Planning for a Financing Pt. 3

Sizing your Financing Round

RE: Size of Financing Round

In this mythical time of free roaming tech unicorn herds, new headlines seemed to be packed with massive financing rounds. Early worries that the Covid-19 pandemic would depress the capital markets have long been abated.

In fact, the venture investment market this past year was the second largest ever. According to Crunchbase, venture funding topped $300 billion in 2020, which is only surpassed by deal value in 2018. There is just a lot of money out there, looking to be put to work.

Photo by Annie Spratt on Unsplash

Individual financing rounds have routinely climbed into the hundreds of millions to even billions. All this capital and the resulting valuations are enough to make even the most cautious and pragmatic startup CEO dream of what could be.

In early days of your venture, however, there are two important basics to remember about financing rounds: a) Venture Capitalists (VCs) typically pre-determine a range for how much they are willing to invest based on the round you are raising, and b) with any equity financing round, a company is selling a percentage of itself in exchange for capital.

Pre-determined Investment Ranges

As you progress to each new round of financing, investor types can change. VCs with varying focuses on a company’s stage of maturity will be evaluating companies using different criteria to meet their investment strategy.

For example, Seed and Series A investors focus on earlier stage companies and make more investments with smaller amounts in order to spread out their “bets” to maximize the probability that they will invest in a company that provides a Home Run (100x) return. Conversely, later stage (Series B and on) investors focus on more mature companies that are somewhat surer bets, and can deploy much more capital in each investment.

Based on Data from Pitchbook, this is what you can expect in terms of financing round sizes and investor focus during financing stages:

  • Round: Company Stage, (Investor Focus); Range of Round Size
  • Seed: Development, (Proof of Concept); $500k to $5M
  • Series A: Monetization, (Proof of Target Addressable Market); $5M to $25M
  • Series B: Scaling of Team and Product Offerings (Proof of Ability to Grow); $25M to $75M
  • Series C: Market Leadership (Vertical Growth); $50M to $150M
  • Series D and Subsequent Rounds: Expansion into other markets (Horizontal Growth); $100M+

Of course there are exception to these broad generalizations — for chrissakes, Club House raised a Series B of $100 million, vaulting it into the Unicorn stratosphere within 1-year of its founding. And startups in certain industries like biotech and hardware, just require more capital to get started. However, it’s more important to pay attention to the median versus the mean — overall the bounds of this rubric apply to most startups.

In terms of valuation, the size of financing round and the ownership percentage you are willing to part with are the main levers, and are ultimately dependent on investor appetite. After all, it is a supply and demand market.

In the current flush market, founders may be willing to take the most amount of money as possible in a financing round. And while for any company, having a larger cash war chest is generally better, dilution and other intangibles should weigh heavily into your considerations.

This Money, for That Equity

In every equity financing, you are giving up a portion of your ownership in exchange for financing. Logically, the more financing rounds you raise, the higher the potential trade off in terms of dilution. Financings, while often necessary, can become very expensive in terms of dilution and dangerous in terms of founders’ control.

Typically, during every financing round, a company can expect to sell between 10% to 30% of itself to new or existing investors. *A notable exception here is that Y Combinator’s New Standard Deal for pre-seed, which will run you 7% for $150 thousand on a post-money basis. Companies also tend to increase their equity incentive plans (EIP) during every round to replenish their option pools that are needed to hire and retain employees.

As such, there is a theoretical cap to how many financing rounds a typical VC backed company can raise prior to going public. The chart below visualizes the effects of dilution on Founder’s ownership across financing rounds.

Note: Investor ownership in previous rounds also get diluted by new money

Assuming that a company sells 20% new shares and refreshes its EIP by 5% (pre-money) every round, you understand why founders start to eye an exit liquidity event (sale or IPO) after Series C/D.

Investors also start to push for the same exit — there is of course the time value of money implications of generating an exit within an acceptable investment time horizon. But also, such a heavy imbalance of investor to employee ownership can start to cause issues for the company when it looks to list on a public stock exchange.

Specifically, it can be harder for investment bankers to sell IPO shares if prospective IPO investors are worried that the existing private investor ownership base will be tempted to realize their gains at the end of their lockup period six months after IPO. Take into consideration the graph above. If a Company lists for a valuation of $10B, and nearly 50% or $5 billion of ownership is held by funds or private investors that have been holding their stakes for years and have their own incentives to realize their investments, then you may have a sizable sell off after lockup ends.

Additionally, incoming institutional investors may worry about employee retention if employees aren’t being properly incentivized to stay with their companies. With this understanding, it becomes apparent to see why very few companies are able to raise a Series E and beyond. And though there are Series E+ exceptions aplenty, most investors in these late-stage rounds must feel highly confident that an IPO or other type of liquidity event is imminent.

In summary, while you can try to plan perfectly how much you want to raise down to the last cent, in many ways how much you can actually raise will be dependent on the financing round you find yourself in. Financing amount ranges are somewhat pre-determined for most startup companies, as is the amount of equity you will have to part with.

The amount you can feasibly expect to raise at any stage will also influence what you can expect to accomplish with the capital financing, and ultimately the timing of your next, next financing round.



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