Fundraising: The Dangerous Games Startups Play

What’s a startup to do?!!?

Entrepreneurs live in a new age where the lowered costs for development and marketing (theoretically) mean that a company can be launched without having to take traditional venture capital financing.

For entrepreneurs this seems great because they can keep more of the company, rather than needing to sacrifice a big hunk of equity in exchange for a million bucks. However, this also means that many startups have begun to play dangerous games. In particular, many a young startup is seeking an angel(s) to provide a seed round, more akin to a bridge loan, that will see them to a Series A. The idea being that during a Series A, the valuation with have doubled or tripled and the amount of equity that will be given up will be at a considerably better valuation than if the same amount of money had been taken during at the seed round.

There are a few things to consider:

The economy. This ability for startups to acquire a bridge loan getting them to a Series A is most effective during a strong economy.  How so? If you only raise $300,000 and the economy caters you’re in double trouble. You’re stuck with a minimal amount of money and the prospect of a) a tougher/longer lag time needed to close the next round and b) face prospect of having to accept a lower than expected valuation.

Competitive Landscape: A startup hoping to get ‘just enough’ money to bridge them to a Series A also runs the risk that the competitive landscape might change during that time. I’ve been told that the minimum amount of time need to close a Series A is 120 days. Three months. More likely thought it will take a company six months. If during that time a better funded, or higher profile competitor launches a similar product, what will that mean for the Series A? It means it’s going to take a lot longer, which means more money will be needed.

Whacky Valuation Principle. Although it is a dangerous game for the reasons suggested above (due to the economy and competitive landscape threats) risk-taking startups do stand to benefit from the whacky valuation principle (I’m making this term up). Whacky valuation principle is the idea that raising a small amount of money, or taking a small amount of money from ‘smart money’ will double or triple a startup’s valuation for really no good reason. Yes, raising even a small amount of capital is business model justification, but really it changes nothing intrinsically. Bottom line, why raise $1M on a valuation of $2M when by raising $250,000 your valuation is likely to jump to $5M overnight?

Convertible Note Loans. Thanks to Charles River Ventures (Quickstart Program), these have become all the rage. Many VCs are now willing to provide convertible note loans under $400,000k – what VC’s call ‘playing around the rim.’ However, it’s important to note that these firms often charge interest on a monthly basis. In some cases the interest is so high that such financing should be viewed as equity and not debt. Don’t believe me? (thanks to our CFO for help on these calculations).

Example 1: ASSUME that company X is worth $3 million today. If it raises $300,000 from VC A they would give away 10% of the company.

Now ASSUME that company X takes $300,000 from VC A as a convertible note loan at 5% per month.

ASSUME that company X raises a Series A in 12 months. After the 12 months they owe VC A 60% more (or $180,000). So if company X has not increased in value by $1,800,000 they will have to sell more than 10% of the company. (If company X is worth $4,800,000 they sell 10% of the company and raise $ 480,000 and pay back VC A). CONCLUSION: Company X has to grow a lot in value to pay off VC A.

Example 2: Assume everything the same except company X has the Series A round in 6 months. Now company X owes VC A $390,000. Thus company X has to be worth at least $3,900,000 in order for them to pay VC A off with only selling 10% of the company — Maybe the whacky valuation principle takes care of this worry :)

Level of Involvement. If a VC does decide to do the type of deal mentioned above, it’s important that entrepreneurs understand that the VC’s involvement will be limited. A VC can’t afford to spend time with a company that it has so little invested in. This is a good reason why taking money from an Angel (who might only have a couple of investments and to whom $300k likely means a lot more since it’s personal money) might in fact be better than a VC. In theory having the VC be hands-off is good, but in reality, the more time they spend with (or at least thinking of you), the better.

Credibility/Distribution. On the plus side for VC firms, getting in with the right high-profile company can be instant credibility in the eyes of the PR and Blogger illuminati. How do you find them? Try theFunded for starters. Such credibility goes a long way since possible the biggest concern for any new startup is in fact not funding, but distribution.

Conclusion: In my opinion, the best situation for a startup right now is to find at least one well-known angel and supplement him/her with either a convertible note loan, or money from dumb angels. Having at least one smart money person is key to making introductions and for the person’s experience hopefully in the space. Yes, dumb money supplemented by having a smart advisory board, but it’s not the same. You want your most influential supporters hugely incentivized to help you succeed. Also based on the concerns of folks I’ve talked to in the Valley and here in New York, looking for a minimum of $500k bridge money seems like the safe bet in these ominous economic times.

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