Deciding when to raise money and how much to raise are among the most crucial decisions a startup CEO makes.
The “textbook answer” for the questions above is to raise enough capital for the company to achieve an accretive milestone. After hitting that milestone the company can go out again and raise more money at a significant step up (2x increase in value is a good number to start from). An accretive milestone is something that significantly reduces a risk which the company faces. This can be proving the technology works for technology-intensive startups, generating user traction for internet companies, finding a scalable GTM model, or even getting your first paying customer.
One of the most important milestones is starting to generate revenue. Many companies don’t generate revenue for some time since launch. This happens for many reasons such as having to build a complex technological product before being able to sell it, or having to reach enough user traction for the product/service to be worth something (e.g., Pinterest, Facebook), or even wanting to test several business models before deciding on the correct one.
The important thing to note is once you decided to “turn on” revenue there is no going back. From this point on, the company will mostly be evaluated based on revenue multiples (and later EBITDA multiples). It is often easier to convince an investor to agree to a high valuation when the company has little or no revenue solely based on the promise. Much later, when the company reaches significant revenue, valuing the company becomes easy again since the valuation is based on revenue multiples and growth projections. However, there is some kind of ‘desert’ in the middle when the revenue is still small and the Go to Market (GTM) plan is not yet optimized. Funny enough, in this stage the valuation the company will attract will likely be lower than previous valuation before it started generating revenue. This is how it looks like:
The “pre-revenue” round (Series A in the chart above) valuation also plays a role here. The higher it is, the larger the revenue the company is ‘forced’ to generate before it can raise the following round. Therefore, raising small amounts of capital at a high valuation before the company generates revenue is very risky. It just doesn’t give enough buffer to crack the GTM model before you need to raise capital again, but this time based on a revenue multiple.
I have seen several startups stumble because they didn’t have enough runway to get to a point where they can easily raise their next funding round. These companies were forced to go out to investors prematurely only to realize they can’t raise a successful round. The CEOs wasted a lot of time fundraising, exploited too many connections, and demoralized the management team. They were then forced to go back to their existing investors for a “bridge round” which is not a good situation both for the entrepreneur and the investors.
So make sure your financing strategy is aligned with your revenue plan. The timing and size of the financing rounds can have a huge impact on the company’s success.