Raising: Choosing Winners and Structuring The Round

March 28, 2021

Decide How To Weight Firm, Partner, and Valuation

There are three basic “preferences” when fundraising: firm, partner, and valuation.

Some founders choose primarily by firm. We covered rank ordering of firms in Part 3. Some founders primarily want to raise from Benchmark or Sequoia, because they care most about the (real) signaling effect.

Some founders choose primarily by partner. Sometimes founders have chemistry with a particular VC, or they stand out for some reason. Perhaps they have very deep experience in your space. Perhaps they were the first investor to believe in you. Perhaps your other suitors are all assholes.

Some founders choose primarily by valuation. More money with less dilution is an unreserved good thing! Especially for the many founders are deeply skeptical of any proclaimed VC “value-add”. Note that openly signaling that you are primarily optimizing on price may be perceived as uncouth.

In reality, everyone chooses some combination of these, but weights them differently. Some may take a 30% discount to choose a top-tier over a second-tier firm. Others may take a 10% discount, but no more, to work with the partner they like the most.

When Diligencing, Weight Founder Feedback More Than VC Feedback

There’s a lot written about conducting due diligence on potential investors well. Read it. Use the front door. Use the backdoor. Ask the right questions.

At the end of the day: trust references & remarks from founders more than from other VCs.

VCs all work with each other constantly. As a result, they will often be reluctant to shed negative light on another VC, especially if they are in a similar domain. Founders, on the other hand, particularly if they no longer have a relationship with the VC in question, are much more likely to spill the beans on negative behavior.

Be Thoughtful About Round Composition

A common option is often to split up the round. Be sure to strike the right balance between “complementary skillsets” and “people who enjoy working together”.

(See Part 7 for a how to evaluate VCs’ “unique value-add”)

A warning: VCs are good at being friendly and persistent. It’s part of the job. Don’t over-crowd your round because you didn’t want to tell a VC no.

Dilution Math Is Counterintuitive, So Model Out Your Fist Three Rounds

Dilution math is very unintuitive the first time you’re raising money. Keep some factors in mind:

  • In a success case, you’ll probably have at least three significantly dilutive rounds (seed, A, B, sometimes C), where you sell around 20% of the company.
  • After that, you may have two or three growth rounds where you sell 5-10% of the company.
  • You need to re-inflate the option pool after each round, to around 10%.
  • This is much, much worse if you’re in anything capital intensive.

Some advice:

  • Make a simple spreadsheet model, keeping in mind you’ll need to re-inflate the option pool after each round to 10% of the post-round number of shares.
  • Read posts by Jason Lemkin: The Pernicious Effect of Dilution in SaaS, Normal Startup CEO Equity.
  • Keep in mind VCs will almost always want to buy more. Their lines like “making sure you have extra gas in the tank” can have some truth, but generally come from a self-interested position.

Understanding dilution can help you understand the tradeoffs in saying yes to a particular VC request. A good target for an instituional round is probably between 15 and 22% of the company in each round. Less, and VCs will complain they aren’t hitting their ownership percentage (and you may run out of money if you’re not careful). More, and you’ll be over-diluting yourself.

Last words of wisdom

All of these are just factors. You may be working with this person and their firm for 10 years. There’s no “right” way to make the decision. But if you’re not sure, make it the way you’d make another significant career decision, like choosing a job. Make a pro/con list for each candidate. Talk to your significant other / spouse and close friends. Sleep on it.

Profile picture

Written by Sam Bhagwat, cofounder & chief strategy officer at Gatsby; programmer, analyst, writer; follow me on Twitter!