Raising Venture Capital
In the mythology of entrepreneurship, venture capital (VC) funding has been enshrined as a rite of passage: Businesspeople have a brilliant idea, they secure an exciting investor at an amazing valuation, and the company Skyrockets.
I learned that the journey is not so simple and the choice to take VC money not clear cut. The myth that accepting VC funding is a sacred initiation comes from the amazing venture-backed success stories that have become modern global brands including Zoom, Workday, DocuSign, and many more. But the truth is that for each success story subconsciously cementing VC as the go-to growth model, there are literally thousands of companies that didn’t Skyrocket on their VC fuel. Also, I’ve spoken to many more businesses that don’t manage to raise capital, claiming that if they could then their company would take off. But fuel alone doesn’t win motor races: it takes the right car with the right driver being on the right track.
There are some very good reasons to raise VC money. I will explain them and spend time on them, as well as look at the difficulties and alternatives.
In a B2B SaaS business, the key is to balance expansion with capital efficiency. With enough cash backing, anyone can sell anything. If I were willing to spend $100 to sell $10 of software, then by using financial brute force I could probably create a market for the world’s worst app. When considering the potential of raising equity funding from venture capitalists, a helpful lens is to look at the sales and marketing costs needed to close new software deals.
Unlike long ago, when enterprise software vendors sold large six-and seven-figure one-time deals, today’s software purchasing is closer to a pay-as-you-go model, with annual contracts that subscribe to a set of services. But the cost of selling such mission critical applications hasn’t changed. Like before, there are competitors to outsmart and out-market, as well as champions and economic buyers to find and persuade in prospect accounts. But today the size of the prize is smaller, and it can only grow if you do a good job and retain the customer. From a cash flow perspective, cash outflow for sales expenses are as high, and perhaps even higher, than ever, but inflows are staggered over months and years of subscription commitments.
Before SaaS (which is a long time back I know…), a couple of big deals could bank roll a start-up through its next year and allow it to expand. Now the described cash hole needs to be funded. So how big is this cash hole?
A viable SaaS business spends 1 to 3 times the gross profit it generates from an average-valued annual contract to win a customer. All SaaS businesses want to hone their model to get customer acquisition costs (CAC) paid back for less than the annual contract value—that is, in less than a year. But speculating on strong contract renewal rates guaranteeing future income of, say, 5 times CAC across the customer’s lifetime value (LTV), they accept higher up-front sales costs.
On average, a decent SaaS business expects to spend $1,000 to $3,000 to create $1,000 of free cash contribution a year (i.e., after deducting roughly 20 per cent for running costs on infrastructure, etc.) for the lifetime of the contract.
For simplicity’s sake, let’s pretend our software makes 100 per cent gross margin, not 80 per cent. Then if a new business, just starting out with a high performing sales and marketing team, wants to sell $1 million in software in their first year, they need probably another $1 million available to them when that deal takes a year to sell. If they can sell the deal in six months, then their cash need is halved to $500,000. If their sales and marketing performance is decent but not stellar and it costs them three times the annual contract value ACV to win, then they need $3 million to hit their $1 million target for the year.
The cash flow in SaaS is geared against scaling in the early days. Taking our simple illustration further, if the business does an exceptional job and retains 100 per cent of its customers every year, then after three years, if targets have not changed, the company has generated $3 million in annually recurring subscription revenue. In year four, that cash can fund a $3 million expense to sell an on-target $1 million in new contracts. These dependable future free cash flows are at the heart of the shareholder value created in a SaaS business, and the reason why they get acquired for the multiples that they do. Venture capital can be an excellent way of filling the cash hole needed to reach scale and incite cash generation rather than cash burn, where they are confident that the CAC is efficient compared the overall LTV return.
On the other hand, bootstrapping has created some of the biggest businesses in the world that did not, or could not, turn to the venture market. These include massive success stories like Oracle, SAP, and Microsoft. These examples were from a different era when software was a huge product to buy. It cost hundreds of thousands of dollars, and there was an installation fee and a cost of annual upgrade. This was an extremely cash generative model. But in Enterprise Sales we can learn valuable lessons that are applicable today: sell ambitious deal sizes, plan set up fees that generate cash, sell adjacent support and maintenance services that make margin and are sticky, and have a pathway to sell more software products each year. For companies that do this and manage cashflow tightly, bootstrapping remains a realistic option.
How it Works
There are four principal players in the venture capital marketplace:
1. The entrepreneurs who want money to grow their company more quickly.
2. The venture capital firms funded by the institutions who find and fund businesses.
3. The institutions looking to make money on their investments.
4. The bankers who want to sell the businesses in order to make a commission.
Start-ups are by their nature risky, and when a new business needs cash to grow, it’s common for that business to be outside the borrower profile that would satisfy a bank. Government regulations restrict banks on the risks they can take and the interest they can charge, and start-ups usually don’t fit their profile. Neither can small companies go to the public market; typically, businesses smaller than $10 million in revenue cannot float, and the cost of doing so would be too high and prohibitive. Therefore, the private market is their only option. That is why the venture capital market exists.
The challenges faced by venture funds in a market filled with inherently high-risk investment portfolios include earning consistently high returns for the institutions that put money into venture funds, as well as making money for the start-up founders.
The institutions that do put money into venture funds are typically insurance companies, pension funds, universities, and financial firms. As the high-risk component of their own portfolios, these institutions put a small portion of their total investment into venture capital funds. The idea is to make returns of around 30 per cent a year over the lifetime of the fund. They pick the venture capital business they wish to fund, based on the track record of the company and the story and credibility of the partners running it.
Within this risky investment category, venture firms can meet the investment goals of the institutions only through the way they structure their deals.
What do they invest in? It’s common to hear it said that venture capitalists invest in great people and great products. This is true to an extent, but what they’re really looking for are large markets at the right maturity stage.
Venture firms are not interested in either nascent and early stage “unproven” markets that are yet to see predictable customer adoption, or late stage “mature” industries that are at a lower growth stage. Regardless of talent and product, in those other life cycle segments, venture funds will always invest in the middle stage of a market’s lifecycle, that “growth” stage of predictably high opportunity. This approach means that most companies in which they invest have a good shot at success over the relatively short time horizon.
In his 2007 blog, VC titan Marc Andreessen quotes Andy Rachleff with Rachleff’s Law of Startup Success:
The #1 company-killer is lack of market.
When a great team meets a lousy market, market wins.
When a lousy team meets a great market, market wins.
When a great team meets a great market, something special happens.
In these accelerating “growth” markets, it’s likely many companies will be doing very well. However, when the market has become “mature,” there will be a much smaller number of successful players.
The challenge for venture capitalists is to spot which of these early competitors could be winners. At this growth stage, all the companies serving the market will be struggling to deliver products to a product-starved customer base. The trick for venture capitalists is to spot the management teams that can execute effectively on delivery, therefore taking best advantage of supplying the market as it grows.
Eighty per cent of all venture capital investment goes into businesses focused on markets that are in the growth phase.
There are exceptions to this rule. Some of the remaining investments go into “moon shot” ideas and areas that are thoroughly unproven but could, over the long run, do extremely well. I’m old enough to remember mobile phones in the 1980s, which were not very mobile, and the quality of the phone service was extremely low. It was another decade before this product was proven. Likewise, companies had been investing in artificial intelligence since the 1970s, yet it was not until the 2010s that the technology was successfully commercialised. Elon Musk created his own markets for commercial space travel and electric vehicles, priming investment rounds with his own capital from two successful prior exits, before any VCs would touch those outlier opportunities.
But in general, as a founder seeking success, looking at the 80 per cent of investments going into markets that are at growth stage is more helpful.
Our VC Decision
We started our business in 2009. In October 2011, our financial year ended with revenues of over $4 million and a profit of $700,000. But during this time all the co-founders of the business were taking less than 50 per cent of the salaries we’d previously earned in professional settings, and in tough months when cash was tight, we did not pay ourselves. We did this to fund payroll of our growing staff of over thirty people.
In the days before Zoom, we all worked together in an office. This was a tough expense to bear, even though the cramped office was the size of a squash court, overlooking a dark alley behind a bar where the only visitors were those forced to leave the establishment by the back door after one too many. We were trying hard to keep expenses down so that we could fund more engineering and more expert services salaries, whose steady monthly billing kept the lights burning whilst our immature software sales process created intermittent feast and famine.
We were fortunate to have found in our office manager someone with a strong billing and collections discipline. Her previous company, where she honed her talents, was a low-margin, hand-to-mouth operation. She took this duty very seriously and carried far more responsibility than her administrative role suggested—and she made sure we all got paid.
Building good enterprise software takes time and money, and once it’s viable, the sales cycle runs into many months. We could not expect to recoup the cash going out the door on engineering any time soon. We were hustling for deals that would at best take six months to close, and then a month to collect, and the margin contribution didn’t cover the fully loaded cost of our engineers. Our CTO had recognised that a smaller, highly skilled group of engineers worked best for fast product delivery, but the “rock stars” we needed in the early days of little process and pressing deadlines were often contractors with eye-watering day rates, which compounded this expenses problem. Our SaaS product wasn’t going to “wash its own face” any time soon.
However, we could see overall progress was good. We were struggling to keep up with orders, and this was putting our expenses under a lot of pressure.
We discussed bootstrapping the business beyond 2011. We liked the fact that collectively we owned 100 per cent of the company, without an outside controlling influence. We liked the fact that we weren’t speculatively risking our individual stakes in the company on an unproven forecast of future success.
Consequently, we looked hard at how we’d run a bootstrapping strategy through the next phase of growth.
We considered whether we should throttle product costs, move our scare resources into sales, and sell a lower innovation product. If we could sell efficiently, it would generate higher cashflow by multiplying sales orders. But this plan risked not really innovating enough to solve the identified pain for customers and it had no contingency for any inconsistent sales performance.
We wouldn’t be the first B2B software companies to sell their customer with a transformative vision, an exciting roadmap, and a demo that in truth represented the future potential of the product, not its current ability to solve their problem. That road leads to bad customer success issues, and low customer retention.
Defunding product and only focusing on sales carried too many down sides that we were not prepared to accept. We needed to maintain high ambitions for customer satisfaction and focus on quality first and at the same time meet the needs of a fast-expanding market.
Our business was in demand in the marketplace, and we needed to raise external capital as the fuel for our growth.
Our Market Timing
In 2011, the venture capital market had not yet spotted how big the CPQ software category would become. It was firmly in the list of unproven software categories.
Like any market, the software market has inefficiencies. There is a delay between customers benefiting from an innovation and that same innovation spreading across many customers, creating its market and a narrative, and finally becoming a proven growth category.
When we started, I think we were in that period of delay, where only a small number of customers knew we were solving a severe problem and word had not yet gotten around.
For our small start-up that was signing up 20 customers per year, the fact that we were not yet in a recognised global need was immaterial. We knew that within our niche, the tribal networks were talking about us. We were getting referrals and were already in that phase of struggling to supply a product-starved customer base.
Given we were early to market, we were fortunate to be able to secure venture capital investment at all. The configure-price-quote software was a niche within the much bigger category of software of CRM that was experiencing massive expansion at the time as part of its growth stage.
Whilst we were not recognised as a CRM software business, our expert services people were skilled in “customer experience,” the heart of the CRM process. This knowledge was valuable to us because as they set up our software, they needed to configure it within the customer’s CRM process. This also made our expertise valuable to one venture capital firm intent on creating returns within the CRM category. In their case, they were not a venture fund backed by external institutions; they were what is known as corporate venture capitalists. They were a team within a large software company that happened to be our partner. Their twofold ambition was to make venture returns for their firm within this market they knew well and at the same time drive scale and maturity around their partner ecosystem. Salesforce wanted to help grow companies like ours who had expert services skills that made their own software successful. Many large enterprises have corporate venture arms, and these can be an effective way of cementing partnerships and gaining access to sales opportunities.
In our case, we secured venture backing not because we’d demonstrated to a VC market already leaning into CPQ that it was the next big thing but rather that we were competently executing CRM set up and it just happened to include our CPQ. Salesforce was investing to close an expertise gap in their growth market. To their mind, the market was starved of experts like ours, but not software like ours. I think they thought our software plans would fall by the wayside as demand increased for customer experience experts increased.
We were focused on growing a high value SaaS business. Our eyes were wide open to what we were doing as entrepreneurs getting money on favourable terms when we could, to serve our growth ambitions. We knew we had a product starved market, and they were buying our CPQ. All start-ups must expect to remain fluid about how they will reach their goals and spot the opportunities that come their way. Finding an early-stage investor can be all about spotting a mutual interest area and emphasising it, because at that time, product and market may not be proven in the eyes of the VCs.
But in the following years, this mismatch of intentions became a source of some pain and difficulty on both sides. On the one hand I regret not having our first investor aligned with our ambitions, while on the other this initial investment allowed us to mature our business and cement ourselves as a market success story, with a growing number of customer testimonials before most people even knew there was a market.
Our story highlights that in a growth market, external capital can be key to keeping pace with the opportunity. Experiencing growth in a product-starved market makes the decision to take external investment simple. In the early stage of a growth market, however, the venture capital industry may have less data on this than you do, and therefore the need is to find areas of mutual interest to get ahead before others follow. After all, Jeff Bezos began by telling friends and family he was setting up an online bookstore, not a ubiquitous digital retailer. Without first making strong organic progress in a niche, venture money can distract from finding that niche and serving it well, which is why product market fit should come first.
How VCs work
As we began our fund-raising process, my co-founders looked to me to protect our interests. I was leading the discussions, and I had to learn fast. Most entrepreneurs are vaguely aware of founder horror stories: “My business was taken away from me…” or, “I lost control of everything….” As my instinctive slow-to-trust mentality kicked in, I needed to get a much better grasp on what the VCs would be looking for and what we could and should give away.
For me, the perfect remedy was ready made. For many years, my brother had been a stand-out corporate finance professional. He’d raised money and bought and sold businesses many times over, and so was the first person with whom I shared our decision to go down the venture capital path. We met for coffee between his office and mine in Fitzrovia, one of my favourite parts of central London, with its fabulous old buildings and mix of film production companies, media agencies, and food from every corner of the world. That was the first of many discussions where he opened my eyes to how VCs invest, and he was thankfully there to guide me through each negotiation as it unfolded.
Venture capital firms typically invest money in exchange for equity in the company. The type of shares they often seek are preference shares. Commonly referred to as preferred stock, these are shares of a company’s stock with dividends or exit proceeds that are paid out to shareholders before common stock dividends are issued. They also give downside protections, such as a liquidation preference. In the event of a liquidation, the venture capital firm will get its investment back before any of the ordinary shareholders receive payment.
Under certain circumstances, VCs may seek a participating preference, so that upon exit they get their initial investment back before the proceeds from the upside of the sale get divided and shared. This risk mitigating tactic may be deployed by the VC if the business has not got many options for further funding or if the valuation upon which the business is raising money is too high. Then the venture firm may accept the valuation but only based on the additional return on investment that they would achieve by getting their money back before calculating the upside.
VCs may seek to negotiate other notable decision-making rights as they invest. These include blocking or consent rights on certain issues giving them disproportionate voting rights over key decisions, such as on a sale of the company, relative to their stake in the company. To keep track of the investment, the VC will want access to board packs and management information. They will commonly want board representation, either as a voting board director able to take decisions on behalf of the company or as a board observer, where they get to participate in discussions without a director’s vote. The terms offered on board representation and decision making will relate to the size of their investment. However, even under such circumstances, without a director’s vote they can have decision-making rights as shareholders, and these can be stronger rights than those of directors because the board of directors is appointed by the shareholders and answerable to them.
Another downside protection the VCs may seek is antidilution on a down round. In other words, if the company is not doing so well and must raise more money at a lower price than previously, then the VC will automatically receive additional shares during that round to top up its per centage stake back to where it was before, at the expense of ordinary shareholders and management.
On the other hand, if a company is doing well, venture firms want to have pre-emption rights in the agreement, so that they have the choice to follow their money and invest further in the company on the same terms as the new investor coming in.
Normally, VCs also look to limit the risk by investing alongside other venture firms rather than taking all the risk themselves. In this situation there will be a lead investor who is responsible for setting the investment price per share and for setting out the terms or term sheet, against which all other investors—the followers in the round—will invest. They will negotiate this with the entrepreneur. These lead investors are the ones most likely to ask for a board directorship.
One area where all investors have the opportunity to contribute is in due diligence, where investigating the investee business becomes the job of all the firms and therefore the scrutiny is greater. Working in this way limits everyone’s individual risk, and the more funds that are interested clearly drives up the credibility.
Funding our business
We’d reached our crunch point decision. To capture a fast-expanding market, we needed more money to cover outgoings. Next, we needed a business plan around which to centre the investment and valuation discussion. We modelled all the cash inflows from sales and outflows from hiring, marketing, sales, development, support, and so on. This gave us a good idea about what the total cash needed might be, our excess outgoings beyond our means, and our “burn rate.” At a certain point in time, this cash burn creates a cash-low-point. This is the maximum cash need before the company turns the corner and reaps the benefits of investment funds and begins generating more cash than it spends. This cash low, or funding gap, is the amount we needed to fund with external capital.
If, like me, your plans represent the internal struggle between only the money you really need and the anxiety of taking more money than you need and being diluted, then I think it helps to be prudent when modelling so that you don’t raise insufficient funds by applying a 20 per cent buffer to the expected cash need. Running out of cash without enough progress in your business likely spells the end of your company
Valuing the Business
My brother also helped us with setting the valuation at which we started negotiating our capital raise. Working out this value became the key driver behind how much money we wished to raise, which in turn informed the way in which we structured our business plan, and the “cash need” to fund us to profitability. In later stage funding rounds it was easier, with a well-established track record, for us to agree with investors on valuations, calculated as a factor of performance and our market opportunity.
In this first round, we started with a thought process about how much ownership we wanted to give away to achieve our funding ambitions. Likewise, the VC we were speaking to had in mind how much of the business they needed to own to justify parting with their capital, as they forecast forward how much money the business would likely need to succeed and then exit, and consider what residual stake they needed to own at that point to hit their own investor return hurdle. Without solid foundations to base a valuation on, early-stage equity raising is a negotiation based on a combination of market, operational team, customers, competitive benchmarks, and innovation.
Understanding How VCs Make Money
Early-stage venture investors who are taking the highest risks look to achieve at least 10 times their investment. (I’ll explain why in a moment.) They’ll probably work on average investment time horizons of five years to get to their return. When you look at it as a 5-year facility returning 10 times the initial investment, then if you took it as a loan it would cost the equivalent of nearly 60 per cent interest, compounded per annum. Typically, the money raised will fund that business for one or possibly two years as it grows.
These costly structures are needed to make the promised average annual return to investors of 20 per cent. The reality of overall portfolio ROI is more complicated because many failed or struggling businesses can be sold off for some small or negative return on investment. It’s not as if the VC always either strikes it rich or gets nothing. But in a super-simple analysis, you can say that 80 per cent of a VC’s investments will return nothing, leaving 20 per cent of businesses to make the required 10 times returns. For those 20 per cent of companies that are the winners, taking in averages masks a distribution curve where the top quartile of successful investments makes a disproportionately high percentage of the overall returns. In other words, the chances of real, long-term investment success are considerably slimmer than 20 per cent—more like 5 per cent.
If a business has raised more than one round of venture capital, the founders’ equity stake will have been reduced more than once. It is common even in successful businesses for founders to have little or no equity stake remaining in their hands when the eventual exit takes place, so the emphasis as a founder must always be on generating data points to measure progress so that investment capital is used most effectively.
The equity cost of raising venture capital will vary company to company based on its performance and circumstances. Raising multiple rounds of venture capital reopens this risk and value conundrum multiple times. So what should a founder do to limit the amount of dilution taken during venture raise? Building a realistic business plan that leverages venture capital for far faster growth than would be achieved by organically available working capital growth is the first step. Execution of this plan would mean it is easier to raise again, to grow faster again, and to do so on the least dilutive, competitive terms.
Creating a plan that returns the company to generating positive cash flow again without any future additional venture capital requirement is the safest way to limit future dilution.
If it is not possible for a founder to create a plan that is both realistic in its achievability and complete in the sense that all investment ahead of generating positive cash flow is done and dusted within the time it takes to that spend venture money, then that founder is taking a real risk that they won’t realise an exit that’s personally profitable. This starts with the sources of revenue. Being convinced from your historical performance that you have found a niche for sustained growth should be your own prerequisite. You owe it to yourself before you commit to a path of selling equity and investing years of your time with such a risk profile. Money alone won’t solve a market issue.
It isn’t just businesses showing a path to profit that get funded. It’s possible for early-stage businesses to get funded on the back of plans that show achievement of “investment milestones,” which may be something like getting a first version of a product to market or achieving a certain sales threshold. My own opinion is that such “seed stage” milestones do not sufficiently provide how the founder will get traction. In a buoyant market, pre-revenue, seed stage companies may also access venture funds on the basis of a good idea. When your business takes cash at such an early stage, the investor is looking for years of commitment from you to deliver on the idea. However tantalising this route to raising money fast may be, consider that you will part with a disproportionately high percentage of your equity for an investor to take a chance on you, and, more importantly in my view, you are stepping away from the hand-to-mouth earning and learning that bootstrapping necessitates.
Funding Rounds and Equity Dilution
Raising capital in exchange for equity brings added potential for start-ups to grow. Yet starting, growing, and exiting a start-up still takes a long time. Thirty years ago the cycle was quicker—for example, Amazon went public after two years. In today’s highly competitive market, recent data suggests the median time to exit for a SaaS business is nine years, with hardware companies a little more and consumer software a little less.
An article by the Corporate Finance Institute broke down the odds as follows:
The chances of raising money from a typical leading US VC firm is 0.7 per cent. The firm will review 75 per cent of the 4,000 inbound requests each year. Of these, they will closely consider 200 and invest in just 20.
In fact, of the 4,000 companies, 200 will eventually receive funding from a member of the community of good quality venture investors. From these 200 investments made by industry players, 15 businesses will generate most of the venture returns. The other 185 will either “limp along” or fail outright.
The Corporate Finance Institute concluded that total odds of success are 0.05 per cent, or one in 2,000 This stark data analysis should be borne in mind before spending time on and committing equity to a venture capital funding process. My experience is that it was a very positive approach to growth funding our business, but we entered that process with realism and a strong ethic of preserving the cash we raised and spending it as wisely as we could.
Seed Round
The objective of a seed round is to create product and prove product-market fit in an identified market.
This is funded by friends, family, angels, or seed VCs paying to get a business off the ground. You may find friends and angels more flexible than institutions, and they will bring business experiences potentially valuable to a new venture. In the UK, the sorts of shareholder agreement and rights sought are standard and simple, founder-friendly ones. The structure of seed investments is not always the same as other venture rounds. It may be structured as a convertible loan note because they are simple and fast to do. Unlike an equity investment that requires a lead investor to set a price, the price doesn’t need to be agreed advance, which is something that can be difficult on an early-stage business with little track record. Only a cap on the future valuation of the business, as and when the loan converts into equity, is needed.
The timing of the conversion is linked to the next equity investment round. For example, an angel investor may agree to fund the business with debt and a rolled-up interest charge and set a cap on the value at which that debt converts to equity at, say, $3 million. If a future equity investment is priced at $6 million, then the loan converts. At that point, it is twice as valuable to the angel whilst paying half what the other equity investors do and receiving additional equity for their interest amount. Three million dollars is likely a considerably higher valuation than the business is worth when the company is funded, making the structure less dilutive to the founder. This structure means that different angels could agree different caps with the founder, which gives the owner scope to negotiate.
This structure provides capital as debt to the company. Being a debt instrument, the investor has stronger rights to recoup the investment in the event of insolvency, and the angel may receive some tax advantages to investing. Under most conditions, setting the valuation for buying equity in a business is a capped conversation from the start.
Regarding the cost of a seed investment round, angels may be more flexible than early-stage institutional investors. As Y Combinator, a successful early-stage investor, puts it, if you can manage to give up as little as 10 per cent of your company in your seed round, that is wonderful; but most rounds will require up to 20 per cent dilution, and you should try to avoid more than 25 per cent.
Based on the business, the experience of the team, and many other factors, seed rounds can vary in size tremendously. The round size in total is likely to range between $50,000 and $1 million.
The Series A Round
The objective of a series A round is to accelerate early growth once product-market fit has been established. Often this is to keep up with and get ahead in a fast-expanding market.
This is often the first institutional investment round where a venture capital fund is putting money into a company. By this time, the business has shown a performance track record in a growth market. For companies with a good record, their performance opens the potential to raise external capital to fund faster growth.
In terms of valuation, this can be crunch time. It may be the first dilution event for the founder, and one that can carry compounded dilution if there are earlier convertible debts also moving to equity.
Because of the varying nature of business models and plans to fund them, the series A investment range is big, ranging from approximately $1 million up to $10 or $15 million. There are exceptions, such as when a larger, profitable business decides to raise VC for the first time. In 2019, Tenglong Holding Group, a Chinese global distributed data centre (IDC) providing in-depth customization services, had a VC series A round that brought in nearly $4 billion.
The amount of ownership given up to new investors is also high, with 20 to 40 per cent being an oft-quoted range. However, once again there are outliers in both directions.
At this stage in a fundraising cycle, the founder shareholders must now be looking hard at the efficiency of the money they are putting to work, as they trade equity for cash. At the upper end of this scale, some owners will have been diluted down to owning as little as 40 per cent of the business, having lost control over decision making along the way as they become minority owners. With 60 per cent of ownership gone, the cash raised must be well spent to ensure the enterprise equity value x 0.4 is worth materially more than it would have been as a smaller business organically funded, where 100 per cent of the equity resides with the founders and owners.
In other words, the founders should ensure that 40 per cent of X is greater than 100 per cent of Y.
This value equation is the unanswerable question. But if 90 per cent of all businesses go bust within ten years, most due to running out of cash, and 1,999 of every 2,000 venture-backed businesses fail to make significant returns to their founder owners despite cash having been at times abundant and many having gone well past series A to raise more later rounds, then the lesson must be that the funding method is less important than relentless execution, focusing on the details, and operational excellence. Bessimer Ventures were first to popularise “five Cs” to focus on: Committed recurring revenue, Cash (burn rate), Customer acquisition cost, Customer lifetime value, and Churn (retention rates). All of these are essential measures for any founders hoping to win in the equity stakes over the long run.
Subsequent Funding Rounds B, C, and D
These rounds are always going to be linked to performance over previous stages. It is not so easy to list all the different scenarios from here onwards; the best businesses will continue to raise ever larger rounds, continue to grow capital efficiently with satisfied long-term customers, and raise their funding at ever higher valuation where the cost to VCs of becoming an owner is rising but the odds of failure are declining. But if this doesn’t happen, then post-series A, it may become harder to raise equity, and the necessary cost cutting can leave any business that can keep trading cash-starved and low-growth as the market matures and moves on.
Alternative Financing Options
There are other sources of capital other than debt and equity. I learned how important it was to explore these and use them to improve cash flow and drive business growth. Having started a company with a 25 per cent ownership stake, each time we were to take a capital investment in exchange for equity, my quarter of the company was materially diminished. I accepted this as a sensible approach so that I had a smaller part of something big at the end. What I learned was that I could reduce the equity dilution by turning to alternative sources of finance.
The first such alternative opportunity came relatively early when the business was turning over a couple of million dollars a year and we were certainly pre-venture investment. We were generating good invoicing for our expert services and our customers were large, reliable, and creditworthy. We were well placed to take advantage of factoring or invoice discounting. Invoice factoring companies purchase the unpaid invoices outright, whereas invoice discounting is a loan secured against your outstanding invoices. This service is provided by a lender who for a fee will advance the value of an invoice when it is issued, and they will collect the money from the customer in due course. This can be a helpful way of boosting cash flow. It removes the risk of late payment and it can give a one-time 30-day boost to working capital. This extra month of cash allowed us to expand our team more rapidly than we would otherwise have been able to do. The downside to invoice discounting is that it provides a hit of cash that is very hard to wean a business away from. From another perspective though it gave us a one-time cash injection of $200,000, as very cheap and largely risk-free debt. It meant we could delay venture financing a little longer and drive up the valuation of the business, which would mean selling less equity for the same money and suffering less dilution.
We were fortunate in that our business continued its growth trajectory. Had our billing dried up, having already taken the cash in advance in this way, we would have hit a crunch. Early-stage businesses need to take fundamentally risky decisions all the time, and on balance we felt this one was worthwhile for us.
In 2016, at a much later stage in our development, we had a strong base of recurring revenue, and we were able to secure venture debt. Once again this gave us access to additional capital. It was seen as a safe bet by the investment bank, which did due diligence on long running subscription contracts, and the annuity revenues that they guaranteed. This gave them comfort that in the worst-case scenario, even if we switched off the lights in the office and let the staff go, their loan would be repaid from the ongoing contracts.
By this point our annually recurring subscription revenue was running at about $7 million a year and we were able to secure a $3.5 million debt facility against this. The interest rate we paid at the time—around 12 per cent—was high versus commercial rates available in the market today. These interest payments were rolled up to be paid, as a single bullet payment at the end of the debt term. Once again, this was a risk for our business. What if we couldn’t repay the debt? However, for the founders it was equivalent of about 40 per cent of all the capital raised to date without any equity dilution whatsoever. Without using this type of facility, my co-founders and I would most likely have seen our equity stake diminish to a level where it was possible we would not have earned life-changing money at exit. This is the end point for many founders—where their own stake diminishes to a rounding error in the business.
There are other sources of capital available and, worthy of consideration through crowd funding networks, where individuals pool their money to back an early stage start- up. This is an extension to the friends and family funding model that start-ups have relied on for decades.
Our first two rounds of equity investment were also structured as convertible debt products. This meant that having taken advantage of the additional cash, we put off the inevitable equity dilution until the business was larger. We were able to negotiate at the time of agreeing those facilities on higher valuations for future conversion than we would have been able to had we been getting an equity cheque at that point. This tactic of delaying issuing new equity once again added to a collection of measures that we were actively using to preserve our equity in the business.
Our Fund-Raising Journey
Our own investment profile between 2011 and 2017 looked something like this.
In 2011 we raised $500,000 seed round in a convertible loan note with a future valuation guaranteed on conversion to be higher than the current valuation of the business.
In 2013 we raised $3 million, once again as a convertible debt facility which pushed up the future valuation. Once more, this was our series A, and it was very unusual to raise debt at series A. We could do it because we had strong cash flow, good gross profits, and low cash burn. We’d achieved this by having a blended portfolio of software subscriptions, expert services, and long-term support agreements, which pushed up our revenue and built our cash flow higher than we would have done as an early-stage software company with only the SaaS license income. We’d used the playbook of the old-fashioned bootstrapped companies Oracle, SAP, who sold projects alongside their licenses to drive up working capital. We combined this with an investor story of being a high growth SaaS business with its own delivery team. We were able to raise more money at a higher valuation because of the size of our revenue, our growth rate, and customer list, than if we had been a software revenue pureplay business.
In 2014 we raised $10 million of equity as a series B, converting all the loan note debt into equity at this point as well. This was our biggest investment, and it required the business to mature, and it was supposed to be our shot at building out the company to scale and profitability.
But things didn’t go that way. Our expansion brought fresh risk to the business, and as I’ve explained elsewhere in Notes on a Startup, we ran into underperformance issues, no doubt caused at least in part by trying to deploy capital at a level to which we were unused.
In January 2016, following the sales struggle we’d had in 2015, we were forced to raise an emergency series B1 round of $3 million. We’d burned through our cash faster than planned. Our performance was way off and there was no way we could get a new lead investor. I had to show our investors that I was serious about fixing a damaged business and began by going to the board with a plan that took out $9 million of annualised expenses and recommended letting our CFO go and bringing in an interim, and I personally took back responsibility for sales leadership. Through much heated and pressurised negotiation, we managed to get the emergency funding at the same valuation as the prior round. This result was by no means guaranteed at the outset. But it was key to the founders, as a lower valuation would have decimated our ownership. Our under-performance had put us on the brink of having nothing to show for years of hard work.
Thankfully, with four founders running most of the key areas of the business, the investors wanted and needed to keep us incentivised. If we’d not agreed a deal at all, 2016 would have been the end of our company.
The deal had lots of hooks to getting the money. Because we’d used up a lot of good will and trust, and our track record was in question, to keep the pressure upon us the investors decided to drip feed the money into the company against sales and cost milestones.
Our scaling and performance crisis and having to piece things back together to survive is not a unique story. But we were unusual because we pulled off the turnaround while retaining enough equity and control that we could still hope for a strong exit for founders, on our terms.
I believe that we achieved this by using debt wisely to delay dilution, using a blend of revenues beyond SaaS licenses to create growth and cash, and by learning how to measure performance and deploy capital in an efficient way, that many competitors who were raising literally in the hundreds of millions when CPQ exploded, were not.
Final Thoughts
In this note, I explore the complexities of raising venture capital (VC) for a B2B SaaS startup, emphasising the importance of balancing growth aspirations with capital efficiency.
Key Takeaways:
Understand the Cash Flow Dynamics of SaaS: In SaaS models, significant upfront sales and marketing expenses are incurred, while revenue is realized over time through subscriptions. This creates a cash flow gap that needs to be managed effectively.
Assess Customer Acquisition Costs (CAC): A viable SaaS business may spend 1 to 3 times the gross profit of an annual contract to acquire a customer. Strive to achieve a CAC payback period of less than a year to enhance capital efficiency.
Evaluate the Necessity of VC Funding: While VC funding can accelerate growth by bridging the cash flow gap, it's essential to consider whether it's the right choice for your business model and growth stage. Not all successful companies rely on VC; some achieve growth through alternative funding strategies.
Consider the Long-Term Implications: Accepting VC money involves trade-offs, including potential dilution of ownership and influence over company direction. Ensure alignment between your business objectives and the expectations of potential investors.
Explore Alternative Funding Options: Before committing to VC, consider other financing avenues such as bootstrapping, debt financing, or strategic partnerships that might better suit your company's needs and growth trajectory.
By carefully evaluating the decision to raise venture capital and understanding the associated dynamics, founders can make informed choices that align with their business goals and operational realities.