The Round Equation and 5 tips to optimise it — Part I
A couple of weeks ago at #DSLive3 we were lucky enough to pin down the Who’s Who of European pre-seed, Reshma Sohoni (co-founder of Seedcamp), Saul Klein (co-founder of LocalGlobe) and Christoph Janz (co-founder of Point 9), to discuss everything pre-seed and open the investor kimono. We are forever grateful for their generosity — giving us their time and sharing, no-filter, all their learnings from many years at the forefront of the European (pre)-seed market.
Fundraising, especially for the first time, can feel daunting. Let alone finding and getting in touch with the relevant investors, but even once you manage, what are the right questions you should be asking yourself as a founder building a round?: what should I optimise for as I build the round? what investors should I go for? why this one over the other? both? what about angels? what KPIs should I be looking into to decide? and where do I find that information? what round size? and structure? and valuation?
Inspired by our discussion with Reshma, Saul and Christoph, we have come up with 5 tips on hacking your first round of funding. Disclaimer: it includes some musings of our own, so credit to Reshma, Saul and Christoph for everything you find useful, blame us for the rest. Also, see link here to listen to the full panel, it is definitely worth it! And thank you as well to all the founders we’ve worked with, as a lot of these learnings, we have learned together.
General framework: The Round Equation
When you raise a round, you should think about it as solving for the following equation: money + value-add = dilution (+ economic/political rights). I call it The Round Equation and you should run it for the round as a whole but also for each investor individually, especially as you decide which ones to bring on board and which ones to leave out.
a. what you get: money + value-add.
b. what you pay for what you get: dilution, i.e. the price you are paying for the money and value-add that investors will bring to your business, measured as the percentage of your company you give away. Most likely you will also be giving away certain economic and political rights and that is part of the price you are paying as well. But that is to be considered on a later stage of the round, when you negotiate the legals.
As you build the round, you want to optimise for The Round Equation: money + value-add = dilution by
- maximising money and value-add for each percentage point of dilution. Every dollar you bring onboard has a cost in terms of dilution and every investor you add has an opportunity cost in terms of simplicity of your captable — think of your captable as very scarce and expensive real estate. So, you need to be ruthless evaluating the value-add each investor brings to you, as it really needs to make up for the cost. Today we will be focusing on tips to optimise for this side of the equation.
- minimizing dilution: pay less for the money+value-add you get. Up to a limit that makes sense for you (highest valuation is not always the answer) and the investor (many institutional investors need a minimum stake). This is the topic for a whole other post but just remember that building the round is about optimising The Round Equation and dilution is only one side of it.
Let’s get on with some tips on how the system works and a framework on how to hack it to optimise money+value-add, inspired by our discussion with Reshma, Saul and Christoph. Ah! And remember — we’ve come up with The Round Equation but building a round is an art, more than a science. Ultimately, as you build a round and choose the best partners, you are making a people decision. If you are interested in the human aspect of finding/choosing investors, I wrote a bit more about that here.
Tip #1 [money]: Raise enough money to have minimum 18–24 months runway
Long runway will give you the best chances of success— the possibility of hiring the best talent, of moving faster when things go well, but also more bandwidth to test and make mistakes, to iterate.
If things go very well, you will be in the market sooner and without having spent all of the money. But there’s little downside to that when compared to having to go back to the market because you are running out of money before having hit the milestones. And you want to partner with investors that understand all of this. So, shy away of investors that recommend smaller round sizes that will give you runway of less than 18 months.
Then, if given the option, is the answer to raise the most money? This takes us to the dilution/valuation part of The Round Equation — I will focus on this for the next post. But here’s a little snippet: ‘too large’ round is not always the answer either. If you raise too much money on your first round, you might i) be paying too much dilution for it (not ideal); ii) if dilution remains stable, valuation (= size of the round/total dilution) might be too high, and that can also bring along challenges when raising the next round.
Rule of thumb: set the round size thinking of business needs. Do not raise less than 18–24 months runway, for anything above 30 months, it is about balance and common sense. And if you are a deeptech business, or building a patentable IP, you should consider an even longer runway, as it takes more time to scale and come into revenue.
#Tip 2 [value-add]: For institutional investors, look for skin in the game
Angels invest part of their own assets, so their tickets generally denote high skin in the game. But when looking at institutional funds, assessing skin in the game is key. How much do they have at stake in your company? And relative to other companies in their portfolio? That’s an indication of both their conviction now and their willingness to work hard for you in the future.
Two ways to approximate skin in the game:
a. the ‘at stake ratio’ = size of the ticket/ size of the fund. Different funds have different sizes and the same ticket can mean very different skin in the game. If you’re a $20m seed fund, and you’re writing a check for $2 million (10% ‘at stake’), that’s a high-skin-in-the-game check. If you are a $200m series a fund, and you’re writing a check for $2 million (1% ‘at stake’), that’s a medium-skin-in-the-game check. If you’re a $2bn hedge fund, a $2 million ticket (0.1% ‘at stake’) is a rounding error for you. You can find the size of most funds in crunchbase, or you can ask the investor directly.
It is also relevant to benchmark the ‘at stake ratio’ the investor would have in your company relative to the ‘at stake ratio’ they have in other companies of their portfolio. If they typically invest tickets that are <5% of their fund, >5% of their fund in you is high skin in the game; and the other way around.
This is all important because if I have 10% of my fund invested in a company, I’m going to naturally devote more time and resources to supporting this company than if I have only 0.1% of the fund at stake.
b. how much stake they own in your company. Simplifying a lot but it is important to understand how the math works and why stake is important for funds. Let’s assume I’m a $100m seed fund, when I invest into a company, I will generally look to get $100m at exit (this is what we call a ‘fund returner’). If I own 10% of the stake at exit, post dilution, in order for me to get $100m in returns the company will have to exit at $1bn. But if at exit I only own 1% of the company, the company will need to exit at $10bn, which is less likely.
That’s why investors will be naturally more prone to dedicate time and resources to those companies where they hold a higher stake, as those have a higher chance to be fund returners.
Last but not least, we can try to quantify skin in the game, but ultimately it is also your job to make your investors accountable for it. You should build a relationship that makes your investors not only financially but also emotionally invested in your company’s success.
Tip #3 [value-add]: For the lead investor, DD the conversion rate from seed to Series A
A big part of the value-add an investor can bring, particularly the lead, is to help you raise a new round. Some ideas on how and where to test that they are best positioned to do so:
- conversion rate from seed to Series A: as a benchmark, in Europe, conversion rate from seed to Series A it is at 17%. Hence, investors with a seed portfolio with a higher conversion rate than the market have a big plus, and the higher the better.
- do they follow-on: it is important to understand if your lead investor plans on investing their pro-rata in your next round. Some do, some don’t, but it is important to manage expectations, also from the market. If your lead investor usually follows on and they don’t in your case, signalling to the rest of the market can be tricky.
- who are the investors in the next round: there are plenty of databases where you can download information on the investments of the investors you are talking to (crunchbase, pitchbook, dealroom — they are mostly subscription based but you can find somebody with access). You can take a look at what happened to their investments after they invested and who were the lead investors in the next rounds.
- reference the investor with those companies that took longer or didn’t manage to raise: value-add is evermore important, and telling, when things are not going upwards and onwards. Reference how the investors behaved in those cases, because this is a journey of ups and downs.
Tip #4 [value-add]: Assign investors specific jobs
When you look to quantify the value-add of each investor, think about specific asks each of them could help you with and how much that could be worth for you. Be very clear on what you want from them and put them to work (even before they invest ;)). Options here are infinite, but some ideas on how to think about it:
- network: look at their network and how willing they are to open it up to you. Be specific on what each investor’s network can be useful for and what that is worth — access to talent, intros to potential clients (check their portfolio and their professional connections), intros to investors for next round, open up geographies you want to go after, etc.
- expertise: look at their background and their availability (don’t forget the latter) and figure if they can support with product, growth…and what that is worth for you.
- EQ: is there anybody you trust, an independent advisor with an understanding of the business but not involved on the day-to-day — a sounding board.
This is a controversial topic but I feel very strongly about not giving equity to anybody who doesn’t invest money in your company. In my view, both money and value-add are necessary conditions but neither is sufficient on its own. You have to be ruthless with every percentage of your company you give away and you want to have investors who i) want to invest money and ii) therefore will work hard to add value and earn the privilege to invest.
Tip #5 [value-add]: Ultimately, prioritise personal fit
Getting an investor into your captable is like having a baby with somebody — it is more difficult to kick out an investor from your captable than it is to divorce somebody. So, assume that for the rest of the life of the company, you are tied up to every investor in your captable.
And there will be periods in which you will speak to some of these investors, especially your lead, far more than you speak to the actual mother or father of your kids. So you have to like working with them and like them as humans. This is a lot about personal connection, little science and a lot of human nature — with some people you glue, with others you don’t. You have to glue with your investors. And even when you do glue, in every interaction with them during DD, always ask yourself — is this the person I’ll run to message at 1am, to celebrate the wins? and when s*it hits the fan (because it will happen)? is this the person who will have my back then?
In this fast-moving world, it might seem like for many success arrives spontaneously and fast. And there seems to be this pressure on founders to always be growing and flying. But this is far from reality — today UiPath is a $42bn market cap European darling but at the panel we discussed how difficult the first 4–5 years were. A startup is a 10–15 year journey and you want to choose the best partners, who will hustle with you, celebrate with you and stay by your side for better or worse.
And in that choice, there’s a bit of science and a lot of art. There’s no single right answer for everybody but we hope this post gave you a framework, tools to quantify and tips to navigate the process of building a round more confidently. If you have questions or experiences about raising your first round and you’d want to share, please get in touch! We are also learning every day how to become the best investors for you.
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