By Matthew Cushen
Whenever an entrepreneur raises equity funding they of course should be thinking about the equity they give away. But most think about holding on to equity in the funding round that is straight in front of them, when it is just as important to think about at least the next and ideally a couple of rounds.
Take these two scenarios…
In scenario B the additional funding has given the team extra ‘runway’ – the amount of time they have before they need to raise again. With this additional runway they have achieved more, so they have been able to justify a higher valuation in the second round and have maintained that momentum again in the third round.
In both scenarios the same overall level of funding is received across three rounds, but in scenario A a smaller amount in round 1 and a larger amount in round 2 than in scenario B.
Overall, they have ended up after three rounds giving away a smaller share of their business. Furthermore, when the post-money valuation of the business is taken into account, their equity is worth much more after scenario B than in scenario A.
The way to bump up the valuation is to have some good ‘proof points’ some evidence of what the business has achieved and evidence that the assumptions in the business plan might actually not be too wide of the mark. Gaining good proof points usually comes down to 3 things:
The flip side is when a business has either not raised enough, have invested unwisely or have not driven the business hard enough and they run out of cash before they have proven much. An investor can smell two things very easily – a business that is desperate for cash, and a business that has achieved little since the last raise. Neither of which will help the pre-money valuation an investor will be prepared to invest at. This can even result in the dreaded ‘down round’, when a valuation of a round is lower than the post money valuation of the last round. There are few businesses that have recovered momentum following a down round, and if they do it is at a high cost of diluted equity for the founders and early investors.
So whilst the figures above are conveniently made up to illustrate the point, the concepts of ‘runway’ and ‘proof points’ and the impact on subsequent rounds should be as front of mind for founders as the equity that they are giving away in the current round.