’ll be able to develop a thoroughly researched system of Evidence Based Pitching (EBP).

For pre-seed and seed stage startups, investor updates are a challenge. Often, founders try to make them too ornate and end up getting behind. Similarly, investors don’t always have the time to fully digest a finely crafted narrative and lose track of what’s happening.

At RSCM, our portfolio of pre-seed and seed-stage investments is at about 400 today, so we have lots of experience with updates. Not only do we read them all, we write a 3-7 line internal summary and each one goes into our CRM system so we have a complete history at our fingertips.

In my opinion, useful investor updates have three requirements: they must get done, they must be easy to produce, and they must be easy to consume.

Anatomy of an Update

You can deliver on all three requirements by breaking updates into modules and putting the most important modules first. That way, you need only produce the modules you have time for and we need only consume the modules we have time for. Everybody wins.

Here are the modules and order I recommend:

[Company Name] Investor Update for Month Ending [Last Day of Month]

• Metrics
  
• Highlights (Optional)
• Asks (Optional)
• Thank Yous (Optional)
• Commentary (Optional)

Notice that the only required module is “Metrics”. This should be easy to produce because, at any given moment, you should have a handful of Key Performance Indicators (KPIs) you track anyway. This should be easy to consume because most investors have lots of experience absorbing tabular business data. This should be easy to get done because, in our modern software-driven world, KPIs are at your fingertips. Most importantly, if they are the metrics you are actually tracking to run your business, then they will be reasonably informative to investors. Requirements satisfied!

More detail on metrics in a minute, but first some quick notes on Highlights, Asks, and Thank Yous. If you opt to include these modules, do them as bullets. Easier to produce and easier to consume. But, as with PowerPoint slides, no more than 7 bullets per section! Even then, only go to 7 on rare occasions. No more than 5 most of the time. It’s easy for people to get saturated and when they get saturated, they flush the entire list from their attention. If you’ve got more to say, put it in the Commentary.

Everything after Metrics really is optional. Better to get the update out the door quickly than wait until you come up with points for every section. If you ever find yourself thinking something like, “I’ll crank out the Asks later,” stop! Just hit send. Then if you do think of important items later, put them in a notes file and include them in the next update. Or send out a specific Asks email.

Universal Metrics

Now for some depth on metrics. There are really two types: (1) those that are universal to all pre-seed/seed startups and (2) those that are particular to your business. Investors need both. The first type gives us a general sense of how things are going for you relative to the typical startup lifecycle.  Kind of like the vital signs that all doctors want to know regardless of patient or condition.  They help us triage our attention. So start with them:

• Revenues: [revenues | date when you plan to start selling] (+/- ?% MoM)
• Total Expenses: [expenses] (+/- ?% MoM)
• Net Burn: [total revenues – total expenses] (+/- ?% MoM)
• Fundraising Status: [not raising | planning to raise | raising | raised]
• Fundraising Details: [how much, what structure, valuation/cap, who]
• Ending Cash: [last month’s Ending Cash – this month’s Net Burn + this month’s Amount Raised] (+/- ?% MoM)
• Full Time Employees: [FTEs, including founders] (+/- # MoM)

Note 1: we strongly encourage a monthly update cycle. Anything longer means we get data that’s too stale. Anything shorter, and the financial metrics don’t really make sense. Though if you’re part of an accelerator that encourages weekly updates, we’d love to see them. Just make sure we also get the monthly metrics!

Note 2: always put the percentage or absolute month-over-month changes in parentheses next to each entry. It turns out that highlighting the deltas make updates dramatically easier for us to absorb by drawing immediate attention to the most volatile areas.

A couple of quick explanations. Always have a Revenues line. If your product isn’t finished or you aren’t actively trying to generate revenues, just put the target date for when you do plan to start selling. Either piece of information is enormously helpful to us. Also, provide an FTE number that logically reflects the labor resources at your disposal. A full time contractor is a unit of full time labor that you can call on. Two half-time employees are also one unit. An intern may or may not be a unit or fraction of a unit depending on how much time he/she is putting in and whether the output is roughly equivalent to what a regular employee would produce. Don’t exclude people based on technicalities, but don’t pad your numbers either.

Now, some detail about fundraising status. This topic turns out to be pretty important to existing investors. First, it lets us know that you’re on top of your working capital needs. Second, some investors like to participate in future rounds and even the ones that don’t are a great source of warm leads. Third, it makes us feel good to know that other people have or will be validating our previous investment. Here are a couple of example fundraising bullets:

• Fundraising Status: planning to raise in 4Q2015
• Fundraising Details: $750K – $1M Series Seed at a $5M-$6M pre-money from a small fund and/or local angels

• Fundraising Status: raising
• Fundraising Details: $300K – $500K on a convertible note at a $2.75M cap with $175K soft committed from [prominent angel name] and other local angels

• Fundraising Status: raised and raising
• Fundraising Details: $400K closed of a $600K convertible note at a $4M cap from [small fund name], [AngelList syndicate name], and local angels.

Custom Metrics

At any point in time, there should be a handful of top-level KPIs that you monitor to help run your particular startup. Of course, they vary across lifecycle stage, technology area, and business model. Just pick the most important 2-6 and give them to us. Feel free to change them as you pivot and mature.

Here’s an example for a pre-product enterprise SaaS company:

• Projected Alpha Delivery Date: 11/30/2015 (+15 days)
• Alpha Access Wait-list: 47 Companies (+8)

And one for an enterprise SaaS company that recently shipped private beta

• Max Queries/Minute: 1,201 (+29% MoM))
• Outstanding Critical Bugs: 3 (-2)
• Inbound Inquiries: 481 (-17% MoM)
• Qualified Prospects: 19 (+2)
• Paid Pilots: 3 (New Metric!)

And finally one for a consumer Web company in full operation

• Max Concurrent Users: 1,006 (+30% MoM)
• Registered Users: 23,657 (+13% MoM)
• Monthly Actives: 3,546 (+4.5% MoM)
• Users Making Purchases: 560 (+21% MoM)
• Total Purchase Value:$17,993 (+28% MoM)
• CAC: $12.55 (-7% MoM)

That’s it. We estimate that, if you keep your accounting system up to date and use MailChimp, producing an update with metrics and a few extra bullets should take about 15 minutes (with some practice). And you’d be heroes in our book.  Well, all entrepreneurs are already heroes.  So you’d be superheroes!

In my last post, I showed how taking a round of funding logically reduces the available exit options. As a rule of thumb, each round of funding reduces exit opportunities by 10X (assuming a default price-elasticity of 1). Now let’s focus on the specifics of Series A. If you just want the summary, there is a particularly large cliff at Series A: I estimate a 25X reduction. My guess is that the difference is due to early stage VCs wanting bigger multiples than late stage angels and potential acquirers becoming much more price sensitive in the affected valuation range.

Here’s the detailed math… Traditional Series A VCs want $100M+ exits. (see here, here, and here). This target makes perfect sense when you work the numbers. Adding up the pre-money valuation and amount raised at Series A from Wilson Sonsini, we see that the  typical post-money valuation is currently on the order of $10M. Now, early stage VCs consider 10X returns to be a successful investment (reference here). Result: an exit on the order of $100M is the minimum.

Of course, if a company’s Series A investors become convinced they can’t achieve their minimum, they’ll accept less. But there are two issues with that scenario from the founder perspective. First, part of what VCs do when they make a Series A investment is help put the company on the operational path necessary to support a business worth $100M+, a path that requires burning cash. So by the time the investors admit they won’t hit their target, the company is often strapped and the exit options start heading towards “fire sale” valuations. Second, VCs almost always have liquidation preferences, i.e., they get paid before the founders. The combination means failing to hit $100M often means the founders and employees don’t make out very well.

Therefore, from the founder perspective, if you take a traditional Series A round, the prevalence of $100M+ VC-backed startup exits is a pretty important statistic. This number is fairly straightforward to estimate. According to Ernst and Young, there were an average of 41 VC-backed IPOs per year from 2007 through 1H2012. For our purposes here, I assume all those were over $100M. According to to CB Insights, there were 111 private technology company acquisitions over $100M in 2012, thought not all of these would necessarily be VC-backed. This data jibes with the NVCA data on VC-backed companies with M&A exits at least as large as their total funding: 92 in 2012, 112 in 2011, and 85 in 2010. Not all of these would necessarily be over $100M, but we’re just using this number as a quick double-check. So given these datapoints, I think 200 is a very gracious rough estimate of the number of $100M+ VC-backed startup exits per year.

Now, if we examine the NVCA data on “Early Stage” deals from 2001-2010, we see the average number per year of was almost exactly 1,000. So assuming a relatively steady state, a founder who accepts a traditional Series A round has about a 20% chance of seeing a substantial payout.

Consider the alternative. Run leaner. Try to just achieve initial product-market fit or a significant technological breakthrough. Get acquired by a large company for under $50M. The numbers here are harder to find. the CB Insights report covers this price range, but looks pretty inaccurate. For example, it says Google acquired 12 companies in 2012. But Google’s 2012 SEC Form 10-K says it acquired 53 companies–that’s less than 1/4 accounted for by CB Insights. Presumably, it is the smaller acquisitions they miss.

To achieve better accuracy, RSCM asked a friend with access to the S&P Capital IQ database to do a quick search for us on M&A deals under $50M from 2001 to 2010. Unfortunately, deal size wasn’t disclosed in many cases. We figured the unreported-size transactions were probably almost all under $50M, but conservatively assumed it was 90%.  Given this assumptions, our estimate of the average was 5,000 per year. On the one hand, this estimate is for all private company transactions not just those in the technology sector. On the other hand, we used the number of Google acquisitions as a double check and found only about 2/3 of Google’s acquisitions were in the database. So for the purposes of rough estimation, assuming these errors cancel seems reasonable.

Using the spreadsheet from my latest Seed Bubble post, we can estimate that about 22,000 companies per year receive seed stage angel funding. Remember that most of these companies fail before they reach the point at which they could even consider Series A funding. To be gracious, let’s assume 50% make it to that stage. So that means that a company that forgoes a Series A has very approximately a 5K/11K = 45% chance of seeing a payout via small acquisition.

Bottom line: if you know a founder received a substantial payout, the probability is about 25X higher that it came from a small exit than a large one. Prospectively, a founder that chooses to avoid Series A is about 2.5X more likely to achieve decent liquidity. Though if you do succeed going the Series A route, the amount of liquidity will likely be much higher.

Then there’s the “reputational effect”. Getting a successful exit under your belt is a huge benefit in terms of how people perceive you in the startup world. So first-time entrepreneurs should be particularly biased towards higher probability exit options. Especially because even a modest payout helps fund the next startup (where you can hold out for that traditional Series A if that’s your long term goal).

Taking these factors into account, a first-time entrepreneur may actually lower the total future expected value of his or her entrepreneurial endeavors by accepting a traditional Series A round. Again, I’m not saying that this path is always wrong. But it’s wrong a lot more often than most entrepreneurs think.

Also, I’m not recommending that most entrepreneurs swear off Series A unconditionally. Rather, I’m recommending that most entrepreneurs keep their options open by taking smaller seed rounds and extra angel rounds. Have enough certainty about the technology and business to know what your acquisition price would be before you decide that the traditional VC route is the best alternative. There will be exceptions, of course. An opportunity may be so big and emerging so quickly that even a first time entrepreneur should absolutely take Series A as early as possible. But those situation will be rare.

For what it’s worth. Your mileage may vary. Standard disclaimers apply.

[Update 5/7/2015: Don’t just take my word for it. Bhavin Parikh, founder of Magoosh, weighs in, supporting these cautions about taking a Series A.]

[Update 2/22/2015: I looked up the current numbers from E&Y and CB Insights. Short answer is that activity was up a little in 2013 and 2014. According to E&Y, US-based VC-backed IPOs were 67 in 2012 and 74 in 2013, higher than the 2007-2011 average of 41. According to CB Insights, the total for US-based Tech exits over $100M was 144 in 2013 and 217 in 2014. Subtracting out their IPO numbers gives us US-based Tech M&A of 80 in 2013 and 138 in 2014. So 200 still looks like a very good long term estimate of the number of US-based VC-backed exits over $100M.  Especially because the detailed 2014 report says that 73% of all exits are for companies that never raised VC or PE dollars. Note that Early Stage VC activity is up to ~2,000 per year in 2013 and 2014. So the odds may have actually gone down.]

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.

In playing with the data from my previous angel diversification posts (here, here, and here), I developed the best visualization so far of how to improve your angel portfolio with more investments.  Simply compare the cumulative probabilities of achieving given return levels for different portfolio sizes using historical AIPP angel data.

If this graph doesn’t convince someone, I don’t know what would:

This shows the marginal benefit of doubling your portfolio, starting at 25 investments.  At some point, your cumulative outcome probability drops off a cliff.  For 25 investments, the cliff is at 1x your money.  For 100 investments, the cliff is at 2x your money.  For 400 investments, the cliff is at 2.5x your money. (Yes, I admit to playing with the Y axis scale to dramatize the effect.)

At 800 investments, the cliff is all the way out at 3x your money.  You would have had a 95% chance of tripling your money!

Another way to think of it is that the area between any two lines is the cost of not diversifying your portfolio to that level.  Just look at the “wedge” between 25 and 200.  It’s enormous.  Now who doesn’t want to diversify?