In my last post about raising seed vs. jumping straight to A, I received a good comment from Chris Woods that my analysis neglected to include the impact of option pools that are created at each financing round. It was a good point, and one that is worth touching on with a dedicated post.
In almost every financing round, there is an important stipulation in the term sheet that talks about the employee option pool that will be created in tandem with the financing. Essentially, the new investor wants there to be a certain % of options available to employees after they invest.
There have been others in the past that have detailed the math behind option pools and their impact on venture deals. Here are three good ones from Venturehacks, Mark Suster, and Jeff Bussgang. The short implications are:
- You should definitely discuss this as part of your valuation/deal negotiations. It has a meaningful impact on your net dilution, and I’m often surprised how often founders don’t consider this a malleable term.
- I find that VC’s will tend to propose a larger option pool than is really needed. It’s not that we are bad, it’s that we are self interested. We know that at the next financing round, the new investor will probably want to have a certain sized pool available for future employees, so if we make the pool pretty big up front, we are less likely to share in that dilution down the road
- It does NOT make sense to try to change the rules of the game and get the VCs to handle this term differently than what is standard in the industry. You are better off in almost all cases maintaining the standard, but being savvy about negotiating this term.
- The negotiation tactic to take is to justify the size of pool that you think is reasonable. Basically, have an estimate of the hires that you are likely to make over the course of the next round and the equity packages you are expecting. Provide even an additional factor for “opportunistic hires” in case you happen to find “the best person in the world” for role X and want to bring them on prematurely. Add it up, and ask the VC why that level of options is not sufficient. It’s hard for a VC to make a principled argument in response to this that isn’t mainly self-serving. Or, it will be a good catalyst for an important discussion with the VC that will tell you a lot about how they are perceiving the quality of your team and the types of folks you need to bring on sooner rather than later.
What is a typical size of option pools that we see in the market? This tends to vary by company, stage, and completeness of team. As a result, I think most folks are kind of hesitant to put numbers out there because they can be misconstrued. But I’m going to give some ranges based on our portfolio, as I think it gives at least directional guidance for founders.
For seed rounds, we have seen options pools in the last 12 months in the range of 5% (which is low) to 10% (which is a bit on the high side). 7.5% is a pretty decent place to be. Keep in mind that these are for rounds where a) we are NOT contemplating bringing in an outside CEO and b) we believe that there is enough technical leadership in place to take the company to a good place. As such, these numbers do not contemplate an extremely senior hire that ought to take up a large chunk of the pool on their own.
For series A’s, we have seen option pools in the last 12 months in the range of 7-15%. This means that whatever % remains unallocated, the new investor is asking for the pool to be increased to this percentage. In some cases, it’s getting the pool to more or less the same size as what we had after the seed, but sometimes more or less.
As a means for comparison, historically, first institutional financing rounds used to require option pools in the 20% range, sometimes more, rarely much less. This was more in the days prior to the popularity of institutional seed rounds. Net net, I think that currently entrepreneurs are able to manage this more effectively. It’s fairly typical for a founder to start with a pool of 7.5%, actually only allocate ~5%, and then raise their next round requiring the pool be refreshed to 10%. Thus, the actual net effect is 5+10 = 15% dilution after 2 rounds, with your seed investors sharing in your dilution when you go from seed to series A.
Ultimately though, negotiating too hard here can signal a focus on the wrong thing. Investors want to work with entrepreneurs who want to build great companies, and will attract great people to do it. You don’t want to come off as overly stingy about equity to the point that one wonders whether you will do what it takes to attract the best talent to the team. But I wouldn’t shy away from the discussion either, because it has meaningful economic impact to founders and is the basis for an important discussion with your investors about how they view team building in the coming months and years of the company.
(Note: The majority of this post first ran on BetaBoston. This version goes a little deeper into some of my more nuanced thoughts)
There has been a lot of discussion recently about the bar required to raise a series A.
A few notable excerpts: Kyle Alspach’s commentary on seed and series A at BetaBoston; Brad Feld’s tweet a few weeks ago that “$100k MRR [monthly recurring revenue] used to be interesting. Now it’s table stakes”; Jo Tango’s blog post on the VC Bottleneck in Boston; and Mike Volpe’s comments on a post from my blog on raising seed rounds vs. Series A’s. In fact, Mike allowed me to publish the following facts: When HubSpot raised their $5M series A in 2007, the company had $12K in MRR from 48 customers. They had previously raised $500K in seed, plus about a $1M note shortly before the series A.
I can summarize the sentiment here in broad strokes. The “traction bar” for series A rounds is higher than ever. On top of that, there are fewer series A investors now than there have been in the past (at least in Boston). And the investors that do exist have “no guts” (or so the dialogue goes).
Wow, that sounds really bad. Maybe we should all just close up shop.
I’m not quite as pessimistic. In fact, at this moment, we have a few early-stage companies in our portfolio at NextView Ventures that are raising really nice rounds in the face of this perception. One of our portfolio companies has no revenue, and good but not explosive user growth, and yet it’s still raising a very nice series A from a very good venture capital firm at a significantly higher valuation from our seed. Another company raising series A doesn’t even have product in the market yet, while the third falls far short of the $100K MRR number despite raising from a top west coast firm. How do I reconcile this experience with the observations above, which seems to ring true for others as well?
My first and main thought is that an objective “bar” at which VC’s will want to invest in a company doesn’t exist — nor has it ever existed nor will it exist. I get asked this all the time, and the formula just isn’t there. I know that over the last several years, there has been standard guidance for SaaS companies to try to focus on getting to $100K MRR before raising an A. There are other benchmarks in other segments too. I think these benchmarks are helpful in allowing an entrepreneur level-set their progress with what others have been able to achieve in similar markets. But I just don’t think it’s the right way to think about the bar for raising a series A round.
Instead, I think the most important factor that VC’s consider is the strength of the team and the excellence/uniqueness of the idea. After that, they are looking for some demonstrable evidence that things are working. This is where traction comes in. If you are working in a very crowded space, you probably need more traction to show separation from others in the market. But if the space is brand new or uncompetitive, then the traction bar will be lower. Also, if the team or idea isn’t excellent, then the traction bar will be higher. VC’s are very good at convincing themselves that a team or opportunity is interesting if there is enough traction. But still, I find that the most unique and exciting companies are able to raise capital with relatively limited traction because the right investors require only a small amount of proof to be excited enough to jump in.
I think this was the case for HubSpot in ‘07, and I’d bet it would still be the case for them if the fundraising environment then was like it is today. Sure, not everyone would be jumping up and down to invest, but those people would have been very wrong, and fundraising at the early stages is the search for true believers.
Couple other secondary thoughts:
- There are more investors out there than you think. Some of the classic folks you think of as VC’s have shifted to other parts of the market, so there does seem to be fewer traditional players. But there are more new or non-traditional players emerging all the time. It’s the job of the entrepreneur and their seed investors to put in the hustle to keep their networks fresh and uncover potential capital sources that may not show up in a list published by the NVCA. On top of that, investors from other geographies definitely do invest in early-stage companies that are not in their backyard. Again, two of the companies I mentioned above are raising rounds from investors in other regions. Also, just a few months ago, I connected an investor from True Ventures to the folks at Bolt, and they ended up leading a $2M seed round for Understory. Proximity does matter, but it’s become a little less important.
- I think that emphasizing traction vs. emphasizing potential tends to flip-flop back and forth. Actually, I think we are in the middle of this shift returning to the emphasis on potential, as companies like Oculus, Oscar, and others are showing that some of the most aggressive funds are very boldly going after series A and B rounds for technologies that seem industry transforming, even if actual traction is minimal (or the product hasn’t even launched yet).
- What is challenging is that there is increasingly a market gap at the level of smaller series A’s. As the venture industry has started to recover after the economic crisis, we have seen the best funds increase pretty significantly to $400M+ in size. These large, mega-funds are able to write very large checks to get the ownership they want, or wait things out and invest a little later when there is more certainty. Some of the funds that didn’t do as well are struggling to raise capital, or are shrinking or shifting strategies. As a result, when it comes time to raise a series A and look for an early-stage investor that will write a $3M check to lead a $3-5M round, there are fewer players out there. I see this as a temporary market gap. What’s likely to happen is that some of the older funds will retrench and get back into the business of doing these deals and perform quite well. Some seed funds will decide to migrate up and start making series A and B investments (this is already happening). And seed rounds will continue to get a little bit bigger, and seed-extension rounds will be common and a perfectly fine ways for early stage companies to keep building before showing enough scale to raise a larger round.
Overall, I’m actually quite optimistic about the fundraising prospects for companies in the markets in which we participate. There is a healthy volume of seed activity across the board, and although it seems daunting to raise series A successfully in light of some recent comments, it continues to happen at the same level of regularity as we have seen in prior years (at least based on our own portfolio). Some of the players are changing, and the dynamics around these rounds are a bit different, but of course markets evolve. Overall, I think they are evolving in a way that is more favorable to founders at both the seed and series A stages of development.
Raising capital is really difficult, no matter what people say about the influx of seed and early-stage dollars into the startup eco-system. I know very strong entrepreneurs that need to grind really hard to get seed rounds done, so I definitely don’t want to take away from the challenge of doing that.
But in some cases, I find that exceptional entrepreneurs have the opportunity to “jump straight to A”. That is, by-pass a traditional seed round of $750K – $2M from angels and seed funds and raise $3M+ primarily from one large venture capital investor. The rationale for doing this is obvious. You get a large capital partner involved early who is fully committed to your company. You also get more money earlier that you can use as a weapon. After all, if only a minority of seed rounds (on average) result in a series A investment, why not take that risk out of the equation early and jump straight to A?
There are a few reasons NOT to do this. Jumping straight to an A may seem like a good idea, but you are giving up a few things that I think are pretty valuable, and are offered by raising a typical seed round. Keep in mind that I’m a biased observer here since we are exclusively a seed-focused fund and I think that is usually the best “product” for most entrepreneurs. But having said that, here are the four main reasons to raise a seed, even if you have the option of jumping straight to your series A.
1. Getting a variety of great people involved. Seed rounds tend to be composed of a larger number of participants, including both angel investors and institutional seed funds. Getting access to a breadth of network and resources is pretty helpful in the early stages of a company when you are under-resourced and have no scale. When jumping straight to A, the ownership requirements of large funds will dictate that there is less room for other participants for the round to happen, and that fistfight for allocation will result in fewer helpful investors around the table. The first round is usually the last time one can get some really terrific folks involved, whereas most larger VC funds happily invest in the series A or B rounds of companies. Just check out the list of great people involved in Uber’s seed round.
2. Maximing your series A firm. Great people are always stretching. Entrepreneurs are stretching to get the best investors in the world involved they possibly can. VC’s are stretching to back entrepreneurs that are a little outside of their network, or are more “premium” than the brand of their own firm. Often, I see that when founders jump straight to A, it’s because a VC was stretching and the founder got one of their top choices, but not the absolutely best capital partner for their business. Seed rounds allow you to put some wins on the board for your company, and then run a process to really maximize your series A round and the firm and person that you would want to work with.
3. Maintain flexibility. Raising a smaller amount of capital not only forces more focused experimentation and opportunity validation, it allows founders to be more flexible in the path they want to take for their business. Sometimes, founders will find that the company they thought was going to be great was going to be a lot harder to build, or take a lot longer, or is actually not as big of an opportunity as they thought. If she has raised a lot of capital out of the gates, there is greater pressure to do unnatural things to try to morph the business into something of greater scale, even at much greater risk. A seed round allows you to be more measured about your progression, and respond more flexibly to your learnings. This isn’t primarily about maintaining optionality of a smaller exit. I think it’s primarily about time. Does a founder want to take 7-10 years of his life to grind out a company towards an unnatural outcome, or would it be better to sell a company sooner, make money for investors and employees, and then give it another shot again after a few years? The small or mid-sized exit may mean a lot less for experienced founders, but getting years of their productive life back is pretty valuable for almost everyone.
4. Lower possible net dilution. It’s hard to predict total dilution over time for two different financing paths. But what I do see is that when jumping “straight to A”, entrepreneurs usually do need to sell a large chunk of their company to make it worth the while of a large VC to write a big check. Usually, the dilution is in the 25% range, and certainly at least 20%. On top of that, this capital will essentially need to take a founder through the next 2 value accretive inflection point to be able to raise their next round at a big step up.: 1) getting to product market fit and 2) build a scaleable marketing machine. That’s a pretty tall order most of the time, and if you can’t achieve both, you are going to raise your next round at flat terms or at a very small step-up to the last round.
In raising a seed round, you can minimize dilution up front due to the smaller round size, and then take these 2 inflection points one at a time. At each juncture, you are able to use competition to your advantage and optimize for the best terms. You will still be selling 20% of your company in most cases to your series A investor, but you may be abel to raise more capital than you would have if you jumped straight to the series A. That then gives you a better chance of knocking it out of the park in developing a great marketing machine. So in a big upside scenario, you may achieve less total dilution after the series B, or acheive the same dilution for much more capital. And although capital is never an end in and of itself, it is a weapon that you can use to turn your company into a monster.
Raising venture capital is not an end to itself. Capital is an enabler. Not every great company needs to raise outside capital to be successful, but some do, and that’s the world that we participate in as venture capitalists.
I find that capital gets talked about a lot in blogs in terms of things like runway, getting to profitability, solving the VC math equation, etc. But primarily, I think capital for early stage companies should be discussed in an offensive manner. As my partner David likes to say “capital is a weapon”. It’s true that sometimes too much capital creates tons of issues, but if wielded appropriately, capital is very much a part of a company’s offensive arsenal.
We think about this quite a bit with our portfolio companies as they scale. As seed stage investors, we find that we tend to prefer modest sized rounds early on to focus a team and establish discipline around being excellent at one thing and proving things out efficiently. But beyond the seed stage, capital is primarily about winning and winning big. We look to invest in GOLAZO companies with capital efficient beginnings, and usually, those types of companies do take in a fair bit of capital and use that capital as a weapon. Typically, this happens in some combination of five ways.
1. Solidify Network Effects. This is pretty obvious. If you are building a marketplace and things are working at small scale, you would want to invest big $$’s behind growing the market quickly. Each incremental node in the network increases the value of the entire network, so capital can be useful to accelerate this growth either directly by acquiring buyers/sellers or indirectly by allowing the company to maintain low fees and burn money in the short term while the network is being built.
2. Geographic Expansion. Some businesses don’t have great network effects, or if they do, those effects really only exist at localized scale. Groupon, Uber, Taskrabbit, GrubHub and the myriad of other local-services oriented companies are examples of this, at least early on. If you have hit on something that is working in an isolated geography, it’s relatively easy for another competitor to get some scale in another market unless you get there first. So capital is a weapon to scale geographically much more quickly than the cash flows of the business would allow.
3. Data Scale. This is an internet version of economies of scale. For many businesses, the more data that you have, the better or more cheaply you are able to deliver your goods or services almost by definition. Companies that exhibit this include advertising technology companies (eg: more unique data leads to better performance), financial services companies (eg: more data leads to better risk models leads to lower costs), and many many others to varying degrees.
4. Buying Credibility. Credibility matters for many companies. If you are selling software to enterprises, those companies will want to believe that you will actally be around in 5 years and can meet the levels of service they require. If you are playing in a regulated space, capital and credibility helps you get difficult deals done, or avoid getting taken advantage of by incumbents, or allows you to invest in the things that are required to help you avoid getting sued.
5. Boxing Out Competition. Some companies are able to raise a huge amount of capital relatively early on, making things much more difficult for competitors. These companies drive up the cost of customer acquisition for everyone, drive up the cost of acquiring talent, soak up the attention of the media and BD partners, drop prices, scare off other VC’s who don’t want to short fund the #2 player, etc. An old colleague of mine used to call this “sucking the oxygen out of the room”.
Each of these are reasonable and potentially effective tactics. Pretty much all companies that scale quickly with venture capital employ some combination of these. But they aren’t foolproof, and things can often go wrong too (that’s the subject of another blog post). Raising capital has never been an indicator of success, but if used appropriately can be a critical weapon in becoming more successful faster.
I’ve seen many founders make this mistake over the past 7 years, so I thought it was worth a post.
Surprisingly, one of the hardest types of VC pitches (and one that a lot of founders struggle with) is the pitch to existing investors.
This is the “update meeting” to the broader investment team of an existing VC. Often, this might happen relatively early in the fundraising process, but sometimes, it happens later. Sometimes, the fundraising process hasn’t really started yet (in the eyes of the entrepreneur). So, they are surprised when they walk into an “informal update” and realize that the entire partnership has assembled to critique their business.
Entrepreneurs struggle with this for a couple reasons:
1. Too casual. These meetings are almost always couched more casually then they really are. That’s because as the VC, bringing in a portfolio company to update your team does seem casual. But to the founders, this is a very high stakes pitch. It’s the job of the other members of a partnership to press on a company and keep their partner honest and offer fresh perspective, so although the environment will be friendly, the folks in the room are likely to take a more critical eye on the business than one would think.
2. Assuming too much. It’s easy to see friendly faces in a partnership pitch and think that everyone in the room is up to speed.
As a result, these pitches often dive quickly into the details, and fail to present an emotionally enticing story-arc. Big mistake. Even though other members of a VC team have some context, you can’t assume that they are fully informed and have seen the narrative unfold. In fact, these pitches are tough because you have to cater to both folks who are pretty unfamiliar with the business, and others who are intimately involved. On top of that, VCs are always asking themselves, “how would other investors evaluate this opportunity.” So even if they are aware of the details, failing to cast an exciting vision can lead existing investors to think “maybe there will be future financing risk for this company.”
3. No practice. Often, by the time you get to partner meetings during an external fundraise, you have honed your story through repetition and practice. In this case, you probably haven’t had much practice, and practice would seem contrived anyway since it’s just an “internal update”.
4. No sense of competition or external validation. All fundraising conversations are easier when there is a sense of competition that
creates both external validation and/or FOMO. With internal pitches, it’s harder to create this. Usually, these meetings happen at the beginning of a fundraising process, so it’s hard to create external validation. Also, as an existing investor, there is an assumption that even in a pretty competitive round there will be the ability to do one’s pro-rata and maintain ownership. The investors have a very strong sense of security, which makes it tougher for founders to get investors hot and bothered.
So, what should a founder do? Couple thoughts,
1. Practice. Find some insiders who are relatively small investors that do have experience with this but aren’t likely to influence the round dynamics significantly. Practice the real pitch with them, and do so in a realistic setting so it really does feel like a pitch.
2. Create some external demand. Even if it’s new angels or strategics, it’s helpful all around to show some external demand for the company’s equity. I wouldn’t front run a ton of VC conversations, but some outside validation helps a ton.
3. Own it and deliver. Realize that this is going to be one of your harder pitches and treat it as such. You have to captivate with your story, but show complete mastery of the details, for an audience that doesn’t feel like they are at risk of missing out. It’s tough. Don’t take it lightly, and be prepared.