Most entrepreneurs think in the present. They know they need money now and they go out and raise whatever they can for their current stage of growth. But, it is critical that entrepreneurs look far enough into the future to know what financial targets will be required to successfully raise their next round of capital and managing the business towards those targets to ensure the appropriate valuation step-ups are achieved, with each subsequent financing. It is typically not good for the entrepreneur or the investor if valuations don’t continue to move up over time, as detailed herein.
The Normal Startup Funding Cycle
As a representative example, venture-backed tech startups typically raise monies as follows: $250-$500K seed round, followed by $1-$3MM Series A round, followed by $10-$20MM Series B round. If they sell approximately 25 percent of the company in each round, at the midpoint of the ranges, that would value the company at $1.5MM at the seed stage, $8MM at the Series A stage and $60MM at the Series B stage after such investments.
What This Means for the Business Targets
The above funding cycle is just numbers on a page. To actually get investors excited about making such investments, you need to make material progress with your business along the way. For example, let’s say revenue is the key driver. Most high margin tech companies are valued at 3 times revenue. So, at the midpoint of the ranges above, you will typically need to have $380K in revenues to attract seed stage investors, $2MM in revenues to attract Series A investors and $15MM in revenues to attract Series B investors. Revenues can be the annual run rate of the business based on the most recent month times twelve, it doesn’t need to be the last twelve months.
What This Means for Management
If you want to ensure your future fund raising process goes smoothly, you need to have the above example revenue targets in mind as you are managing the business. Said another way, you better make sure the use of proceeds from each round is enough to afford all the sales and marketing activities that will be needed to propel the business to the next target revenue tier required to attract the next group of investors.
To sanity-check this, let’s say you raise $2MM in Series A and need to add $13MM of incremental revenues to attract your Series B investor. Let’s say we are a B2B company acquires leads at $250 each and converts 10 percent into sales, and the average transaction size is $25,000. If we use half of our Series A capital for sales and marketing, that should attract 4,000 leads, 400 transactions and $10MM in revenues, understanding revenues will have a six month delay behind the sales and marketing spend. So, by 18 months after the round, we did okay at growing the business, but we didn’t get to the full target of $13MM. So, we would want to rethink our sales economics, marketing efficiency or deal terms of the Series A round to make sure we have a reasonable chance of hitting our Series B funding goals.
What Happens if You Miss Your Target?
I think most investors expect entrepreneurs to miss their targets, and most everyone does, at one point or the other. But, you want to do everything you can to ensure that any misses are kept to a minimum. So, be ultra conservative in your forecasting. For example, if you normally convert 20 percent of your leads, run a sensitivity analysis to see what happens if you only convert 15 percent and pivot accordingly, to give your plan enough cushion.
The reality is, if you materially miss your sales targets, the following situations could occur: (1) it will make raising additional outside capital materially harder, at least at the valuation you were originally hoping for (given slower growth rate of the business); (2) it could result in flat valuation rounds or down rounds for the next monies in (which could trigger all kinds of anti dilution protections for your investors, materially cramming down your personal equity stake); or (3) it could irritate your current investors (as it most likely means they will materially miss their ROI targets on their investment in your business). Do your best to make sure that doesn’t happen to you.
Image credit: CC by Ken Teegardin