It has become part of the conventional entrepreneur wisdom that you should raise an angel round, then a first venture capital (VC) round followed by a few more before taking the company public, selling to a strategic or selling to a private equity company.
Most of the well-known internet companies have followed this path – Yahoo, eBay, Amazon, Google and Facebook. However, it may not be the most logical path for most entrepreneurs.
The vast majority of exits are below $100m and most of those are below $30m. You cannot raise a $5m series A round at a $10m pre-money valuation to sell for less than $30m.
Not only will you disappoint your investors, as most VCs are shooting for a 10-times return on their investment, but the liquidation preferences might eat up most of your personal return.
If you have made money before and are looking to build something big for fun, then by all means raise as much money as you can at the highest possible valuation in order to maximise the probability of building a $1bn company. You significantly increase the risk of making nothing, but in this context it is worth it to increase the probability of building something big.
If you are a first-time entrepreneur or have not made much money before, you need to be careful not to price yourself out of potential exits. There is a lot of temptation to raise money at a high price if it is available.
However, often you might just be better off just doing an angel round or asmall VC round – say $2m at $4m pre-money – to maximise your risk-adjusted returns. Likewise, you might be better off trading off price for terms.
A clean, one times liquidation preference at a lower price might be better for you than a participating preferred paying 10% a year, especially if the company ends up taking five to seven years to exit, which is by no means atypical. Having less cash might not make much difference to your outcome.
Start-ups are much more capital efficient these days. You have companies that service your every need, eliminating most potential capital expenditures.
Even e-commerce start-ups are relatively cheap to build these days as there are companies that will handle logistics for you and you can avoid taking inventory by shipping directly.
Just as importantly as figuring out how much money you need at what valuation, you need to pick the right investor to raise the money from. To pick an investor you need to understand their expectations. VCs are not going to help you execute. That is your job.
They may make a few introductions and might help you hire a few good candidates, but the reality is that you probably could have found a way to get introduced to whomever you wanted to meet and would have met good candidates to hire without them.
This does not mean that VC selection is unimportant and that you should just pick whichever firm offers the highest valuation and the best terms.
Quite the contrary, VC selection is essential to your success. By sitting on your board, the VC will play an essential role in discussing and setting the strategic direction of your company. In fact, it is probably the most important role the VC will play.
By pulling you away from the day-to-day to focus on the strategic issue of what maximises value creation, the VC will hone your strategic thinking and steer the direction of the company.
The VC will also play a crucial role in the exit discussions,playing bad cop to your good cop (if you do not have a VC, investment bankers can also play this role).
Given the importance of the role and the fact that whoever you pick is likely to be on your board for years, choosing a VC is like getting married. It is absolutely essential you get along well with and trust the VC. This means that the name of the firm is irrelevant. What matters is your relationship with the partner you are going to work with on a day-to-day basis.
Strategic investors are probably also best avoided. Not only could they have conflicts of interests as they may not want you to get too expensive for them to buy, but even when they have the best of intentions they have proven to be fair-weather VCs – jumping in when the market is hot and retrenching when conditions are tough. They are least likely to be helpful and supportive in a downturn.
To be fair, Intel Capital and Naspers, which made a strategic investment in my company OLX, may be exceptions to that rule as they have shown staying power and have seemingly been fair to their portfolio companies.
Now it is your turn – start a great company and raise the capital you need from the best partner possible for you!