New companies are a person lost in the desert, wandering in search of water. The hot sun beating mercilessly on their reddening skin. They either find water or they perish.
The water, of course, is cash.
And once a company finds it, they can rarely get enough. Don’t get me wrong, cash is king. I love a company flush with cash. I’d posit most investors feel the same. It is reaching that point that’s the challenge. Many younger companies and small businesses will never get there. They will be left roaming the desert until their demise.
But for those that find water, the first drink is never enough. Maybe there’s a rare instance when that is true, but I wouldn’t count on it. It’s the same with companies.
One and Done
Their first raise is never enough.
Before you pass this off as mismanagement or something cynical, that’s not the case. There is a reason companies do multiple rounds of capital raises. Their first raise often comes from friends and family. This simply gets a project off the ground. The idea is to prove your business concept.
They Say the First Million is the Hardest
From there, the company may venture into a private round, but now companies can pursue a Regulation A+ offering or a crowdfunding. But for some, even these aren’t enough on the first go round. Unfortunately, if you’re the company, or fortunately if I’m an early investor, that first bigger raise is typically done at a lower valuation. Even with a proof of concept, it is hard to push the boundaries on a first raise. Young companies and start-ups carry a huge risk, some of the biggest, if not the biggest.
What this means is they need to present a value proposition to potential early investors. There has to be upside, often it needs to be significant. I always look for an asymmetrical reward versus my risk. In other words, for my risk appetite, do I have the potential to make 8x to 10x on my investment if the company is successful because I know I’m risking my entire investment.
So, when it comes to lower valuation, as a company, I don’t want to “give” away too much of my company cheap. I use the term “give” ironically, but I can tell you after dozens upon dozens of conversations with company founders, that’s the prevailing sentiment. And I get it. Every time a company raises money, they dilute existing shareholders. In the early stages of life, the biggest shareholders are often the founders so they can get diluted most. From time to time, founders will use different classes of shares to maintain voting control of a company during this period of dilution. For instance, they may offer non-voting rights shares or create a super share class structure for themself so that they get 10 votes per share for every one vote I may get if I buy into an offering. Although this won’t make me necessarily reject a potential offering, I do have to make sure I am very comfortable with management and what I perceive to be their decision making process.
Second Verse Same as the First
That first raise is meant to set up the next raise. I sometimes call the first raise, a slingshot round. It’s often only meant to propel a company to the next raise. That second raise is typically when a company is looking for the big money at a bigger valuation which brings us back to the initial valuation.
A downround is a kiss of death. That’s when a company raises new money at a valuation below the previous round. It’s the quickest way to alienate your earlier investors and insure you won’t get any additional investments from them.
This is why the valuation of the first round is so important to me. It needs to offer significant upside and it needs to offer a low risk of a downround potential.
Take One Door, Pass It Around
From round 2, series B, or however a company decides to label it, odds favor more cash raising until business is firing on all cylinders. Cash needs rarely dissipate after only a single round or two of investing. And every time a company comes back to me with another offering round, I need to revisit two questions immediately: What is my potential return versus the risk? What are the odds that the next round could be a down round?
But I have to add additional questions to the mix. Am I becoming too concentrated in this single name? What does this do to my liquidity ladder?
What’s a liquidity ladder?
Well, stick around because we’re going to cover that in the next few weeks.