I honestly think the idea that $5-10m is the minimum valuation for any software/tech-related business is wreaking havoc on entrepreneurs. I have actually seen this one decision effectively kill companies that, in my opinion, would have otherwise succeeded. Here's what happens...
twitter.com/Jason/status/1719324875666653333?s=20
A founder gets some very early initial traction. Through personal connections, an accelerator, past track record, raw hustle, or pure charisma, the founder gets interest from angels/small funds. They hear on Twitter that $5-10m is a reasonable valuation and pick a number in there
With initial interest from 1 investor, its usually not too hard to get others to follow, and since the valuation is high, they raise quite a bit more than they need for this stage of the business. Once the money is in the bank, two very strong forces come into play
Force #1: The 12 month runway. Itâs early days, youâre resourced constrained with many great ways to plausibly spend money. Youâre optimistic about future growth so why keep multiple years of runway sitting in the bank? Costs ramp up quickly to {capital_raised}/12 months.
But since you raised $500k instead of say $250k, your monthly burn goes up to $40k+/mo in stead of $20k/mo.
You make solid progress over the next 6 months and MRR is growing steadily. Youâve added a ton more customers, so youâve also added 1-2 more support staff to support them.
But because you set your monthly burn higher, unless you hit rocket ship compounding growth, youâre probably not on track to get profitable before the capital you raised runs out, so now youâre looking at <6 months runway.
Youâre sure youâll kill your companyâs momentum if you cut staff, that you literally just hired, in order to get to break-even. So you go back to the market to raise more capital.
Force #2: raising more and at a higher valuation. Youâve raised money from angels and investors you respect, you want to do right by them and show momentum to your team and the market. The new barometer for momentum is not MRR growth, since MRR wonât get you to break-even.
Once you've raised, momentum = fundraising. Once you raise capital one time, thereâs a strong incentive to make every successive fundraise be more capital raised at a higher valuation.
You raised $500k at $7m to start, so now you need to raise $1m at $10m or $1.5m at $12m, but even though this is just a transaction, founders feel very strongly that both numbers definitely need to be bigger each and every time.
But as those numbers get bigger, you can't rely on $25k - $150k from angels/micro-funds, you need funds writing $500k-$1m. Those that can lead/invest shrinks to (mostly) more professionalized investors who judge more on the reality, than the potential of the business.
Maybe its the very next round, or maybe you squeeze one more round in, but eventually the reality catches up that even though the business has revenue and is growing, its just not (yet) doing enough revenue or growing fast enough to justify another More-At-Higher round.
Now youâre in a very tough spot as a founder. Youâre still a small team and everybody plays an essential role, thereâs no fat to cut, but your monthly payroll is burning through a short runway.
The feedback loop on fundraising is terrible, so you never get clear indications whether its time to cut costs to break-even, or if youâre one pitch away from the round that avoids layoffs. So you keep pitching, right up until the business runs off its runway.
I saw this dozens times over the past few years, and I honestly think many of the businesses that failed would have survived if theyâd raised less-at-lower in the first round, or waited for more traction before raising the first round.
Heck, my own firm @calmfund almost ran into this exact issue until we bit the bullet and cut our staff early this year, so its more of a hard lesson-learned than abstract advice.
None of this is set in stone.
Maybe you'll catch that rocketship growth.
Maybe you'll keep burn low despite having a pile of cash in the bank.
Maybe you'll confidently go back to the market at a flat/down valuation without losing momentum.
It's possible, but tough to do.
I know that as an investor âraise at a lower valuationâ sounds an awful lot like Iâm just talking my book, but I really do think that for founders looking to maximize their chances at a life-changing exit, raising less-at-lower for their very first round is a smart move.