Ignore the demands to raise another funding round unless you need the money
Image you’re a venture capitalist. You raised your last fund 3 years ago and now it’s fully invested in a portfolio of (mostly) great startups.
Out of the fifteen startups you invested in, there’s a couple of failures (can’t be helped), a bunch making slow progress (no startup ever hits their projections), a few doing really well (woohoo!). Things are looking good.
Now it’s time to begin raising the next fund so you can keep investing (and getting paid management fees). You start pitching your existing LPs (limited partners — the investors in venture funds) and reaching out to potential new LPs, trumpeting your incredible prescience with the current portfolio.
The first question all the LPs ask is how is the current fund performing? They’ll want to know the TVPI — the ratio of portfolio value to the amount invested, and possibly the IRR.
In only 3 years, it’s unlikely there have been any great exits, especially for an early-stage fund. Loses tend to come quickly as losers hit a wall, moderate successes come later, while the few big hits that make the fund take a long time to mature.
That means for the first 5 years, there aren’t significant returns of cash to LPs. The value of the portfolio falls to a minimum at around 3 years and begin climbing from there.
Of course, you trumpet your big successes to date, but that’s a hard sell. If you were lucky to invest in OpenAI or Canva, you’ll have no trouble raising the next round. For everyone else, the successes are obscure.
You send out newsletters saying how wonderful your startups are doing, but LPs are just as jaded as everyone else in the startup world. They get updates, notices, Twitter and LinkedIn announcements non-stop trumpeting startups claiming to be shooting into orbit. Until they find out they’re shutting down.
Besides, if I’m choosing between 4 different funds to invest in, looking at a list of obscure startups in their portfolio isn’t particularly helpful. I want to see a metric. I want to know the TVPI. That makes it easy.
Acme Fund I is up 1.5x, Beta Fund I is up 1.7x, Carot Fund I is up 2.2x, and DC Fund I is up a whopping 3.1x. Guess which Fund II investors will be the most excited about handing money?
But where did that 3.1x increase in DC Fund I’s portfolio value come from? There are no big exits yet. It’s all based on the valuation of the startups in the portfolio.
If these were public stocks, we could check the stock market each day to compile a portfolio value. If these were houses or office buildings, we could use metrics such as price per sqft to come up with fair market values. For startups? Hmm…
The rule for funds is that the valuation in the portfolio can only be adjusted when there’s a 3rd party transaction. That means a new funding round with a new valuation.
Let’s say DC Fund I invested in Paltergeist Industries at a $10M valuation when its sales were only $100K. The company is doing great, sales have jumped by 10x to $1M. How much is the company worth now? Until they do another funding round, it’s still $10M. Drat.
That’s not a problem for the startup which needs to focus on revenues, COGS, churn rates, CAC and other operational metrics rather than some theoretical idea of valuation, but it is a problem for the venture funds that invested in the startup.
If the startup does a new funding round at a $50M valuation, early investors can mark up the value of the shares they hold in their portfolio by 5x. Woohoo! That will really help their metrics.
It’s also a lot more impressive in the LP presentation to say Paltergiest Industries has just raised a fresh $50M round from 16z after their fund got in early at a $10M valuation than to say sales from a portfolio company has grown from $100K to $1M.
I expect you get the picture now. Even though your startup may not need more investment, your investors need you to raise another round at a higher valuation.
So the usual rule is a startup will do a funding round every 2 years or so. That’s not just because of venture funds which tend to work in 3 year cycles, but because it takes 2 years to hit major milestones that provide a significant inflection point in valuation.
Most funding rounds therefore provide 18 to 24 months of runway to hit those milestones and begin the next round of funding.
Do You Want to Take Funding?
But…raising another round is not always in the startup’s best interest. If you’re at a point where you don’t need the money, is more funding worth the dilution?
More importantly, VCs don’t just write checks. They have expectations for growth you’re promising to meet or die trying. They’re giving you money to grow the revenues another 10x. They’re expecting you to spend the money on expanding the team and market presence so that you can come back in another 2 years with a $100M valuation.
In the end, though, this is your business. You know better than anyone else how far and fast you can continuing growing. You know whether it makes more sense to invest in growth or focus on profitability.
If you need the money, you have no choice but to go hat in hand to investors and raise another round. But if you’re lucky enough to be in a position where you don’t need to raise, then ignore the insistence of your investors and the demands of the board members to begin the fundraising process. You have to decide for yourself whether raising more funding is what’s best for you, your company, and your customers.
At the startup, SüprDüpr, the demands of Satoshi Nakamoto — the bitcoin king — and the company’s largest investor, to reach an IPO in record time might have something to do with the disappearance of the company’s Chief Elephant Officer. Read the crazy startup novel, To Kill a Unicorn.
