Fund GENEROUSLY to Milestones

Founders often seek advice regarding the amount of capital to be raised.  The conventional wisdom is to raise sufficient capital to permit the company to achieve a milestone that will result in a material increase in the company’s value.  The milestone might be developing a first prototype of the company’s product (reducing technology risk), a significant sale (reducing market risk), or receiving a necessary government approval (reducing regulatory risk).  Raising a portion of the needed capital at a higher valuation reduces dilution to the founders’ position, allowing them to gain a greater return on exit.

Recently, an investor asserted that a company should be indifferent with respect to the timing of raising additional capital.  The investor contended that, if a company raises more capital than is needed to reach the next milestone, the cash remaining in the bank will increase the company’s valuation at the next financing and thereby offset the added dilution from the first financing.  We did some modeling to test this hypothesis and confirmed the conventional wisdom.  Rest assured, funding to milestones does reduce dilution.

Nonetheless, there are good reasons for founders to raise more than just their perceived minimum amount needed to achieve the next milestone.

First, founders frequently underestimate their capital needs.  If the capital is insufficient to reach the next milestone, the result can be catastrophic.  The company may be unable to raise additional capital at all.  As the milestone has not been met, if additional capital is forthcoming, it may be at the same or a lower valuation, resulting in massive dilution.

Second, although not intuitive, early-stage valuations may be positively correlated with the amount of capital raised.  As early-stage companies have little operating or financial history, valuation is more art than science.  Many investors are primarily focused on the percentage of the company that they will own.  Suppose an investor requires a 20% stake in each investment.  If the investor is the sole participant in a $1 million Series A round, the pre-money valuation would be $4 million.  If the investor is the sole participant in a $3 million Series A round, the pre-money valuation would be $12 million.  While ownership percentage is not the only factor for most investors, the tendency to place higher valuations on companies that raise greater amounts does offset some of the dilutive effect of raising extra capital.

Third, a cash cushion can be helpful when negotiating valuation in the next financing.  Even if the company has achieved the value-increasing milestone, it will be in a weak bargaining position if its cash is exhausted.

In short, companies should adhere to the conventional wisdom by funding to milestones.  However, raising substantially more than the anticipated need, that is, funding GENEROUSLY to milestones, is prudent.