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Finance All the Way to Failure

December 21, 2010

Brad Svrluga

I’ve spent my entire 12 years as a VC in small funds.  By today’s standards, I’ve been something of a microVC my whole investing career.  We’ve always talked about looking for capital efficient businesses, and we’ve certainly recognized the tremendous advantages that have accrued to investors like us as cloud computing, outsourcing, and Moore’s Law have made it cheaper and cheaper to run SaaS and web businesses.  You really can get a lot of businesses going, and going a long way, on $1 million or less.

However, in today’s frothy seed investing environment, I’ve seen several examples where the capital efficiency mantra is getting carried too far.  I’ve had entrepreneurs tell me they’re raising oddly specific numbers like $575,000 – as if they can forecast their needs that precisely.  In some instances, I’ve even seen entrepreneurs who don’t even have any idea how much capital they need, they’re just sure it’s not all that much.  So they pick a number without doing even the most rudimentary forecasting.

One of the real risks for seed investors, and for entrepreneurs, as we try to make companies more capital efficient and decrease the size of financings to limit dilution and capital risk in these early stages is that we don’t capitalize companies sufficiently to know when they’ve succeeded or failed.  Skinnying down the size of financings and then realizing you’ve funded the company only halfway to clarity is a bad outcome for everyone.  Should you write another check and buy the company more time?  Are these encouraging early signs, or false positives?  Are things going not so great, or do we have some early false negatives?  Uncertainty at these moments has a way of starting a path of incremental decision-making and, too often, funding companies well beyond the point where they probably should have been deemed failures.

At High Peaks we are very focused, as a firm, on investing to and through financeable milestones, and building in healthy cushions.  Bridges and inside rounds are good for nobody, so finance yourself to avoid them.  When deciding how much money to raise, map out a vision for your company that you and your advisors believe will lead to a next financing that happens at a much higher price than the current round. Regardless what they are, make sure the milestones are meaningful and that investors will reward them.  When you’ve identified the milestones, then follow these three steps to determine how much money to raise:

  1. Think hard about how much cash it will take to reach to those milestones.  If you’ll have revenue in that time period, be VERY conservative about how much revenue you assume is contributing to cash flow.
  2. Add 6 months more of cash – you want to reach the milestones BEFORE you start raising money again.  That’ll be a 4-6 month process unless you’re insanely lucky.
  3. Then add a buffer – at least 30%, but better 50%.  Things will go wrong, stuff will take longer to build, first customers will be slow to commit.  It ALWAYS happens.  So give yourself some cushion.

Bottom line, you need to raise enough money that you know you’ll be able to raise more at a much higher price if you succeed.  And as importantly, you need to raise enough that you’ve given yourself a full chance to succeed.  The bad outcome for entrepreneur and investor alike is staring at an empty bank account thinking “If only we had 2 more months, we really could have gotten there.”  You haven’t yet succeeded, but you also don’t know if you’ve failed.  Those situations tend to lead to bridges, down rounds, and other versions of good money after bad (some nice thoughts on this from Rob Go).

So be capital efficient – minimize dilution and make everyone’s upside that much better.  But don’t be shortsighted in your pursuit of efficiency and avoidance of dilution.  Build cushions into your cash needs and execute with confidence that whatever happens, you’re going to know where you stand when the cash has been spent.


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