I believe that using this algorithm for your fundraising plan will ensure that you’re not wasting your time when pitching to investors, and will also help you see your seed round in the way that most investors will view it
As a software engineer, I try to approach problems algorithmically. That is, given some kind of input, what kind of procedure can I reliably run to generate the desired output? For example, given a bunch of numbers (input), what’s the best process (algorithm) to quickly and efficiently arrange those numbers in increasing order (desired output)?
In my opinion, seed stage fundraising can be approached very similarly. For a specific company, given some amount of seed money (the input), what kind of procedure (product/marketing roadmap) can be run to reliably generate a good output (higher valuation Series A round/profitability/etc.)
Founders think a lot about the inputs: How much can I raise? How little dilution can I take to raise that much? They also put a lot of thought into the algorithm: who would I hire if I could raise my ideal round? What features would I roll out? When would I ramp up sales?
The area that doesn’t get enough attention is figuring out the right output. That is, if you raise your ideal amount and execute on your 18-month plan, where will that get your company in preparation for your next round?
I believe it’s actually better to figure out a great output and then design a good roadmap around that, instead of coming up with a sensible roadmap and then writing down the output that you think it would produce.
The thing that founders who are fundraising must always remember is that investors are motivated by greed (potential rewards) and fear (fear of risks + fear of missing out on rewards). The risk-to-reward ratio is everything, and a typical VC would much rather take a 50% chance at a 5x return than a 95% chance at a 1.5x return, even though the first scenario loses money half of the time. A VC also has opportunity costs, and is typically targeting a 3x or 4x average return across their portfolio companies. Not understanding these risk-reward dynamics is where many startup pitches miss the boat.
Here are two common scenarios:
Founder: “We want to raise $1 million at a $5 million pre-money valuation today to hire three more engineers and get to $25,000 MRR (monthly recurring revenue) in 15 months.” The unspoken addendum: Our plan is conservative and we’re very likely to succeed, but not in a big way.
Investor reaction: “Hmm, a $25,000 ARR (accounting rate of return) would probably probably increase your valuation to $7 million. I’d rather invest at a $7 million valuation when you’re at $25,000 MRR than at a $5 million valuation when you’re at $0 MRR.”
Founder: “We want to raise $1 million at a $5 million pre-money valuation today to hire three more engineers and get to a $100,000 MRR in 15 months.” The unspoken addendum: Our plan is ambitious, and we’re not too likely to succeed, but if we do, it’ll be a decent success (e.g. grow from a $5 million pre to a $15 million pre).
Investor reaction: “Hm, I think there’s a 25% chance the company can get to $100,000 MRR in 15 months. I’d rather invest at 3x the valuation and 1/4 the risk than investing now.”
The problem with these scenarios is that the risk-adjusted return is not appealing to the investor. I think a good pitch should aim for a ~2x or higher risk-adjusted return between rounds. For example, “We have a ~100% chance of raising at 2x the current valuation next year.” Or, “We have a 30% chance of raising at 10x the current valuation next year.” If you’re pitching a 50% chance at 2.5x, then most investors will choose to wait, even if they like your company. There are enough companies with a higher risk-adjusted return that the opportunity cost of investing in your proposal is too high.
So here’s a proposed algorithm for making a fundraising roadmap:
1. Plan out a few potential scenarios like, “If I take a $W dollar investment at valuation $X, I think there’s a Y% chance I could hit the right milestones to raise at valuation $Z before my cash runs out.”
2. Calculate the risk-adjusted ROI to investors for various scenarios.
3. Pick the scenario that appeals most to you while also offering a strong risk-adjusted ROI to investors.
4. Pitch that scenario to investors. Explicitly mention the risk/reward ratio to create greed + a fear of missing out. “If you don’t invest now, the next time we raise will be at 6x-10x this valuation..”
You might be wondering, “I’m not a VC, how can I estimate W, X, Y, and Z?” Good question. The best advice is to ask a VC. Or better yet, ask multiple VCs. These VCs could be people you’re friends with, people who passed on your company (and aren’t worried about negotiating against themselves), or even investors you’re still negotiating with. In the last case, asking for their feedback would help you see whether they’re honest and helpful.
I believe that using this algorithm for your fundraising plan will ensure that you’re not wasting your time when pitching to investors, and will also help you see your seed round in the way that most investors will view it.
Thank you to Sean Byrnes for giving me feedback on this post.
This post was originally published on the Coding VC blog.