Future Financings Posts

How much money should I raise?

Nivi · October 27th, 2010

We get this question all the time and there’s no right answer. So I started a discussion on Quora to learn more. Here’s my answer:

Raise less if you want to keep your valuation down and keep the option open for an early exit where everyone (investors, employees and founders) makes money.

Raise more if you’re here for the long term and you want to protect your company from poor funding environments or hiccups in your growth. Just try to maintain control, monitor your liquidation preference, and monitor your dilution. Also understand that, if your valuation is high in this round, you will have to make a lot of progress for the next round to be an up round.

In summary, raise too little money and you may go out of business when you run into trouble. Raise too much money and you may make less dough when you exit. Take your pick: disaster vs. dilution.

In either case, try to act like you don’t have a lot of money. The conventional wisdom is that when you have a lot of money, it’s hard not to slow down because you start spending it (which takes time in and of itself) and you start thinking that you have a lot of time left before you die, so what’s the hurry?

Read the rest of my answer on Quora. Also see this old post on Venture Hacks for related quotes from Eugene Kleiner, Bill Janeway, and Marc Andreeessen.

VCs in seed clothing: Chris Dixon, Mark Suster, and Naval Ravikant interviewed

Nivi · May 5th, 2010

I recently got on the phone for a cross-continent conference call with Chris Dixon from Founder Collective, Mark Suster from GRP Partners, and our own Naval Ravikant. The topic was VC signaling in seed rounds — and how these signals help or hurt your ability to raise money in the next round.

The interview was inspired by Mark Suster’s (VC) and Chris Dixon’s (super-angel) discussion on whether entrepreneurs should take seed money from VCs — and Mark’s claim that “if we discussed the issue live we’d probably end up agreeing more than disagreeing.”

This is the first time we’ve interviewed so many people. The resulting interview is fun, with lots of actionable info for entrepreneurs — at one point, Naval asks if we’re getting too deep and my response was roughly hell no.

SlideShare: VC signaling in seed rounds
Audio: Interview with chapters (for iPod, iPhone, iTunes)
Audio: Interview without chapters (MP3, works anywhere)
Outline and transcript: Below

Thanks to the SlideShare team for helping us resolve a technical issue very quickly.
[Read more →]

How much money should we raise?

Nivi · April 14th, 2008

Summary: Raise as much money as possible. With these caveats: (1) maintain control at any cost, (2) monitor your liquidation preference, and (3) act like you don’t have a lot of money. Also understand that if you do raise a lot of money, you will have to (1) “go big or go home” and (2) make a lot of progress if you ever want to raise money again. Alternatively, if you would rather maintain your exit options, at least raise enough money to run two experiments.

How much money should you raise? As much as possible—with some caveats. But hey! don’t take our word for it.

Two investors’ opinions.

kleiner.jpgEugene Kleiner, Founder of Kleiner Perkins:

“When the money is available, take it.”

janeway.jpgWilliam Janeway, Managing Director of Warburg Pincus:

“Failure to execute operationally is not the only source of risk; every venture is also subject to volatility in the price and availability of capital due to the volatility of the stock market. After the collapse of the Internet Bubble, many promising companies foundered because their funding dried up.

“By contrast, our biggest successes at Warburg Pincus (VERITAS, BEA) have come from inverting the normal venture funding model, with the visionary investor as company co-founder… And we have supported the multi-year process of building a sustainable business by underwriting all of the capital needed to reach positive cash flow, thereby not only enabling management to focus full-time on the business but also insuring against the risks generated by a volatile stock market…

“In the post-Bubble world, long-term financial commitments are required to fund the ventures that will fulfill the long-term technological vision and implement the long-term commercial promise of the Internet Age.”

Two founders’ opinions.

ramsay.jpgMike Ramsay, Founder and CEO of Tivo:

“One of the reasons that TiVO is thriving today is that we were well-capitalized. We were able to power our way through the downturn—that early 2000 period when [our competitor] Replay went away. We were capitalized enough that we knew we could ride through it. While we had to make a few adjustments at the company, there was never a question that we were going to survive. We knew we were going to survive.”

andreessen.jpgMarc Andreessen, inventor of the bendy-straw:

“So how much money should I raise?

“In general, as much as you can.

“Without giving away control of your company, and without being insane.

“Entrepreneurs who try to play it too aggressive and hold back on raising money when they can because they think they can raise it later occasionally do very well, but are gambling their whole company on that strategy in addition to all the normal startup risks.

“Suppose you raise a lot of money and you do really well. You’ll be really happy and make a lot of money, even if you don’t make quite as much money as if you had rolled the dice and raised less money up front.

“Suppose you don’t raise a lot of money when you can and it backfires. You lose your company, and you’ll be really, really sad.

“Is it really worth that risk?

“…Taking these factors into account, though, in a normal scenario, raising more money rather than less usually makes sense, since you are buying yourself insurance against both internal and external potential bad events — and that is more important than worrying too much about dilution or liquidation preference.”

Make sure you read Marc’s full article for his caveats: How much funding is too little? Too much?

Guidelines to consider no matter how much you raise.

No matter how much money you raise,

  1. Maintain control at any cost.
  2. Monitor your total liquidation preference and avoid liquidation preferences above 1x non-participating. You will have to sell the company for at least the liquidation preference before the common stockholders see a penny.
  3. Raise enough money to run more than one experiment. Some companies need 12 months of runway to do two or more experiments, others might need 24 months. Seed stage companies that can’t raise enough money to run more than one experiment should keep their burn down to extend their runway.
  4. Act like you don’t have money.

Guidelines to consider if you do raise a lot of money.

If you do raise a lot money,

  1. Understand that your investors will have very high expectations. You have will have to “go big or go home”.
  2. You will have to make a lot of progress with this round if the company ever wants to raise money again.

Alternatively, if you would rather keep your liquidation preference low and maintain your exit options, at least raise enough money to run two experiments.

Raise too little money and you may go out of business when you run into trouble. Raise too much money and you may make less (or zero) dough when you exit. Take your pick: disaster vs. dilution.

Image Sources: Marty Katz for The New York Times, SFGate, Wired.

Why do investors want protective provisions?

Nivi · August 2nd, 2007

“AOL almost sold to Compuserve in 1991 for $60M. The VCs wanted to sell. [Steve] Case won by 1 vote. 10 years later, [AOL was] worth $100 billion.”

– Mark Pincus

Summary: Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. They protect the preferred, who are minority shareholders, from unfair actions by the common majority. However, the preferred shouldn’t use protective provisions to serve their other interests.

Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. Roughly, they state that

“The Company requires the consent of the holders of at least X% of the Company’s Series A Preferred to (i) effect a sale or merger of the company, (ii) sell Series B Preferred with rights senior to or on parity with the Series A, (iii) et cetera…”

To understand why investors want protective provisions, you first need to understand how the preferred and common classes control the company.

The board mostly controls the company.

The common and preferred classes control the company through

  1. Board seats, which require each board member to serve the interests of the company as a whole. Board members cannot simply serve the interests of their particular class of stock.
  2. Shareholder votes, where the preferred vote as if they held common shares. In legal-speak, the preferred vote on an as-converted-to-common basis. The preferred usually gets one as-converted-to-common share for each of their preferred shares. The preferred and common use shareholder votes to serve their own interests.
  3. Class votes, which require a majority of the preferred and a majority of the common. We will cover this mind-numbing topic in a future hack. The preferred and common use class votes to serve their own interests.
  4. Protective provisions, which allow the preferred to veto certain actions, such as selling the company or raising capital. In some companies, each series (Series A, Series B…) has their own protective provisions. In other companies, all of the series exercise their protective provisions as a class.

After the common and preferred classes select their representatives on the board, the board takes it from there. The board, not the shareholders, usually approve management decisions. (We previously showed you how to hack the allocation of seats on the board.)

However, some major actions require shareholder votes and class votes in addition to board votes. For example, Delaware corporations require a shareholder vote to sell the company or raise money.

Protective provisions protect the preferred minority from the common majority.

The preferred usually owns 20%-40% of the company after the Series A. If the common is united, the preferred can’t influence shareholder votes—they don’t own enough shares. Nor can they influence board votes if a united common controls the board (e.g., the board consists of two common seats, one preferred seat, and no independents).

If the common controls a Delaware corporation’s stock and board, the preferred need protective provisions to stop the common from:

  • Selling the company to the founder’s cousin for $1 and wiping out the preferred stock.
  • Selling $1M of the founder’s shares to the company so he can get a great haircut.
  • Issuing a bazillion shares to the founders and diluting the preferred to nothingness.

Protective provisions protect the Series A minority from unfair actions by the common majority. That’s why they’re called protective provisions. In future rounds, protective provisions can also protect each series of preferred stock from the other series of preferred stock.

Investors argue that protective provisions encourage good governance.

Some investors claim that they need protective provisions because they can’t use their board seat to serve their own interests. They correctly argue that board members have to serve the interests of the company as a whole, not the interests of their class of stock.

These investors will claim that protective provisions let them serve their interests as investors, so they can serve the interests of the company through their board seat:

Say the company receives an offer to acquire the business. Management thinks it’s in the company’s interest to sell. The board defers to management since management is doing a good job running the company. But the investors think the company is the home run in their portfolio—they don’t want to sell the company now. So the investors use their board seat to vote for the sale and use their protective provisions to veto the sale.

Investors should use protective provisions to protect themselves, not to serve their interests.

We don’t agree that investors need protective provisions to serve on the board without succumbing to their own interests.

In fact, any investor who makes that argument is raising a big red flag. They’re implying that they can’t fulfill their duty as board members without additional veto powers. They’re implying that the interests of their fund can outweigh the interests of the company.

Your response to this argument goes like this:

“I don’t think you mean that you can’t serve the interests of the company without these additional protective provisions. I’m sure you will use your board seat to do the right thing for the company, always.

“You control the company through (1) board votes where you serve the interest of the company and (2) share and class votes where you serve your own interests.

“Protective provisions protect you against the common majority. But they’re not a tool to serve the interests of your fund at the expense of the company.”

They're called protective provisions, not mis-alignment provisions!

We would rather have an “evil” investor who uses his board seat to serve his interests, than an investor who planned to use protective provisions to do anything other than protect himself. At least the “evil” investor’s power as a board member is in proportion to his share of board seats—his protective provisions give him a blanket veto that is wildly out of proportion with his ownership of stock and allocation of board seats!

The next few hacks will show you how to attenuate the protective provisions, reduce this mis-alignment, and leave enough protective provisions in place to protect the preferred.

Image Source: Jennifer Juniper (License)

Keep your Series A options open if you raise debt

Nivi · May 8th, 2007

“[Our existing investors] had put in a right of first refusal. Since I was a young entrepreneur at the time, I didn’t understand that this basically meant that you couldn’t go to any other VC… We could not get a higher valuation because [our existing investors] wanted to put more money in the company themselves. So any time we would talk to another VC, they would talk him out of it: “This is not a good company, don’t worry about it.” So we were really stuck with [our existing investors] for the next round.”

– A Founder

Summary: Raising convertible debt from venture capitalists can restrict your Series A options and lower your Series A valuation—whether or not your investors have a right of first refusal on the Series A. You can keep your options open by raising debt from angels exclusively or raising debt from more than one VC.

Raising convertible debt from angels usually leaves your Series A options open. Why? Angels send a positive signal if they want to re-invest in the Series A, but they don’t send any negative signals to your prospective investors if they decide to pass. There are many simple reasons why an angel may not re-invest in the next round.

You need to be more careful if you raise convertible debt from a venture capital firm. They are more likely to ask for a right of first refusal with respect to some, or all, of the Series A. And, with or without a right of first refusal (ROFR), they can send signals that give them leverage and restrict your options in the Series A financing.

Prospective investors don’t appreciate ROFRs.

Let’s assume your existing debt investors, Blue Shirt Capital, have a right of first refusal on all of the Series A. You’re ready to raise your Series A and Blue Shirt says they want to re-invest. Other prospective Series A investors, such as Herd Mentality Management, will have a standard reaction when they learn that your existing investors have a right of first refusal:

If we make an offer to invest and Blue Shirt exercises their ROFR, then we just wasted our time. If we make an offer to invest and Blue Shirt doesn’t exercise their right of first refusal, then we Offered too much. Yeah… Blue Shirt knows a lot more about the company than we do—they should know what the company is really worth. So, we can only invest in this company if we pay too much. Why should we spend time looking at a company if we won’t have the chance to invest at a reasonable price?

A ROFR can restrict your options and lower your valuation.

At worst, your prospective investors will decide not to waste their time with you, leaving you to take money from your existing investors at a low valuation.

At best, your prospective investors won’t give you an offer unless they are assured that they may co-invest with your existing investors. This forces you to raise money from two investors, implying that you will have to (1) raise more cash than you expected and (2) take 30%-40% dilution from two investors instead of 20%-30% dilution from one investor. Your prospective investors can also coordinate with your existing investors to drive down your valuation:

Hey, Blue Shirt buddy, would you split the deal with us at a $5M pre-money? If that’s what you’re offering, you should go ahead and take the entire round. We won’t exercise our ROFR at that price. We think the company is worth $3M. Sweet! let’s split it at $3M.

(Blue Shirt can use this same signal to drive down your valuation even if they have a right of first refusal on just a portion of the Series A.)

It sucks if your existing VCs don’t want to re-invest.

What if Blue Shirt says they don’t want to re-invest in the Series A at all—whether or not they have a right of first refusal? Herd Mentality will gag on their feed when they learn that your existing investors don’t want to re-invest:

What has Blue Shirt learned since the debt round? Why did they lose interest? They know a lot more about the company than we do—they’ve spent a lot of time with the company. Something is obviously wrong with this company. The only thing worse than this is an episode of Golden Girls. Pass!

At best, once there is no interest left in your Series A financing, Blue Shirt may tell you that they actually do want to invest in the Series A—at the right price. There’s no competition left, so you’re stuck with whatever Blue Shirt offers. However, this is an unlikely outcome since it’s not good for Blue Shirt’s reputation among investors.

More likely, Blue Shirt really doesn’t want to invest in the Series A and this negative signal makes it difficult or impossible for you to raise any more money.

You have the same problems with or without a ROFR.

If you raise convertible debt from a venture firm, you will have the same problems whether or not they have a right of first refusal:

Herd Mentality will still wonder whether they are wasting time since you already have investors on the “inside track”. They will still make an offer only if they are assured that they may co-invest with Blue Shirt. They will still coordinate with Blue Shirt to drive down your valuation. They will still gag if Blue Shirt doesn’t want to re-invest.

Your existing investors can send the same signals with or without a right of first refusal—the signals are simply stronger if they have the right of first refusal. This is a small taste of the game you will have to play when you raise a Series B and your prospective Series B investors interact with your existing Series A investors. Some solutions to this game are coming in a future hack.

For now, you can set up the seed round to avoid playing this game in the Series A.

Try to remove the ROFR.

First, try to remove the right of first refusal by applying the reciprocity norm:

“If you have a right to buy equity in our next round, shouldn’t we have a reciprocal right to sell you equity in the next round? In other words, why should you have a call option to buy the company’s equity if we don’t have a put option to sell you the company’s equity?

Why are we negotiating the next round of financing now? If we’re going to negotiate the next round now, we should negotiate all of the next round, not just your right to invest in it. I don’t want to do the next deal now, I want to do this deal now.”

If you lose this argument, try to contain the right of first refusal to a portion of the Series A. For example, if you raise money from three investors in the Series A, your debt investors would have the right to take up to one third of the Series A.

Overall, accepting a right of first refusal is a minor concession in your debt agreement. Don’t blow up the deal over this term since you will have the same problems whether or not you win this item.

Get multiple investors if you raise debt from VCs.

If you decide to raise debt from venture capitalists, you should try to close two, three, or more venture firms.

As the number of insider investors increases, the influence of any one insider decreases. There is no single source with a single agenda that can send whatever signals it likes. Multiple investors will send multiple conflicting signals that outsiders will not be able to distinguish from noise.

And as the number of insider investors increases, the probability that one of them will send a positive signal increases. For example, at least one of your existing investors may state that they want to invest in your Series A.

You can also make the case to your prospective investors that you raised debt from multiple firms specifically to reduce their individual influence on the Series A:

“Raising debt from multiple VCs is our signal that these insiders are really no different than you. They know nothing more about the business than you do by now. The debt round was simply their opportunity to demonstrate their value to us.”

Finally, you can pit multiple firms against each other to get the best terms for the convertible debt:

Determine what terms Blue Shirt will offer to purchase the entire note. Then tell Herd Mentality that Blue Shirt wants to take the entire note at those terms. Would Herd Mentality consider a more favorable offer? Repeat. Finally, split the debt among all the investors.

What are your experiences with keeping your Series A options open?

Use the comments to share your experiences with keeping your Series A options open. We’ll discuss the most interesting comments in a future article!