For a startup company, serious interest from a venture capital (VC) firm is a big deal that's worth celebrating. Founders shouldn't pop the cork on the champagne too soon, however. VC money can be a mixed blessing if you haven't done your homework and crunched the numbers to make sure you're ready for this volume of investment. Studying all the important variables before accepting money is one key to a successful startup company.
Investment and Dilution Aren't Everything
The most common and potentially devastating mistake founders make when dealing with venture capital is only paying attention to two variables: the value of the investment (the "raise") and dilution of ownership. It's easy to see why startups make this mistake — the dollar figure offered up by a VC firm represents a growth opportunity for a young business. Dilution represents the cost of the growth opportunity in terms of ownership stake lost. Many entrepreneurs look at term sheets and conclude that the best deal must be the one with the largest cash infusion for the lowest rate of dilution.
Unfortunately, it's not that simple. (If the paragraph above didn't seem simple at all, read Matt Nunogawa's Venture Capital Math 101 to get up to speed!) Dilution isn't the only price tag attached to money from venture capital firms — founders also have to consider the high price of elevated expectations.
Why Post-Money Evaluation Matters
There is a third important variable that founders have to evaluate before taking venture money: post-money valuation (check out this handy explanation from Forbes). In the abstract, post-money valuation is the pre-money value of the company plus the value of the new investment. If a business is worth $5 million on paper and a VC firm writes a check for $8 million, the post-money valuation is $13 million. This calculation can get more complicated, but that example outlines the basic idea. Post-money valuation is a potentially make-or-break number that much be considered.
The reason the number is so important is that all future investment in a start-up company will be predicated on the post-money valuation. If that number is $13 million, the business had better be worth $13 million the next time it seeks out funding. Otherwise, the company is hemorrhaging money — the post-money value of shares will have declined when compared to the pre-money valuation. As venture capitalist Albert Wenger writes in a recent blog post for AVC,
"...You can get caught in this trap in two different scenarios. The first one is that you hit a bump in the road. Users or revenues or whatever the most relevant metric for your business wind up not growing as fast as you think or worse yet hitting a temporary plateau, possibly even a small setback just as you need to raise more money. The second one is that the external financing environment adjusts for instance because the stock market drops 20%. Then even if you hit all your milestones, suddenly that may no longer let you clear the hurdle you set for yourself."
Basically, taking a huge chunk of money, even if it doesn't require extra dilution, can set an emerging enterprise up for failure by raising expectations beyond reasonable levels. Of course, if a business takes $8 million in venture capital funding and immediately dominates a lucrative corner of the market, it should be able to reach profitability quickly. In that scenario, post-money valuation doesn't matter very much. But of course, that scenario isn't very likely. More likely, the business will grow significantly but, a few years down the line, need another infusion of cash to scale up. When this happens, post-money valuation is critical.
How to Avoid the Post-Money Trap
The most important lesson for avoiding the post-money trap? Don't bite off more than you can chew.
Entrepreneurs tend to be risk-takers who believe in themselves and their ideas, but that self-confidence can be a liability as well as an asset. Founders have to recognize the limitations of their companies — double digit annual growth isn't sustainable for most companies in most business environments. Even worse, the pressure to accelerate growth can lead to poor business decisions. Think long and hard about what makes the most sense for your company, your industry, and how you're going to spend that money to fuel your growth.
How do you balance the excitement of investment with maintaining reasonable expectations for the future? Share you strategy with us @SparkLabKC!