If you look at the history of U.S. tech companies’ IPOs in recent years, founders often end up owning (on average) 20% of their company, while employees own 20-25% of the company, leaving investors with 55-60% (Source: AVC).
On average, these companies go through 4-6 rounds of financing; in other words, founder equity is diluted on average 5x over the private life of the company.
Savvy investors know that ownership incentivizes founders to stick around, so they tend to pass on early-stage companies where founders only hold the minority shares.
If you sell too much of your equity early on, you run the risk of being unattractive to growth-stage investors. Or worse, you might end up owning nothing at the liquidity event.
For example, Pandora’s founders owned only 2% and Lyft’s founders owned 6% of their companies at IPO (Source: Blossom Street Ventures).
A framework to decide how much money to raise and when is the right time
A lot of founders get caught up in the excitement of fundraising (yes, it can be thrilling to receive so much money in the bank!) that they forget the ultimate goal of building a company is not to brag about how much money you’ve raised, but about building a product that people love to use and will pay for.
It’s crucial for founders to answer these two important questions before fundraising or entertaining a term sheet from a VC.
- How much money should I raise?
- When should I raise money?
Imagine you already had the money in the bank. You’d probably use it one of two way: on external needs to serve the customers, or on internal needs to fuel the business.
Here are examples of different ways to think about each of these two needs:
External needs to serve customers - Investments in sales and marketing
- We need $120k to scale up Facebook ads to put our brand out there
- We need to hire field sales people and will use 50% of our fund to do it
- Our Facebook ads have performed well compared to the market benchmark (average CAC is $2, 3x lower than average consumer app CAC). We have nailed down our targeting and creatives. Now we want to increase our monthly marketing budget from $1k/month to $10k/month and we expect that to increase new users by 8-10x per month.
- Our sales team has been performing well (each of our sales reps on average only takes 1 week to close a deal), but our churn rate is high. We lack resources to onboard customers and support them after. Based on customer feedback, we want to be able to hire 5 new customer success reps, who can serve our customer base over the next 12 months (and this will increase our expenses by $350k).
Internal needs to fuel product development - Hiring needs
- We need to hire mobile engineers to make mobile app
- We need to hire social media people because we are bad at it
- The top feedback we got from our customers is they wish we had an app. We implemented a light-weight no-code mobile app for the last 3 months and saw higher engagement and better monetization from our mobile customers. We think it’s time to bring a mobile web developer in-house to build our app. This will cost us $200k over the next 12 months.
- We had an intern who did a phenomenal job managing our social media page, which resulted in increased sales and organic reach. We want to bring the intern on full-time. Since she’s a fresh grad, the cost is significantly lower than hiring a social media agency. This will cost us $60k.
What’s the difference between the “bad frameworks” and the “good frameworks”?
The good frameworks outline a strategy that results in increased traction. And it’s specific. For example: number of new customers you can acquire, new annual revenue run rate, etc.
These metrics can serve as milestones for the company to hit over the next 12 - 18 months.
How to use this exercise to determine how much you should raise
In the example above, you expect your total annual expenses to go up by $730k.
At the same time, you estimate that these initiatives will also increase your revenue by $230k. So your net burn over the next 12 months will be $230k - $730k = $500k.
To provide some cushion, add about 20% to the net burn ($100k), and that should give you the amount you should aim to raise: $600k in this case.
By thinking through your fundraising goals more logically, you’ll have an easier time raising money. Raising money based on specific growing needs will reduce the risk of being overly diluted in the long run.
More importantly, the growth of your start-up will also be rooted in your strategy and core operations, instead of a superficial goal to hit to raise the next round of financing.
Remember: you are not powerless!
Last but not least, remember that as the founder you hold the ultimate negotiation power when it comes to how much money to take and which investors to allow into the round.
Some investors will pressure you into taking more money, making it sound like it’s a “take it or leave it” deal. In reality, if an investor is interested enough to offer you a term sheet, they see you as a potential unicorn, and they will not let a few hundred thousand dollars stop them from investing in you.
Building a successful company takes years of blood, sweat, tears... and multiple rounds of equity sales. Don’t sell too much equity (especially at the beginning)!
Make sure you’ll be there at the end to enjoy the fruits of your labor.
Are you raising money for your start-ups? Apply with Hustle Fund here.
Mai Ho is a venture partner at Hustle Fund, covering the Vietnam and Southeast Asia markets. Mai was born and raised in Vietnam, and later graduated college in the U.S. with a double major in Accounting and Finance. Mai has 10 years of experience working in London, Singapore, and San Francisco, from equity research at Goldman Sachs to Growth/User Acquisition in Silicon Valley. Previously, Mai co-founded and exited e-commerce marketplace BigBalo.