In this episode of #MatrixMoments, Tarun Davda, Managing Partner, Matrix India, talks about the important pointers that founders need to keep in mind when planning for a fundraise.
Think of fundraising as a balance between dilution and being well-capitalised. Tarun says,
“I think at the outset, like every business balances growth and profitability, fundraising also needs to be thought about as a balance between dilution and being well-capitalised. And, how much capital you need is a question that the founder first needs to spend time thinking over before they even start discussing with VCs.”
He explains, raising too little means that you are going to be in the market too often to fundraise or will run out of cash.
Tarun adds, “On the other hand raising too much comes with all sorts of issues. There’s a lack of discipline. There is too much dilution for the founding team. There is over-valuation, and one can’t justify the price to the next-round investor. So, I think the rule of thumb is, don’t raise too little, don’t raise too much.”
How much capital do you need to execute your plan for 24 months?
This is the basic rule of thumb. Assuming that it takes you anywhere between three and six months to fundraise, that’s basically giving the team enough runway for 18 to 24 months to ensure that they are able to show meaningful progress before hitting the market for the next round of fundraise.
He adds that, at the same time, it ensures that the team isn’t constantly distracted by the activity of fundraising, which does tend to happen often.
“When you look at a competitive sort of market, there are companies which operate in highly competitive dynamics where there is a huge premium for those that end up becoming the category leader. And, in such cases, obviously the competitive dynamics will inform how much you raise and when you raise. And, it’s harder to predict and say, I am going to be on this 18 to 24 month cycle of raising capital. And, at that time, very often the advice is ‘raise as much you can when you can’, essentially, see money, take money,” Tarun explains.
Understand the kind of market you are operating in
Citing an example, Tarun says, “If you are operating in a market where capital can help you scale disproportionately, I think it makes sense to raise as much capital as you are able to access because, to the point I made earlier, if you are able to use that to get category leadership, more capital will get concentrated in that company, which will most likely help the company scale even faster, and more capital then sort of chases you.”
He adds this isn’t always the case. It obviously needs to be followed up with execution. But, capital being a sort of fuel does become important. On the other hand, if you are in a market that isn’t necessarily growing fast, capital doesn’t have the network effects.
This basically means that the business model is more linear. Raising too much capital can actually cause more harm than good because your company becomes over-capitalised, investors are looking for generating IRR on the investment and start pushing you for growth, you start doing things that aren’t scalable, and this potentially starts destroying the economics of the business.
“So, raising too much in those situations can actually result in your company becoming significantly worse off. So, I think understanding what the right number is for your business is very important,” says Tarun.
Control what you can
Tarun points out that the market determines the valuation, but founders should focus on dilution, which is how much money is available at that price. What matters at the end is how large a company you are building, which is the size of the pie, he says, adding,
“But also, what percentage of that pie you own. And so, I tell this to all the founders: valuation is vanity. That number is going to keep changing with every round, but what will not change is the percentage of ownership. And, once you dilute it, it’s unlikely you are going to get back that ownership. And, so diluting too much too early on can result in various issues down the line. And so, control what you can, which is the dilution and how much money can you raise at that dilution.”
Early-stage valuations are as much art as they are science. There is no one size fits all. A lot of it is a negotiation between the investor and the founder. Today, typical seed checks in India are anywhere between $500,000 and $1.5 million or so.
Typical Series A checks continue to be in the four to seven million kind of range. Typical Series B checks are anywhere from 8 million to 20 million or 25 million even, depending on how much progress the company has been able to make. And, obviously, there are always outliers.
“If you are a repeat founder, if you are a successful founder, if you are a senior executive who’s worked at one of the successful startups, you will end up raising much more capital and the check sizes will go up. But, the numbers I have given you are more sort of the 80 percentile sort of median,” says Tarun.
He adds that dilutions have also been stabilised. Dilution at seed rounds maybe of a million dollars or so tends to be in the 15 to 20 or 25 percent kind of range. Dilution for Series A round is in the 20 to 30 percent range. And dilution for Series B rounds is again 15 to 25 percent.
“If there is a competitive dynamic to the round, it’s almost always the case that you end up raising more money for lower dilution. If, however, the fund raise has been hard and there isn’t enough interest, investors tend to have more of a say in the valuation, and the investor that is investing in your round tends to have a bigger say and likely will want to put in slightly lower amounts of capital for getting ownership at the higher end of that range. And so, that’s basically what decides valuations at the early stages. I guess the question that founders, like I said earlier, should ask themselves is how much capital is available at that dilution,” adds Tarun.
The ‘10x value’ rule of thumb
Tarun explains: “One should aim to create at least 10x value relative to the capital that you have raised. If you see the best and the most capital-efficient companies the worldover, if you take Facebook, Uber, Slack, Appdynamics — all of these companies at various points in their journey of fundraising were valued at 10x of the total capital raised prior to that round.”
So, if the company had cumulatively raised $100 million, the next round of financing after that would be at a billion dollar pre, or more. Not all companies are able to hit that.
“So, if you see a bunch of ecommerce companies in a market that is highly competitive, some of them have ended up raising at 2.5, even 3 times of the total capital raised. Now, that’s not to say that those aren’t good companies. It just means that the capital efficiency of those business models is significantly lower than what would be required to create a lot of value for early shareholders in the company. And, founders will likely need to dilute a lot more to take the company towards a large outcome,” says Tarun.
Enterprise companies, in fact, tend to be even more capital efficient. And, these are valued sometimes at 10 to 20 or 25 times of total capital raised. So, Zoom, which is a company that recently went public with an IPO, raised all of $160 million before. And, its IPO was priced at a $9-billion valuation which was 55-odd times the total capital raised.
“And so, with very minimal dilution for shareholders, the company has actually managed to create excellent value. Like I said, these are benchmarks. Not all companies will be able to hit these benchmarks. But, it kind of gives you a framework of how to think about it, because otherwise you are just shooting in the dark; you need to know how far you are from what the best companies are able to do,” says Tarun.
Aim for a 3x markup between rounds
Citing an example, Tarun asks to assume you raised your last round at $10 million pre-evaluation. You should then aim to make enough progress in the company with the capital that you raised that you can at least justify a $30 million pre-evaluation for the next round, he says.
Explaining further, Tarun says, “Obviously, the flipside is that the company needs to have made enough progress. You can’t just say, listen, I want these multiples, without having enough metrics to back it up. But again, the founder then needs to start thinking: ‘I have raised money at a $100 million valuation. If I need to now match the three-times value creation that is doing the rounds and, if my valuation that I am targeting for the next round is $300 million pre-evalution, I need to ask myself, with the capital that I have today, am I going to be able to take the company to a point where an investor will be willing to pay me 300 million?’ And so, it could be a revenue multiple, it could be GMV multiple, it could be whatever metric is used to value your company at that stage.”
He adds that working backwards is important. The ‘bottoms-up’ math has to make sense for that investor because otherwise you are not going to be able to fundraise.
“So, it’s important that when you are thinking about raising capital at that stage when you raised whatever dollars you did at the $100 million price, you have to ask yourself, how do I architect my business today such that 18 months out or 24 months out, when I go back to the market to raise capital, I can raise money at a $300-million target valuation? Have you built enough in terms of the numbers, in terms of revenue, in terms of GMV, in terms of whatever the metrics that you are focussed on, are those at a value that somebody will be able to pay you 300-million valuation?” adds Tarun.
The market your company is in
“I think whether your startup is leading industry growth is a big determinant of what multiple you can raise money at. High-growth companies and category leaders almost always get valued way higher than the number two or number three player. And we have seen that, across companies, if you are the market leader, you will end up raising capital at a much higher multiple compared to anyone else or any other company in your space,” concludes Tarun.