Start-up fundraising is hard. Despite ubiquitous headlines about unicorn valuations and how it’s never been easier to raise money in Silicon Valley, the process of raising capital can be gruelling, unpredictable, and non-transparent. To shed some light on best practices for successful startup fundraising, I sat down with my partners Eric Feng and Randy Komisar to ask and answer the most frequently asked questions entrepreneurs have about fundraising today. You can listen to our conversation on the newest episode of KPCB’s Ventured podcast and can read an edited version of the transcript below.
What’s the best time to raise money? Is there a way to time fundraising correctly?
RK: The old adage is the best time to raise money is when you don’t need it. The best time to raise money is usually before the product is placed into the marketplace, where you can tap and elevate the expectations of the marketplace ahead of results. The best time to raise money is before you have to increase your burn rate significantly and cut down on your runway.
EF: Two other adages that I’ll add and throw in the pile are “the best entrepreneurs are always raising money, yet never raising money.” And another one: “You ask for money, you get advice; you ask for advice, you get money.” I think both of these really point to the fact that effective fundraising is not transactional. It’s this continuous process that takes far longer then you have planned for, but if you think about it that way you’ll be better prepared to have successful fundraises.
What does the funding climate look like today and what are the implications for entrepreneurs looking to raise? Is it a good time to be raising money or starting a company?
RK: There is a slowdown. People aren’t as frenzied about investing as they were, say a year or two ago. Today I think people are more comfortable stretching out their due diligence and relationships pre funding with companies. They are more comfortable losing deals if they can’t get to a valuation that makes sense for them. So valuations are clearly coming down at all levels, from what they would have been a year or two ago.
This is not necessarily the best time to build a company if you need a lot of capital. If you’re going to need a lot of capital, you’re going to need high valuations in order to prevent soul killing dilution down the road. This is a hard time to build a hardware company as a result.
What milestones does an entrepreneur need to hit after raising each round of capital?
EF: The A round is about achieving product market fit and traction. The B round is about achieving revenue at scale. The C round is about profitability and unit economics. It’s really hard to raise rounds ahead of reaching those milestones. Those are the key inflection points everyone needs to be cognizant of when going after different rounds of funding.
How much capital should entrepreneurs raise at a given time? Do entrepreneurs need to raise more than they think they need? Is there such thing as raising too much money?
EF: I would advise entrepreneurs to reverse engineer the end state. As a rough rule of thumb, each funding milestone should last two years. One full year to put heads down on building the business and then pick up your heads to fundraise with the intent of closing six months after. That way, you’re never within six months of being out of cash.
RK: I think there’s a big danger in raising too much money in many companies, particularly seed stage companies, because it allows the entrepreneur to ignore the market feedback and continue to believe what they want to believe for too long. I’m a big fan of raising only enough money to get through the core risk reduction in that round, whether it’s product market fit or proof of revenues. Then add something like six months onto that runway for each one of those rounds to account for uncertainties.
EF: There are two dangerous stages where having too much capital can actually be a detriment to the company. The first is before a company finds product market fit because it takes off the sense of urgency. You can ignore market feedback. You can chase the wrong opportunities because you have just too many resources. It leaves you unfocused.
The second is when you are at max revenue growth, but don’t yet have good unit economics because you can get in the trap of continuing to burn your excess capital to fund for the revenue growth whereas if you had more constrained capital, you would start to think about converting that revenue growth to actual unit economic growth.
RK: The reason this feels so much like a bubble is because there are so many companies out there who continue to invest in user growth who haven’t proven unit economics or certainly haven’t proven that they can build unit economics off of a contained infrastructure and ultimately be profitable.
In this environment, you’ve got to pull back from growth until you’ve got good unit economics that justify that growth.
How do entrepreneurs raise money quickly without distracting their teams from building product?
RK: If you’re a CEO in a pre-cash flow positive company, assume that half of your job is raising money all the time. Do not consider that to be a distraction. You need to protect your team as best possible, but understand that when raising a round of capital, product leadership, sales leadership, operational leadership, and financial leadership need to be in the room with you.
EF: Three strategies that might help:
1. Try to quarantine the fundraising process so only key stakeholders in your company bear the brunt of it.
2. Always be prepared for fundraising by understanding your own business. Prepare your own financial models, growth models, and marketing plans. This is just good business hygiene and will expedite the process.
3. Optimize for success. There’s probably always a better term sheet somewhere out there and you can look forever for that, but at some point, you need to optimize for success. Don’t optimize for dilution, cash in, brand firm or partner. Optimize for success. That’s the key metric.
What are some tips for entrepreneurs on how to evaluate their potential investors?
ERIC: It’s about chemistry with the sponsoring partner and the firms with those term sheets. It’s less about the actual dollars and cents of the term sheet. If you’re optimizing for success, the price of that financing event is a single discrete moment of time. Your relationship with the partner, your board, and the firm is a lifelong relationship, something that’s really important to remember.
RK: All things being equal, choose the partner and not the firm. Who do you want to navigate trouble with? I use my own threshold for determining what entrepreneur I want to invest in by asking how I would feel if they called me 11 o’clock at night on a Sunday with a critical emergency, do I want to take the call or do I want to simply skip it and pick up in the morning? If I don’t want to pick up at 11 o’clock on a Sunday night, it’s probably the wrong entrepreneur for me.
How can entrepreneurs protect themselves and their teams from equity dilution when raising money at the early stage?
EF: It’s math. It’s a function of two numbers: the amount you raise and the valuation of the company. So if dilution is a sensitive issue, you need either a larger denominator which is the value of the company and you can get that through potentially proving out more before. Or you can take less money to decrease the numerator.
But again, being obsessed about dilution I think is the wrong thing to obsess about. You should, optimize for success.
RK: The venture business is built around the notion of an expanded pie, not the size of the slice and that’s how an entrepreneur should think about it as well. Entrepreneurs and investors should be asking what’s the biggest pie I can bake and not asking about protecting a slice. Frankly when I talk to an entrepreneur who seems obsessed with protecting their slice, I wonder whether they have the ambition to build as big a pie as I do?
For a new start-up, what would be an acceptable equity percentage given to a VC, let’s say for a series A fundraising?
RK: When looking at the amount of capital we invest in a company, we evaluate a couple things. Number one is, if we don’t own enough of the company, it’s not worth our while as a firm to apply our resources and our network to that company. So there’s a minimum threshold of ownership. The second is how much capital are we going to need in the long term and what’s that stack going to look like on top of us?
If you take a look at my portfolio, the smallest ownership I have taken in an early-stage company has been 20 percent. The highest has been 50 percent, as an incubation.
EF: Another factor too is, how much time the firm and the partner will be spending on it? There needs to be commensurate ownership levels to justify that time. In a seed stage round, you may not be spending that much daily time or weekly time with the company and therefore it’s a smaller ownership requirement on the way in with a smaller check size as well.
The A round is very heavy lifting in the form of creating a board, setting up governance, actually helping the company build, operate, and execute, therefore there’s a strong ownership requirement in the A.
In the B, it can be highly variable. Often the B will take a board seat and therefore be very involved and therefore might have higher ownership requirements. But sometimes the B is a very passive investor. Same with the C, D and subsequent rounds, so you could also factor in the time involvement with the firm as a lens which to judge dilution and ownership.
What types of investors should entrepreneurs target at various stages?
RK: Venture capital accounts for less than 2 percent of all investments and start-ups in the United States. It does account for a disproportionate 20 percent of the value created in these start-ups which goes to show the value of institutional investors or at least the filter of institutional investors. Probably 20 percent of the time that I meet with an entrepreneur, I encourage them to think about something other than venture capital. Because the thing to realize when you take a venture capitalist money, you have committed to providing a liquidity event to those investors. You have now put yourself on a track where it is your job as an entrepreneur to find either an acquirer for that company or get into the public markets and be able to deliver value to those shareholders and their LPs. That’s your commitment.
EF: There are tons of different places that you can find capital these days as an entrepreneur. In the venture institutional world, our goal is not to be the cheapest form of that capital. Our goal is to be the most valuable form of that capital. So if you’re looking for cheap capital, I definitely encourage entrepreneurs to find other sources of that, loans, debt, friends and family, different structures, but hopefully if you’re looking for the most valuable form of that capital, VC is the best option.
What are your thoughts on strategic investors?
RK: I like strategic investors, at the right time. The problem is that if you bring in strategic investor too early while the company is still formative, the expectations have a tendency to become misaligned. The reason is that while the company is out there experimenting, trying to find its way, the strategic investor has already invested based upon a strategy that is inherent to their [corporate] company.
And given the amount of uncertainty at the entrepreneurial level, to lock and load that relationship at that stage is usually a cause for disaster. At a later stage when the company has proven out its product, its market, its revenue model and is simply executing against a very well defined plan, the strategic investor can feel confident that what they see is what the entrepreneur is going to do.
Prior to that time, there is always a very significant risk that these two directions fall out of alignment.
EF: There’s two words, it’s ‘strategic’ and ‘investing’ and you can never lose sight of that strategic part. So I think a litmus test is always just to say if we took the dollars out of it, is there a deal that we would want to do with this company? Is there some partnership that we could strike? And if you can’t answer that, then it may not be the right thing to do here, you may just be collecting a logo that’s actually complicating your business, not helping it.
Many entrepreneurs worry about sharing too much information too early on with their potential investors. How should entrepreneurs think about confidentiality while raising money?
EF: In the investment game, our biggest currency is not our check size, it’s our reputation. So, we always put the entrepreneur’s interest first. As a general rule of thumb, there’s good hygiene that you should have in terms of data practices and data retention and making sure you’re being responsible. But I think entrepreneurs should start from a position of trust and make exceptions to that position of trust as opposed to coming in with a position of distrust.
RK: Most of the top tier venture capitalists won’t sign an NDA. If somebody comes in and insists on us signing an NDA, I wonder if their idea is good enough for me to invest in, because if my knowing the idea suddenly undermines their opportunity, that doesn’t sound like a very good business to me. There better be a whole bunch of proprietary and execution opportunity for them to create a competitive advantage beyond simply the idea itself.
I do advise my companies to be careful with their most important information. Meaning, until you’re at the latest stages with a venture capitalist, I would keep my most sensitive information close to my vest and give it out carefully.
Should entrepreneurs come into a fundraising meeting asking for a specific valuation?
EF: Transparency is the right starting point for these types of discussions. People lose sight of the fact that it’s not a negotiation. It’s not this one off transaction where, “Oh man, I got a great deal on this car. I’m never going to see the buyer again. I won that round.” If you stop thinking about things transactionally, you can demystify that number. A great financing has two winners: the investor and the entrepreneur. Be direct, be transparent, have a discussion.
RK: What you really want to do is, like selling a home, price it low and have it bid up. I usually ask my entrepreneurs how much capital we need to create the next great inflexion in this business? What dilution are they willing to accept today, to get that amount of capital? Then I ask them another question; if I could grow it faster in that same time period with more capital, what would that number be and what dilution are they willing to take for that? And suddenly, the discussion with an investor turns out to be different than simply a number. It says, I need between $15 million and $25 million in this business, $15M grows it to X, $25M grows it to Y, I’m willing to accept between 12% dilution at X, and 18% at Y. Now, what you haven’t told them is the price, but you’ve given them a target and they can now play with the variables in their head. You know their expectations are in a range. The investors can begin to think about their modelling of the opportunity and then you can begin to converge.
We talked a lot about successful fundraising, but what if fundraising efforts don’t result in an investment? What are some alternative options?
RK: It’s important to look at what variables you can control in this process. You can start the process early, cast a broader net, signal for a lower valuation to see if that gets people intrigued, so you can maximize your opportunity for raising capital. But if you’re finding a cold shoulder to all of that, look at the alternative of what it will take to continue to stay in business and remove risk to become more attractive to investors later on. Look at your various buckets of expenses in the company and focus on the two or three things you need to prove in order to get around the corner and raise the next capital.
I believe an entrepreneur sometimes needs to think about the strategy of going backwards to go forwards. If you believe strongly in your vision, shrinking back to the essential business that allows you to remove the white hot risk while living on the capital you’ve got, or raising less capital, you may be able to raise potentially much less capital on convertible debt and build value methodically before fund raising. You might be able to secure funding from a strategic or a customer, financing the business off of services. This is always dangerous because once you start taking service revenues, you can become dependent on it, deviating from your core strategy. But if that’s what you have to do, it’s a way to keep afloat and fight another day.
You also need to look at the possibility of acquisition. Entrepreneurs need to think in markets like today that potentially giving up control in order to be able to continue to invest in their mission, or product or vision is not a failure. It’s just a different strategy.
How should entrepreneurs think about raising a down round if that’s their only option?
RK: I do not think a down round is a terrible thing. There’s a stigma attached to it just like there was some halo attached to being a unicorn. I think that they’re counterpoints of the same problem which is people focusing too much on valuation and not enough on success. By and large, down rounds reflect down markets and just like Apple has its good days and its bad days, a start-up will have its good times and its bad times.
What is your best piece of advice for entrepreneurs about to raise a round?
EF: Fundraising is a mile-post, not a milestone, on your much more important journey of building a great company, so have that perspective in mind. It is a moment in time. It is not the end goal. It is not what you’re setting out to do. It’s not why you started the company, but it is an important enabling event that happens. Never lose sight of the overall journey that you’re on.
RK: Pick the partner that you believe is going to help you be your best you and this business be its biggest and best business. Pick a partner that you’re going to be able to work through tough times with and whose advice and counsel you trust. If you can get that person on board, think about that as hiring talent, not accepting an investor.