Let's start at the beginning; what is a Series A?
A “Series A” refers to a round of investment made into a startup company. It is normally the first round of financing that involves professional investors (venture capitalists). This is mainly due to the size of investment at a Series A fundraise.
The average startup valuations at Series A stages range from £10m-£25m+, and companies sell 15%-30% of their company at this stage to new investors. Hence, the capital injected in a Series A fundraise can be anything from £1.5m-£7.5m+.
These figures are too large for most angel investors, and unfortunately, early-stage startups are too risky for bank loans. This created a financial death valley for startups of old. Thankfully, startups can now apply to raise such capital from venture capital funds.
Read this blog here to find out how a venture capital fund works.
A Series A round typically occurs after a startup has raised a seed and pre-seed round (these are capital raises that are in the low hundreds of thousands).
The wrong time to raise a Series A
The wrong and yet most common time a startup founder looks to raise a Series A investment round is simply once they are close to running out of capital they have previously raised.
This is an unsuccessful strategy, as venture capitalists look for startups that have achieved product-market fit.
READ THIS BLOG TO LEARN ABOUT PRODUCT MARKET FIT
As a short summary of the blog I linked above, venture capitalists like to invest in startups that have achieved product-market fit as this significantly de-risks an investment. A startup with product-market fit simply needs capital to grow.
Every £1 invested by venture capitalists needs to grow and generate a return.
Start-ups that haven’t found product-market fit yet, need to spend additional capital on new product iterations and experiments with no guarantee that they will produce something that is actually demanded by the market.
As such, investing in startups that haven’t achieved product-market fit is a much riskier game.
If said startup cannot find product-market fit before capital runs out, the startup will die. As such, most venture capital firms look for signs that you have achieved product-market fit before they invest in a Series A.
This is why you will find certain minimum investment criteria set out by some venture capital funds. They have decided that unless you satisfy these criteria, you are too early to invest into i.e. you haven’t achieved sufficient product-market fit yet.
What a Series A is used for
Once a startup has found product-market fit and decided to raise venture capital, the goal becomes growth.
Some startups decide to grow, even if it is unprofitable. This is what Uber decided to do, as they were scared that if they grew slowly, competitors would pop up all over the world and compete for market share.
Other startups try to grow profitably, this is mostly true for SAAS and consumer brand-type businesses, where each sale contributes to your net profit.
Regardless of your profit strategy, the funds raised at a Series A are normally used to facilitate this growth. Whether that be through expanding your human capital with new sales, marketing and engineering hires or on customer acquisition such as google/instagram adverts.
Three ways to think about how much you should raise at your Series A
1) Needs Analysis
In an ideal world, you would optimise your fundraising such that you’d raise just enough capital to become profitable and not a pound more. This would minimise your equity dilution, as you wouldn’t ever have to raise external financing again.
However, not all start-ups are able to become profitable this quickly and for others just being profitable wouldn’t be enough to capture significant market share against competitors that have used external finance (Uber vs Lyft / Didi Chuxing). In these scenarios, raising external financing might be your only chance of survival.
For these types of start-ups, common consensus from the best venture capital funds is that a founder should look to raise enough capital such that you are able to achieve the milestones required to raise a future round.
So how does one go about doing this?
A reasonable starting point would be looking at companies in a similar space to you. Good questions to ask are:
- How many users did they acquire between their Series A and B?
- How many people did they hire?
This should give you an insight into what milestones to set for your company. They need to be quantifiable achievements.
Please note that milestones are very different to setting internal goals. A milestone is a subset of an overarching goal i.e. creating a valuable company. A milestone should significantly reduce one or more key risks with your business whilst revealing more insights over the TAM and potential exit scale that you could generate.
What are key milestones for venture capitalists?
If you’re struggling to work out what milestones you’d need to hit in a series B round then you can ask venture capital investors that have reached out to you in the past.
Once you have these milestones in mind, you can work backwards. How large is your team in 2 years’ time? From here you can plan a reasonable hiring strategy and what the cumulative salaries of your team will be. This in addition to your other costs i.e. rent, marketing, development spend etc will give you an idea over how much capital you need to get to a Series B.
It also looks great to a venture capital fund to show that you are a thoroughly well researched and detail orientated founder. It creates the impression that you will be responsible with their capital and that you won’t need hand holding when it comes to growing your business.
Please prepare for prospective venture capital investors to challenge your plan. They might for example think that you are underestimating your marketing expenditure. In this case, a strong rebuttal would be to provide data that shows your tests indicate said marketing strategies are scalable and your customer acquisition costs remain reasonable.
2) Competitive Response
The perception of being financially under-resourced when competing directly may be a nearly impossible challenge to overcome. This was definitely the case when it came to ridesharing. Uber was burning through $100m a month to try and build a foothold in China. This was spent on new rider offers and sending significant ride discounts to encourage repeat app usage.
The problem was, their Chinese competitor Didi Chuxing was spending more than them. Both companies were having to raise additional external funding just to afford their war for customers, but this had the knock-on effects to significantly dilute the founders’ equity.
If either company had failed to fundraise, they would have lost the war to their competitor. This was also the case for food delivery platforms. Unit economics took a back seat as rivals competed to first acquire market share, crush their competition and then become profitable.
In this situation a certain large fundraise may be ‘required’ to enter the market with strength. Fundraising a war chest that makes you too small to compete is a fatal mistake.
3) Let the market decide
Now I know that this might sound a bit riskier when compared to a needs analysis or a competitive based approach, but this is the best position to be in as a founder growing a highly demanded business. However, rather counterintuitively, to get the best final valuation that will minimise your personal equity dilution, you need to pitch the opportunity at a reasonable/attractive price to venture capital funds. Tactically speaking, this could be done by presenting a deal in your pitch deck at a 30-40% discount to your final desired valuation.
Pitching a highly attractive deal will hopefully attract interest from several venture capital firms. This is where the fun begins. Watch how they fight each other to try and win the deal.
Venture capital funds are competing against each other, as they raise funds from the same people. The next time they want to raise a fund, they will be compared to their rivals. As such, there can be fierce competition to land a hot startup. In some cases it might make the difference between venture capitalists being able to raise their next fund or not.
Armed with this knowledge, a 30% increase in your series A valuation will not really impact the returns you generate for your venture capital investor (assuming you do go on to become a unicorn/decacorn).
As such, the decision of a venture capitalist to invest in your startup becomes a battle of conviction. Different venture capitalists will calculate the probability that you will succeed and at what scale. This will drive their investment decision and allows you as a founder to increase the valuation once there are several venture capital funds interested.
Please be aware, it is close to impossible to get a venture capital fund to change their mind on your startup once they have passed on the opportunity once. You will be de-prioritised and categorised as un-investable. The venture fund will focus time on new deals. So please, do not start you pitch asking for out-of-touch valuations. It can kill your chances of fundraising entirely.
Series A Red Flags
Venture capitalists hate it when a founder says that they are looking to raise money either for M&A activity or that you would like to have a cash buffer for safety.
Venture capital funds rarely engage with start-ups that grow inorganically (acquire other competitors to grow vs growing their own user base via marketing activities).
In a similar vein, venture capitalists tend to be cautious not to oversupply their founders. Too much capital might allow you as a founder to become wasteful. There are plenty of examples like this and perhaps the most famous example is WeWork.
Venture Capitalists are working to tight time deadlines. The return they generate for their investors is not only measured in value, but time. The longer it takes a fund to generate investor returns, the lower their annual returns will be. As such, venture capitalists would rather invest the cash that you intend to simply sit on into another opportunity that has growth potential.
It is not a good allocation of capital from their perspective to invest money that doesn’t directly contribute to making your company more valuable. Every £1 they invest needs to become at least £2.50 within 7 years. And that’s just to hit market average returns.
Can you raise too much?
It is a truism that with more capital you will hire people more quickly and spend more liberally whether it’s on external contractors, PR firms, attending events, doing legal work (trademarks, patents) or whatever. You will build out features before you have enough market feedback to warrant it.
Justin Kan (Twitch co-founder) says that: “No matter what you end up raising, you’ll spend it in 12-24 months”. As a serial entrepreneur himself, the advice he gives founders is to only spend 70% of what they raise in 18 months.
Think about a VC. In a series A they are looking to by anywhere between 10-25% of your equity. Read more into how VC funds work for this
Can you raise too little?
Of course it never feels this way when you’re the founder, but constraints can actually force creativity. Each person is the company has to personally do more vs. lead others doing work. Each person in the company has very short timeframes for making progress because you know proof-points are critical in fund raising.
And importantly — having limited resources forces you to make hard choices about what you’re build and what you won’t. It forces harder decisions about whom you’ll hire and whom you’ll delay. It forces you to negotiate harder on your office lease and take more frugal space. It forces you to keep salaries reasonable in a market where wage inflation has been the norm for years.
I’d personally say that the largest drawback of doing something like this is the potential to price yourself out of hiring the best talent.
Toxic funding rounds
This is something you really want to avoid. Toxic’ rounds (not a technical term) can be defined as fundraising rounds that can pre-dispose a company to struggle to find subsequent financing because newer investors shy away from a potential investment once they find out what the state of the company’s current cap table and or governance. Reasons future investors might view you as a toxic investment round:
- Because the company will likely require more capital in the future should it prove successful, and potential new investors feel that the founders will be less motivated to stick with the company as the value of their equity declines over time through premature excessive dilution.
- New potential investors feel that current investors own too much of the company and perhaps the company has a governance issues as a consequence.
- Because the investors have a large stake, it brings up a lot of questions about how the company got itself into this situation. Did it happen through a down-round? Was it due to other negative circumstances which could affect the future of a new investment? The circumstances raise a lot of questions and doubt in a new investor, and considering how many investment options an investor receives per year, frankly, as a founder raising capital you just don’t need any more reasons for a new investor to reject you.
- In the specific case of ‘debt’ or an ‘early exit of existing investors as part of a new financing’; potential new investors can sometimes object to having the money they are putting in as part of a new round be used for anything other than to expand the growth of a company. This means, potential new investors may shy away from companies that have investors that are eager to dump their shares as part of the financing transaction or companies that have too much debt outstanding that is repayable as part of an upcoming round.
