Dan Hoffer is a Managing Director at Autotech Ventures and a former technology company founder/CEO.
Every founder wants to continue to own as much of their company as possible while still raising the capital they need to grow. But maximizing ownership and raising capital are fundamentally at odds with each other. Investors need to own a piece of the business, too, in exchange for their investment, and it is a zero-sum game–the total amount of the company that can be shared between all parties cannot exceed 100%. With each successful fundraise, the founder’s ownership stake is (typically) reduced. Thus, the founder wishes to fundraise infrequently and for the smallest amounts possible (mitigated only by their parallel desire to secure funding from the “best” investors), so knowing when to fundraise –and how much each time–is a strategic question in and of itself.
Conventional Wisdom
The common wisdom in the early-stage startup community–among startups and VCs alike–is that approximately 18 months of capital should be raised in each round of equity financing. Fred Wilson, the co-founder of Union Square Ventures, advises founders to “plan on eighteen months of runway from a financing and three to six months to raise the next round.” Josh Kopelman, a Partner at First Round Capital, advises: “You should target 18 to 24 months of runway post Series Seed. The best time to raise follow-on capital is when you don’t need it, and 2 years of runway gives you the best chance to land in that situation.” And JPMorgan summarizes: “Experts say most seed-stage startups should plan for a runway of 12-18 months, allowing time for essential projects to reach the finish line plus wiggle room to line up additional funding.”
Meanwhile, data gathered from Crunchbase in this graphic highlights that 18 months is, in fact, the amount of time that typically elapses between the seed and Series A.
But all of the above fails to take into account a fundamental question of correlation versus causality. Is it advisable to wait 18 months between financings simply because that’s the norm (the amount of time that most commonly elapses)? Or is 18 months of time the amount of time that typically elapses because waiting that long is what is advised by investors? In reality, the most important question is: What amount of time will actually benefit the business’s shareholders the most?
The Value Creation Journey
Let’s return to first principles.
The goal for any founder is to raise money at the highest possible valuation (within reason–it’s possible to raise at too high a valuation, but that’s a different article). Given that the goal is to maximize valuation, then what drives valuation?
Valuation is driven by investors’ perception of progress toward an eventual sale of the company or IPO, which increases in likelihood with each milestone as the business gets de-risked. Internally, every functional division can achieve milestones, such as the launch of new products, the recruitment of key hires, the maturation of internal processes, the obtainment or buildout of new facilities, etc. Externally, progress can occur with the execution of a meaningful new partnership, the launch of a promising sales channel, the spinout or acquisition of a business unit, etc.
Many early-stage investors use the concept of an “inflection point” to describe the moment when the business achieves a step-change in value. (The term is loosely derived from calculus, in which an inflection point is found where the graph of a function changes concavity.)
Immediately after an inflection point is reached–such as, say, the signing of a major partnership–investors will often assign a much higher valuation to the company than immediately beforehand. Therefore, the savvy founder knows to wait to fundraise until after the inflection point has been achieved so that their ownership stake will be diluted less when they fundraise.
In some cases, it is not known if the inflection point will be achieved–deals can fall apart, new hires can back out, and product launches can underperform. If the founder is a skilled salesperson, they may be able to convince investors to give them credit in advance (e.g., a higher valuation) for the achievement of an inflection point that has not yet occurred but seems imminent. Savvy investors, of course, may push back with a “show me the money” response, though investors are also often motivated by a “fear of missing out” and especially a fear that if they don’t move quickly enough, a competing fund may preempt them. In that case, investors may knowingly invest ahead of the inflection point occurring with a generous valuation that is probability-weighted according to how likely they believe it is that the inflection point will be reached as expected.
Optimizing The Runway
The journey of value creation comes in fits and starts. Value creation (and destruction) can take many forms and can be driven by things over which the company has a high or low degree of control.
The conventional wisdom to wait approximately 18 months between early-stage financing rounds is flawed at worst and simplistic at best. Eighteen months is an arbitrary number and as such has no intrinsic significance. The approach that maximizes shareholder value–and minimizes dilution for founders and existing investors–is to forecast as best as possible when the business will achieve step-changes (“reach inflection points”) in their development and value creation journey.
These step-changes may not occur precisely in 18 months; rather, they may occur in seven, 10, 22 months or any other length of time depending on what is driving them. Raising a round typically requires three to seven months depending on the stage, the strength of the business, and the economic climate. While taking those three to seven months into account, waiting until the step-change occurs (or is about to occur, if investors can be convinced that it will occur as planned) is the best way to minimize dilution.
Thanks to Ed Yip for his feedback on this article.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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