Is Greed Good When Asking VCs For Money?Growth & Scaling
It’s been said that when setting goals to shoot for the moon, because even if you miss, you’ll land among the stars.
Does this same advice apply to asking for VC money?
It seems logical to ask for more money than you need. Fundraising is a stressful and anxiety-inducing experience. Fundraising also forces founders to confront awkward truths about their business.
As Kunal Gupta, founder and CEO of Polar, a digital media startup explained to Forbes, “Part of what makes starting and growing a business special, is the personal connection an entrepreneur will have to it. And sometimes that connection will be grounded in reality, other times it may not be. A fundraising process will naturally add a dose of reality to the business, and an entrepreneur should be ready and open to receive that.”
But even if you’re willing to go through rounds of criticism, questioning, and feedback, that doesn’t mean you enjoy it. Altogether, it seems logical to raise as much money as possible upfront, so you hopefully never have to raise money again.
Raising more money than you need provides you with a buffer from the stress and anxiety of keeping your business afloat. In the early days of a startup, the focus is on developing an MVP, establishing product-market fit, and gaining traction. Profitability isn’t always possible early on, which is why keeping the business funded is so important. Securing a buffer early gives you a safety net in case it takes longer to establish product-market fit or you need to spend more on marketing and sales to gain traction.
That said, having a hefty war chest isn’t always the best approach.
The disadvantages of asking for too much money
If your answer to “How much money are you raising this round?” is “As much as I can get!” you may want to consider the following downsides to that approach.
It may not be worth the terms
With more money, comes more problems – or at least, more terms. The more money you take from investors, the more terms and conditions you’ll likely need to abide by.
In the early stages of your business, you don’t have many tangible things to offer in the form of a product or recurring revenue for your services. This limits your negotiating power, and people willing to lend you a lot of money may ask for changes to your business or a disproportionate amount of influence.
While this may seem like an acceptable trade off at first, you run the risk of losing interest in your business. Two of the primary motivations for creating a startup (aside from the universal motivation of a lucrative exit) are:
- The ability to make a living on your terms
- The opportunity to revolutionize an industry and deviate from the standard ways of doing business
As more cooks enter the kitchen and try to de-risk your operation, you may find yourself in the unattractive position of working for people all over again. They may not be your “boss”, but for all intents and purposes, they’re calling the shots.
It may create an over-inflated post-money valuation
You’ve reasonably valued your startup as worth $1 million. But during your funding round, you decide to raise $2 million. Unless you’re going to give investors a majority stake in your company (which you probably don’t want to do in the early days for the reasons of pride in startup ownership we discussed earlier) you’re going to need to bump up your valuation – and this bump up is likely “artificial”.
Translation: It’s not a reflection of the actual value of your company. It’s just a number you’ve chosen that makes the equity split acceptable.
This may not be a problem at first, but what about later when you’re participating in more funding rounds? If you haven’t grown into that earlier inflated valuation, you may need to take a hit to your valuation in order to raise more money. This is not a good look for an early-stage startup. Even worse, other investors may pass on the opportunity to invest in your company because your startup’s considered unreasonably expensive.
It may create an “easy come, easy go” money mentality
When people have an abundance of a resource, they tend not to value it as much or watch it as closely. In the infant days of a startup – when it’s just the co-founders and no outside funding – every penny is carefully watched because a dollar put in the business is a dollar taken away from their lives and their family.
On the other hand, too much money can cause entrepreneurs to lose their prudence and scrappiness. Instead of finding creative ways to do business and solve problems – defining features of a startup – they spend money more freely and spend less time tying their expenditures to clear goals and objectives.
The result? The need to raise more money again, with very little to show from the last round.
How do you determine how much money to request from VCs?
In the early days of your business, it’s difficult to put a dollar value on your company. Most valuations of early-stage VCs are a bet on the future value of the company. They’re also a reflection of prevailing sentiment around technology and market trends.
Consequently, valuations are both an art and a science, so there are no hard and fast rules for how much a startup should be worth. Some startups may wind up with a multi-million-dollar valuation at the seed stage while others struggle to hit $1 million.
Strategies for valuing your startup
There are a number of strategies you can use to value your startup including:
- Cost-to-Duplicate: How much would it cost for an investor to build your exact same startup, at its current stage, from scratch? This approach often focuses on physical assets, the time it takes to develop a piece of software, and other elements with an objective price tag. The problem is that this approach doesn’t take future potential into consideration. For instance, someone valuing Amazon in the early 2000s would have valued it simply on its status as an online retailer. They wouldn’t have had the tools to evaluate the problem-solving potential of its team which turned an internal IT infrastructure scaling problem into a multi-billion-dollar cloud computing business, Amazon Web Services. The Cost-to-Duplicate Approach also struggles to capture things like brand value.
- Market Multiple: This approach is kind of like property pricing. Yes, there’s a physical, tangible component, but there’s also a comparative element. Home buyers often look at what a nearby house sold for in recent months for an idea of how much they should pay for a home. Likewise, venture capitalists will look at similar companies that have been recently acquired for an indication of how much they should value your company. This gives them an idea of how much the market is willing to pay for a company like the one they want to invest in, and by extension, how much they in turn can sell it for. You can use this approach, but it’s not always easy to find companies for comparison, especially if you’re an early-stage company doing something disruptive.
- Discounted Cash Flow (DCF): This approach looks at how much a company is expected to make in the future. Since a dollar earned today is not equal to a dollar learned in 4 years (the dollar in 4 years will be worth less), a discount is applied. So a $1 earned in year 4, may actually only be 75 cents, depending on the discount applied. The difficult part of using the DCF approach is coming up with a reasonable forecast of your future cash flows. You’ll need a good analyst who can provide supportable claims about future market conditions.
- Stage-Based Development: This valuation approach is usually a scale created by an investor’s firm. They may consider a company with just a great business idea and strong business plan as worth no less than $250,000 and no more than $500,000. Startup founders using this approach will need to accurately align their valuation to their targeted investors’ scales.
This is why founders should be wary of generalizations about what a startup should be valued at each stage. Different investors will use different strategies to get to this number, so it’s worth taking the time to use a combination of tactics to figure out what works best and be able to defend your valuation to investors. Provide a number that’s too low, and you’ll give away too much of your company for cheap. Provide a number that’s too high, and you run the risk of looking like you don’t know what your startup’s actually worth.
Deciding on a number
Generally speaking, startup founders should:
As a founder, you need to carefully consider how much you need versus how much equity you’re willing to give away. Equity dilution occurs when you give away portions of your company in exchange for resources, usually some cash or talent. Remember that if all goes according to plan, you’ll be making the VC rounds again and will need equity on tap for future fundraises. You don’t want to give away too much too fast. Funders won’t want to invest in companies with too many other stakeholders calling the shots.
Raise for what you need, not how much you want
Avoid taking more money than you need. It’s useful to have a buffer for unexpected costs, but don’t let your eyes get bigger than your stomach. And it’s not just about equity dilution. With more money comes more problems in the form of pressure to do something productive with it. It also makes it harder to exit down the road. Taking on too much capital means investors will balk at impressive, but modest, exit opportunities that don’t give them the ROI they anticipated.
Be specific about your spending needs
As discussed earlier, a milestone-based approach ensures you’re deliberate and thoughtful about the money you receive. Even if you manage to receive money without a clear explanation for its use, you risk falling into the trap of becoming spoiled by your riches which can lead to unfocused spending sprees and losing your ability to run a lean operation.
“If I were to dispense any advice, I would really envision someone coming up with key milestones and understanding a pathway to success, identifying where they want to go and what their gaps are. Is it capital? Is it management advice? Be clear on what prevents you from being successful at your next step and go about solving that problem. You’ll find a lot more interest from investors if you have that clarity.” – Marshall Ring, CEO, Manitoba Tech Accelerator
Scrutinize your models
Your business model will understandably have a combination of knowns and unknowns, but you should still scrutinize them all and be clear on the assumptions you’ve made to produce certain numbers. This will help you understand your business’ risk and by extension, how much risk a VC might be willing to take on. If you don’t take a hard look at your numbers, your VCs certainly will and a lack of understanding will impact whether you give away too much or too little of your company in exchange for funding.
- Don’t instantly accept the wisdom to raise as much money as possible. Understand and consider both the advantages and disadvantages of asking investors for a lot of money
- Consider different strategies for valuing your startup and be prepared to defend those valuations and strategies to investors
- Be specific about your spending needs and tie funding requests to timebound deliverables or milestones you’ll use the money to achieve
- Raise for what you need, not how much you can get, to avoid falling victim to an artificially high valuation or unrealistic expectations for an exit
Interested in learning more about how to raise money for your Prairie-based startup? Download our free Harvest Guide to Funding Ebook to learn more.