Fundraising for startups is usually hard. I start most of my articles about fundraising with some variation of that sentence because it’s almost universally true. Hype around a handful of companies that benefit from irrational exuberance that leads VCs to throw wads of cash at business models that are still very unproven is not the norm. For the rest of us, we have to get creative and flexible when raising capital.
As the stress builds around a fundraise, all money starts to look like good money. That’s where I see founders make mistakes. Taking on very small investors in a structured round can be a mistake. However, small checks from big investors can create negative conditions for future rounds that need to be considered as well. I will save you the Goldilocks metaphor.
Let’s take a scenario we see regularly.
Founders are raising a $1m pre-seed round for their startup using convertible notes. There is a commitment from a lead investor who plans on taking $750k of the round. The founders have another $150k from a VC fund in another state and leaves about $100k open for additional investors. The founders then agree to take money from five angel investors. The amounts vary per angel and range from $50k to $5k. In this scenario, the founders will close their round with 7 investors added to their cap table. Pretty clean round, right? Maybe…
Pari Passu
Startups can carry pre-seed investors on their cap table for 5-10 years. Before closing a round, investors can ask for all kinds of due diligence materials. The larger or more structured investors will require it- in great detail. After closing, investors normally get basic information and access rights and those rights are shared among all investors in a given round.
It’s not strange for terms of the investment to require founders to provide quarterly and annual financial reporting as well as updates around the business operation, personnel and other matters. Each year, founders may have to pull together four quarterly reports and a proforma for the next calendar year. In addition, there will be some amount of investor relations they will have to complete including everything from random calls or emails from investors to recurring monthly meetings and sending out regular updates. It’s safe to estimate it takes about 50 hours a year to get all of this done. Founders may hire an accountant or other contractors to complete financials or proformas but much of this work can only be done by the founders. You can calculate your own opportunity cost but it’s probably, at minimum, 5 figures.
Paying for Investors to be on the Cap Table
For simple math, let’s assume about $20k in total annual opportunity and hard costs to satisfy the basic information rights requirements for those investors. Each investor’s annual portion of that cost ($20k / 7) is about $2,800. Before the end of year 2, the $5,000 angel investor’s capital has, essentially, been spent on servicing that investor’s information rights. Before the end of year four, a $10,000 investor’s capital has been spent on servicing their rights.
At some point, those small individual investments can be worse than worthless. Those starts to, conceptually, become a financial drag on the startup. Founders are then paying to carry investors who provide no relative capital value.
Bigger is not Always Better
Now, let’s assume that same scenario but the $100k open in the round is taken by a massive VC fund or investor. Most founders would be thrilled to get a superstar name on the cap table. Big VCs often have scout funds or allocations to place small bets, almost like options, on early stage companies. They might place $100k on 20 early companies a year just to get the same rights as the other investors in the round. They will get the startups’ financials, see the inner workings of the businesses, watch competitors and track progress for what is, essentially, a sub-atomic amount of their total capital.
In many cases, having that kind of star power as an investor is very helpful. It’s a strong indicator to current investors that the founders are onto something. It’s helpful unless that same famous VC decides not to participate in the next round. Now founders have to explain to potential Seed or A Round investors why a mega VC, with hundreds of millions of dollars to invest, is not going to continue providing capital to their startup. Future investors may worry this means there is something wrong or the business can’t create venture scale even if that’s not the case.
Relative Value of Money
The implied advice here is to assess the value of each investor’s capital over time. Founders have fixed costs for each investor, regardless of their check size. How big does your minimum check size need to be to be worthwhile? Depending on the founders you talk to, many will share that some of their smallest investors are the ones that demand a disproportionate amount of their time when compared to other investors- further accelerating the devaluation of a small check.
Small investors can carry strategic value beyond the capital and offering to include them in a round to maintain access can make sense. Just make sure you and that investor share the same expectations for what you expect of them outside of the investment.
It’s hard to know if a mega-fund is going to pass on your next round but you can look at what they’ve invested in previously. Do you see a resemblance to those investments to your own startup? Could you reasonably expect a repeating pattern from them? Look to see if they usually follow-on with scout-funded bets or not and if that’s unclear- ask them and get specific examples.
If you determine the relative value and potential costs of both of these kinds of investors, you can decide what investors are the right size for your round.
