The math behind startup fundraising

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Figuring out how much money your company should raise is a complicated process at best; at worst, it can be downright confusing. After all, fundraising inevitably puts founders in a Goldilocks-style conundrum-—raise too much money, and you risk over-diluting yourself; raise too little, and you risk having too few resources to successfully raise your next round. 

To figure out your fundraising sweet spot, you need to take a few key considerations into account. But before we dive into those, let’s review the two most common fundraising options  for early-stage founders: convertible instruments and priced rounds.

Common fundraising solutions

Convertible instruments

During the earliest rounds of funding—your pre-seed and seed rounds—there’s a good chance you’ll be fundraising using a convertible instrument. Most commonly, there are two popular types: convertible notes and SAFEs

A convertible note is a form of debt that can convert into equity during a future qualifying event or transaction. A SAFE, which stands for Simple Agreement for Future Equity, is a warrant that can convert into equity during a future priced round. 

Both convertible notes and SAFEs give you the option to fundraise without conducting a formal valuation of your company (i.e., you can raise funds without having to put a price on your stock yet). 

Here’s how they work: interested investors give you money during your seed round, and in exchange, you’ll issue those investors a contract  promising them shares of stock in your company at a later date. 

To protect the investors’ money, convertible notes and SAFEs typically include a valuation cap. We’ve written plenty about valuation caps in our Founder Resource Center, but high-level, just know that the cap effectively gives early investors a cheaper price on your company’s stock compared to investors who come onboard later on. 

Priced rounds

Typically, once your company has matured beyond the seed stage, you’ll begin raising via priced rounds. A priced round is an equity investment based on a valuation of your company. After your seed round, you’ll gear up for your Series A round. Unlike with a SAFE or note, where investors have to wait before purchasing shares of stock, investors in a priced round receive preferred stock immediately in exchange for their money. The stock is set at the price per share determined by the company valuation. 

How much capital should you raise?

Now that you have a better idea of the fundraising methods you’ll use in your first round or two, it’s time for the big question: how much money should you raise? The exact dollar amount depends on a handful of important factors, including your company’s current stage and projected trajectory. 

While determining your fundraising target can be more of an art than a science, there are certain strategies you can use to arrive at a number you feel confident in. Here are the two main factors you’ll typically need to evaluate: 

Your company milestones

Milestones are the specific benchmarks you want to hit on the way to reaching your broader company goals. Most milestones are quantifiable achievements that indicate where your company is at growth-wise. Think: launching your minimal viable product (MVP) within 12 months or securing your first 1,000 customers by a certain date. 

When contemplating your most important milestones for fundraising, there are two underlying questions you may want to ask yourself: 

  1. Where do you want your company to be by the time you reach the next stage of fundraising? 
  2. What specific  metrics do you need to show in order to get there? 

For each milestone, consider the following components: 

  • Resources: What will it take to reach the milestone? Whose specific talents and skills will you need? What kind of tools will you rely on? 
  • Time: How many months or years will it take to reach the milestone? 
  • Costs: How much money will you need to reach the milestone? 

Let’s go through an example.

Imagine you’re about to raise your seed round of funding. You have a prototype of your SaaS product; in order to make it to Series A, you want to launch a commercial version sometime during the next calendar year. This is your first major milestone.

This means you need to accomplish three key things: create an MVP, conduct beta tests, and push a product to market that attracts an initial batch of customers.

To accomplish  all of that, you determine you’ll need four engineers, one marketing expert, and a suite of tech products and tools. With all five team members working full-time, you estimate it will take about 18 months to reach your milestone. 

Accounting for tools, equipment, labor, time, and unexpected issues that might pop up, you figure it will cost about $20,000 per person per month to reach your milestone. This puts your total seed fundraising needs at $1.8 million. 

That’s the amount of money you need to raise to successfully reach your milestone by the time you get to your Series A round of fundraising. It’s a great start! However, it’s only the first part of the equation. Once you know how much money you need to raise, you’ll now be faced with a second question:

What should your valuation (or valuation cap) be? 

In its simplest form, a valuation is an assessment of your company’s worth. Valuations aren’t based solely on your company’s metrics, though. They’re also based on your fundraising needs, your track record as a founder, your company’s growth potential, and your competitors’ valuations. Valuations—and valuation caps, for that matter—are important because they directly affect your dilution (aka: how much equity you retain as a founder). 

How? Let’s break it down by first addressing the concept of dilution

How dilution works

When you raise money for your company, you invite investors to take a portion of your company’s equity. Imagine, for example, that there are 10 million shares of your fledgling company. You and your co-founder each have five million shares, meaning you each own 50% of the company. 

When you bring investors in, however, you create five million new shares for them, which puts your total company shares at 15 million. You and your co-founder still own five million shares each, but you no longer own 50% of the company. The additional five million shares you added dilutes your ownership percentage down to roughly 33%. This is how dilution works: the number of shares you own stays constant, but the percentage of the company you own decreases as new shares are created.

Where valuations come in

Valuations and valuation caps dictate the price per share of your company stock. Typically, your dilution as a founder will depend on the amount of money you raise combined with the valuation you set.

Let’s say, for example, that you need to raise $1 million in your Series A. Assuming you’re comfortable giving up 20% of your company in equity (a common percentage for this stage), you would need to set your valuation at $5 million. This is because $1 million (from your investors) should equate to 20% of the whole company. Doing the math, this means your whole company should be worth $5 million. 

Typically, when raising funds it’s helpful to simply set a maximum and minimum valuation; that way, you have room to be flexible when negotiating with investors. Ultimately, you want your valuation (or valuation cap) to let you raise enough money to meet your goals while still maintaining a reasonable percentage of equity. 

A common fundraising pitfall to watch out for

Fundraising can be exciting, especially when you begin to receive offers. But if you’re over-eager, you risk moving too fast and setting yourself up for excessive dilution. 

Let’s say, for example, that you want to raise $1 million on a $5 million valuation, which means you plan to give up 20% of your company’s equity. Before you know it, though, you have a handful of interested investors offering you a total of $4 million instead of $1 million. 

This may seem like a positive turn of events, but in fundraising, more money isn’t always better. If investors are offering you $4 million but your valuation stays at $5 million, you’ll end up handing over a whopping 80% of your company’s equity to investors. 

In order to prevent that from happening, let’s say you decide to negotiate a higher company valuation—to the tune of $20 million. That means you get to take $4 million instead of the original $1 million you were expecting, but you still only have to give up 20% of your equity as a founder. Win-win, right? 

Not exactly. If you value your company at $20 million during your Series A, then your Series B investors are going to assume your company is worth more than $20 million when the Series B round begins. If you don’t have the metrics to demonstrate that your company has increased that much in value during that period of time, investors will likely be turned off, and you might struggle to raise a Series B.

Raising just the right amount

There’s no perfect solution for determining the right fundraising target or valuation. However, the prevailing wisdom, especially in the early stages, is that you should figure out how much you need to raise to meet your milestones and maintain your ownership percentage—then stick to that.

At Carta, we help startups with fundraising, compensation, valuations, equity management and much more. Talk to us to find out how we can help you grow.

DISCLOSURE: This communication is on behalf of eShares Inc., d/b/a Carta Inc. (“Carta”). This communication is for informational purposes only, and contains general information only. Carta is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult a qualified professional advisor. This communication is not intended as a recommendation, offer or solicitation for the purchase or sale of any security. Carta does not assume any liability for reliance on the information provided herein. ©2021 eShares Inc., d/b/a Carta Inc. (“Carta”). All rights reserved. Reproduction prohibited.

 

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