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Since I started mentoring early stage startups, by far the most questions I got was around fundraising, especially about how much to raise and how to find a valuation. This article is an attempt to demystify the process.
How much to raise
Two schools of thought:
1. Raise as little as you need
- To get to the next step / take away risk
- Avoid dilution at early stage (you might want to prioritize Top-Angels over a mediocre VC Fund)
2. Raise as much as you can
- More fire power to win over competition & scale faster
I would generally try to raise an amount that covers the following:
- 12–24 months runway (tends to the higher end with earlier rounds). This is the critical time you need to focus on the company and not on fundraising!
- Enough to ‘get you to the next stage.’ When you go to raise your next round you need to say “we took €Xm and turned it into Y traction & Z product.” Think about what milestones you will need to have achieved to raise the next round and what story you will need to tell.
Also, think about what you want personally. I believe your most valuable asset is your time. A startup (even one that doesn’t go well) can easily take ~5 years of your life. I think it’s better to give away more equity and fail / succeed faster than to cling on to more, but with a slower, more drawn out process.
There’s three factors that determine early stage valuation:
- Demand for the deal — how hot are you?
- Healthy captable — will the founders be incentivized going forward?
- Comparative valuation — what did a similar company at a similar stage raise?
If investors ask you for valuation, it’s ok to say that we’re not talking about it right now. When you talk about the round size, it kind of implies valuation.
Key takeaway: Valuation is typically a product of how much you want to raise and the round dilution.
Example: If you know you want to raise €1.5m at pre-seed then your valuation should be at the higher end of the dilution scale e.g. 18% implying a valuation of ~€6.8.
Calculated by (€1.5m / 18%) — €1.5m See here for valuation calculations.
Do fundamentals matter at early stages?
Fundamentals e.g. your revenue don’t matter so much at pre-seed or seed. They can be used as a sanity check based on VC standards e.g. Valuation ~= 6x SaaS ARR at Series A.
Can I raise a large round with just an idea or a live product not generating any revenue?
Yes! This happens. Typically you need one or more of the following:
- Track record e.g. you founded a successful company before
- Strong traction e.g. your product is exploding
- Luck 🤷♂️
Structure: Equity vs. SAFE vs. Convertibles
In earlier stages you tend to use a non-equity agreement:
- Convertible Note
Both are constructs which typically have a cap and a discount, but do not name a final price of the equity. A convertible note is a loan structure (with a small amount of interest) and SAFE is a more modern, but less accepted structure. Both get converted when an equity round happens.
The motivations for a SAFE or convertible opposed to an equity round are
- To avoid fixing a final price which can be tough at early stages
- To avoid the notary costs of smaller rounds
Caps & discounts
To reward an investor for coming in earlier and taking more risk, SAFEs and convertibles typically have the following mechanisms:
- A discount on the price of the future equity round (typically 20–25%)
- A cap (capped / maximum valuation) of the future equity round
- The discount and the cap can compensate for each other e.g. higher cap with a lower discount
- Be careful about the message that the cap sends — if you close a convertible with a cap of €5m, that’s setting an ‘anchor’ for the next round. Be careful you are not swallowing a poison pill!
- A high discount can also be off-putting for a future investor
- While SAFEs & convertibles avoid setting a final valuation, they typically have a cap which is an implied valuation so the problem does not go away entirely!
- SAFEs & convertibles should still take the above dilution guidelines into consideration
When a VC comes in, they will typically want an equity round. This is because they can stipulate favourable terms for themselves e.g. to get extra equity in the event of a downround (Anti-dilution protection) or to be paid out first when an exit happens (liquidation preference).
At this point, your SAFEs and/or convertibles will be converted into equity.