[Editor’s Note: This post was written in response to recent conversations I have had with entrepreneurs. I have heard entrepreneurs say that the more money you raise the higher price you get from VCs, as if they have “cracked the code” on the venture capital market. If you are an aspiring entrepreneur this post may save you some headaches and might even save your business.]
First a few stats: on average, venture-backed companies raise money every 18 months, and the average holding period of a venture investment is seven years. If you put this together, most companies raise money four or five times before they are sold or go public.
This venture capital treadmill is a tough ride for many entrepreneurs. First, every round results in new dilution. Companies should expect to sell a third of their business in the first round, and a similar percentage in the second round. By the third and fourth round the valuation is normally high enough that there is less dilution, but it still adds up. Second, venture-backed companies need to grow. The average step-up between rounds is normally a 2x, which translates into over 100%/yr growth on a compound basis. Companies that fall short of this target often have a hard time finding new investors. They might get bailed out by their existing investors, but that has negative consequences for management.
The math of compound growth means that small differences in the starting point produce a cascade of big jumps in the out years. See the example below:
Scenario 3 might look attractive, but out of 2,000 digital media companies funded every year only 1-2% will have the revenue growth to sustain Scenario 3. Most that go down this path fall out of orbit sometime after the first round closes.
If I could convey one lesson for entrepreneurs it would be to think about the next round AND the round after that. Realize that over the next three years you will have to find multiple new buyers at even higher prices. Experienced entrepreneurs that have been through this process before often try to raise the LEAST amount of money possible. They understand how starting off on the wrong foot is likely to cost them their job in 3 years.