First-time Fundraising: Deciding to Raise

This is part 1 of a 3-part series on First-time Fundraising. You can read the overview of this series here. Here are part 2 and part 3. 

What does “venture-scale” mean?

If you decide to raise venture capital, you should know what exactly you’re signing up for. Let’s start at the beginning: what is venture capital? 

In simplest terms, venture capital is money invested into privately-owned companies with a high risk profile & outsized growth potential. 

An underrated element of venture capital is that VCs manage other people’s money. VCs raise capital from investors called “Limited Partners” who are typically high-net-worth individuals, family offices, corporations, or institutions such as endowments, foundations, and pensions. These LPs invest in VCs for various reasons, but generally, LPs are targeting 3x+ returns on early stage funds over a ~10-year time period.

Related to these return expectations are the definitions of “high risk profile” and “outsized growth potential”. While these terms will vary depending on VC fund size, structure, and strategy, seed-focused VCs generally abide by the assumed constraints of the power law. According to the power law, 80% of the returns come from 20% of deals (if not even more skewed). Said differently, VCs assume that 80% of their investments are unlikely to generate returns (this is the “high risk” part). As a result, each individual investment must have the potential to compensate for the losses of the rest in order for the fund to achieve its overall return goal (this is the “outsized growth potential”). For a deeper and more technical explanation of power laws in venture, check out Jerry Neumann’s analysis here.

In making investment decisions, VCs often evaluate whether a given investment has the potential to “return the fund”. Here’s a quick example. If a $50M seed fund owns, on average, 10% of each portfolio company at exit, the company will have to sell for $500M for the investment to “return the fund”. In order for the investment to 3x the fund, it would have to sell for $1.5B, and so on. The actual analysis regarding portfolio “survival rate”, dilution, follow-on investments, exit magnitude, and time period will vary from firm to firm, but this simplification illustrates why VCs generally shy away from sub-$1B potential outcomes, let alone sub-$100M ones.

Depending on business type, this return expectation dictates that a company has to grow fast (often 200-300% year-over-year consistently) and achieve $100M+ (if not $1B+) of revenue per year within 5-10 years. Of course, these goals vary by business model and fund type/size. While a $100M exit would not move the needle on the returns of a $2B fund that invested $2M at a $20M seed valuation, a $10M micro-fund (or an angel investor) that invested at $500k at a $5M pre-seed valuation could be thrilled. Understanding whether a VC’s deployment strategy and return expectations are aligned with your business goals is critical to making the right fundraising decision. 

So, should I raise?

Raising capital from outside investors doesn’t just affect your cap table and balance sheet; it impacts the operations of your business. Choosing to take on outside investors, whether they are individual angels or institutional VCs, is a big decision. 

A few key questions to consider:

  • Is this business opportunity venture-scale? Expectations for revenue, market share, and margin will vary by company, but there has to be potential for an outsized outcome as described above.

  • Are your aspirations for this business aligned with investors’ expectations? Do you want to try to build a multi-hundred-million-dollar business? Are you excited about that risk/reward trade-off? 

  • Do you need to raise capital? If profitability is within reach, you may not need to raise any external capital to run or scale your business. But in some cases, money is required for upfront product development, investment in key talent (including founder compensation!), compliance/security requirements, etc. In other cases, the competitive dynamics create urgency to capture market share, and capital is critical to accelerating sales, marketing, and customer support. Ask yourself what the alternative is if you don’t raise, and if the difference to the business trajectory isn’t material or existential, it is worth seriously considering alternative pathways.

Even more important than whether VC is a good fit for the business is whether VC is a good fit for the founder. By raising capital, founders potentially gain:

  • Network: Investors often have broad relationships that can help with hiring, business development, future fundraising, and liquidity.

  • Counsel: Some investors have specialized backgrounds in functional areas or verticals. While the tactical relevance of this experience may be limited, access to hundreds of data points can provide helpful benchmarks, aggregated best practices, and foresight in avoiding common pitfalls.

  • Accountability: Having to report to shareholders (and potentially Board members) provides a forcing function that can improve discipline, focus, and performance.

Of course, the true value-add of VCs (both individually and as a group) is variable and debatable, but if the above doesn’t excite you, I’m sorry to say that this is as good as it gets 😅 In exchange for the above, by raising capital, founders give up:

  • Full autonomy: Once you have external investors, the business is no longer entirely “yours”, and you have a fiduciary responsibility to act in the best interest of all shareholders. While issues of “control” are generally limited at the early stages, you still give up total independence.

  • Optionality: The stakes are higher once you raise external capital. While good investors tend to support founders’ decisions even if they diverge from the original plan, fundraising creates an inherent pressure to pursue larger outcomes. Because of the dilution, increased burn for the sake of growth, and additional risk, the venture track may ultimately be less financially lucrative for founders than bootstrapping would have been. 

  • Peace of mind: While the additional accountability may be a net positive, let’s be honest, having investors can be a pain in the neck. If you became an entrepreneur because you cannot stand to work for anyone else, having VCs may not be your cup of tea, either!

How much should I raise?

If despite all these caveats you still think venture capital is the right path for you and your company, you are now tasked with figuring out how much to raise.

There are two main elements to this question. The first is specific to the company and operating strategy. Working backgrounds from your end goal, think through the specific stage-by-stage milestones that you need to achieve, and consider how much you need to raise in order to reach the next set of goals.

The second is specific to the market: what’s “in market” for a specific stage? For example, raising a $10M-15M Series A (as of 2022) is not unreasonable, but raising an $8M pre-seed round is anomalous. Fundraising outcomes are not evenly distributed, and if the round you need to raise, for all good reason, outside the typical ranges for that stage, creating a viable fundraising strategy is trickier. The best way to get a sense of where your round lands is to chat with other founders (particularly those who have run a fundraising process recently) and investors to get input on what they’re seeing regarding valuations, round sizes, and other benchmarks. Companies like Pitchbook also regularly publish fundraising data, which can provide useful ranges.

If not VC, then what? 

If you decide that VC is not the right fit for your company after all, what are your options? Below are some alternative funding sources. This article also provides a good overview of the different funding buckets and trade-offs. 

Below are a few resources to consider:

Up next: running a competitive fundraising process. If you have any thoughts / feedback, reach out via twitter (@geri_kirilova) or email (geri at laconia dot vc). 

Geri Kirilova