A Developer's Guide to Startup Fundraising

swyx 2020-08-12

Note: this doc has continued to be updated up til 2022.

Someone in the Coding Career Community asked:

Is there a good guide out there to familiarize oneself with the structures and lingo of startups? I mean knowing about seed fundraising, equity rounds… don’t be afraid to go really basic on it. Startups for Dummmies.

I realize that the lingo can be pretty scary for new developers and the tech news media never really stops to explain some basics. So here is a quick brain dump of thoughts at least from a US-biased perspective. This is a living document, please feel free to add in comments and I will edit.

Important Caveats and Disclaimers

I’m just a developer with a former finance background and an interest in this stuff. But I’m no expert or VC. I have never personally raised any startup money. but I do keep tabs on the US startup ecosystem and have worked at a couple startups, most recently from Series B to C (Update: I posted an update on working from Series A to B here.)

Just sharing what I know, developer to developer, not trying to come across as an authoritative source or anything.

Why Fundraise At All

We should probably start with why you even want to raise funds, when most “normal” (non tech) businesses start with a bank loan or a “rich uncle”.

This happens because of the economics of scale. If you’re just starting a mom ‘n pop shop, you don’t need a lot to get started, and you can (hopefully) recoup what you invest in a short amount of time.

But if you’re building a $1b factory to make $200 computer chips or hiring a bunch of $200,000/yr engineers to write $10/month software, you need a lot of money upfront, and patience to grow sales up to the point where your overall profits start to cover the upfront cost you incur.

Many startups don’t start with their full economics worked out yet. The assumption is that if you can get a bunch of users first, you can figure out how to monetize them later. So modern startups can often run with negligible revenue for years (think: GIPHY, Reddit, Facebook, but also open source developer tooling companies like Gatsby) while having a burn rate (contractually obliged spending, like employee payroll or office rental) of hundreds of thousands a month. This is especially important if the goal is to spread virally, or to form a sticky habit.

Often, aggressive companies will even use the money they raise to subsidize their customers, just to grow the customer base and build the habit (think: Uber/Lyft, Postmates/Doordash). They will literally make a loss on every transaction, something you can only do if you have deep pockets. So you go deeper in the #red the faster you grow. As you might imagine, this is high risk, high reward. Giving money to customers to get customers sounds like a terrible business, but it worked very well for Paypal.

Pop culture reference: You saw this happen on HBO’s Silicon Valley where Richard Hendricks “bankrupts” Sliceline in order to acquihire the company, by buying a bunch of pizzas from them. In reality this is very unlikely to happen due to the expense, but it’s a TV show 🤷‍♂️

Money is often also bundled with advice and network. You may not NEED the money, but if you are building a social network, you might well want to raise money from Reid Hoffman or Peter Thiel just to get their advice. If you are selling to developer enterprises, you may want to raise money from Y Combinator just to get your foot in the door to sell to all Y Combinator alumni companies. Do note that the actual value of these non-monetary aspects of fundraising is heavily disputed.

Fundraising Economics

There are two main ways of financing any business venture: Equity and Debt. There’s a thousand tiny variations of combinations of them (see “Nuances” section next) but you should understand the big picture first.

  • Debt is what you might be familiar from taking on a mortgage for a house - I lend you a sum of money, and you agree to pay it back to me in future, with some amount of interest due every year for my trouble.
    • If your business valuation grows, I take no benefit from that, I merely continue to receive my interest payments.
    • If your business goes bankrupt, you don’t owe me anything (more accurately, I take possession of your remaining assets) - thats the risk I took in exchange for those interest payments.
    • Since most startups fail, most startups are not able to get lenders to take this risk (aka, raise debt capital). ”Venture Debt” does exist though, for the small category of startups who can raise it.
  • Most fundraising takes the form of sale of Equity. This is a straightforward exchange of cash for a partial ownership in the company.
    • The math gets a little circular, because the value of the company goes up when the money goes in, which then affects what % of the company you actually own. So the startup community has adopted a simple terminology. You have a “pre-money valuation” and a “post-money valuation”. The “money” here is the amount invested/raised. So say I give you a $45m pre money valuation and I invest $5m. Your post money valuation is $50m, and I now own a 10% stake in your company (5 divided by 50). In practice this lingo can be shortened in various ways: “I raised 5 on 50”, “I’ll take 10% on a 50 post”, so on. The lingo differs but the math is the same.
    • Most valuations quoted are post-money, because it is the bigger and easier number to do math with. If you are given $1m in equity of a company valued at $1b, it means you have 0.10% of the company (important nuances apply w.r.t. dilution, vesting, and preference stack)

Important Nuances on Equity

Early stages of startups often have a hybrid between debt and equity. This is often used to deal with the fact that trying to place a valuation on an early stage company with no revenues is meaningless, but standard debt is unattractive for the investor, so we improve the upside for them by letting the debt convert into equity at some future point. This has a few names, and is known as convertible debt in the public markets, but in startups the popular version of this is the Simple Agreement for Future Equity or SAFE (explainer here, UpCounsel explainer here), introduced by Y Combinator in 2013. SAFEs recognize the futility of placing a valuation number on an early stage, and only convert to equity in a future priced round.

Technically if you raise SAFEs and then never raise a priced round, your investors and employees never get anything back. Toptal founder Taso du Val is accused of doing this.

also, if you raise MULTIPLE SAFEs, do note the antidilutive properties of post money SAFEs.

Another way startup investors sweeten the deal is to include special terms in the contract. There are a wide range of these:

  • An option to invest further money in future funding rounds
  • Some sort of “preference” or “preferred” status in the investment, where, if the business gets sold, they get paid back first ahead of other investors
  • Anti-dilution terms to defend against dilution from future fundraising (I’ll explain below)
  • Board seats (which lets investors have a say in company strategy and hire/fire senior management including founders - routine for lead investors of each stage to have, but also where they turn from fans to your boss.)
  • Jason Calacanis likes to attach side letters to SAFEs
  • and more I cant think of and don’t know about (what other major terms should i add?)

Dilution is what happens when startups issue new shares to raise subsequent rounds of funding and you aren’t involved. This happens because nobody ACTUALLY sells “10% of a company”. You create, out of thin air, 1 million shares, and give me 100,000 of them. Then, for the purpose of simple math, when you raise your next round, you create 1 million more shares, and I for whatever reason don’t invest more money, my 10% goes down to 5% (because I now own 100,000 shares out of a shareholder base of 2 million shares).

Typical dilution by stage from Index Ventures:

  • Series A: 20%
  • Series A+B: 33%
  • Series A+B+C: 41%
  • Series A+B+C+D: 47%

You most famously saw dilution dramatized in The Social Network, when Eduardo Saverin was diluted out of his ownership of Facebook. This happens to cofounders, employees, and unsophisticated investors if they aren’t careful (ugly wipeout example here). Therefore anti-dilution terms are used to protect investments. Some go overboard and become genuinely predatory, eating up more of the company when it is not doing well, like the dreaded full ratchet.

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Fundraising Terms are deals with the devil. You of course get better valuation and more money with these terms, but they make it more complicated for you down the line as well as for everyone else on your “cap table” (the list of people who invested with you). If you wish to be acquired some day, you ideally want to have ”clean terms”. Of course this is the domain of lawyers and much negotiation.

Now that you know what dilution is, you can also learn the difference between primary and secondary share sales. Primary fundraising happen when you create new shares out of thin air and sell them to investors. Secondary sales happen when you transfer ownership of existing shares to investors. Most fundraising is primary. However, you often see some secondary sales as well bundled alongside the primary sales, especially in later stages. This allows founders and employees to “take some money off the table”, and is usually not a sign of lack of faith in the company. Instead, secondary sales are mostly simple pragmatism in that founders and early employees may sit on paper wealth worth millions which might go to 0 someday, so it is prudent to cash in some of it in. Basecamp founders Jason Fried and DHH are famously criticized for “raising money” from Jeff Bezos, but this was a secondary sale that gave them the financial security to build for the long term.

An extreme version of secondary sale is VC’s buying out other VC’s. Chris Sacca became a billionaire by buying up 10% of Twitter from other shareholders who weren’t as optimistic as he was. VC’s have also been known to stalk departing employees to snap up their shares in a hot company.

Most employees do not get outright grants of equity. They get options to buy equity. They also don’t get these options right away - they vest over time to ensure that you can’t just join for 1 month and leave with the whole amount (Founders vest too). If they leave the company, they get to “buy in” to the company they helped to build. If the company gets acquired, all employee options convert to shares. For more details on the employee perspective, see the Holloway Guide to Equity Compensation.

In the US, it is generally illegal to openly solicit funds for your startup. To protect the average Joe from losing money to some get-rich-quick scheme, you can only raise in private from accredited investors (read: rich people). Of course, this could also have the downside of reserving opportunities to get rich only to the already rich. Exceptions to this rule are opening up, between the JOBS act and Reg 506(c) for rolling venture funds.

Fundraising Stages

In the course of their life as a private startup, startups often raise anywhere from $5m to $5b, between their founding to their Exit.

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An “exit” is VC lingo for either an Initial Public Offering or an Acquisition. In both cases, the VC gets paid back on their investment either in public company stock or in cash and are said to have “exited” their investment - although in reality many VC’s often hold on to their stock after IPO, sometimes for years, because they continue to believe in the company as an investment.

When you hear a company do a successful exit, it can be common to assume that the founders are billionaires. This is often far from the truth, though they certainly won’t have to work again. Typical founder ownership percentages by exit range from 5-20%. It’s much more likely that VC’s have more ownership than founders and therefore make more from the exit (and are financially more incentivized to push for an earlier exit than founders). If that sounds like a bum deal, it can be. Someone running a $100m bootstrapped company can be wealthier than someone running a $10b unicorn. So of course, putting off fundraising can be very beneficial for founders, at the expense of speed of growth. the Atlassian founders owned 60% of the company at IPO, but took 15 years to get there.

Most professional VCs are not investing money out of their own pockets. VC firms take a partnership format and raise funds in vintages like wine. They raise money from institutions, which range from pension funds to university endowments to family offices (read: “rich people”), who form their “Limited Partners” (LP’s). The principal VC investors are thus “General Partners” (GP’s) of those partnerships. Now you know what it means when VC’s talk about their “fiduciary duty to LPs”. The compensation model is usually some variant of “2 and 20” - speaking VERY VERY loosely, VC’s earn 2% of funds invested per year, and 20% of realized profits over some pre-agreed hurdle on exit. This varies WILDLY, and I want to be extra clear that I have only very third-hand knowledge of the actual terms here.

But the point is this - funds are raised for a specific purpose to serve a specific clientele with desired risk profile and investment mandate. Some LPs are comfortable with the risks of early stage investment. Some only want to invest in proven later stage companies. Money is NOT the same shade of green everywhere. It is completely reasonable and natural to have different profiles of investors along the lifetime of a journey. Further, these investors expect a return on their investment within a reasonable timeframe, say, 10 years (the commonly cited amount of time between starting and exiting a “unicorn” startup - though this has gotten longer recently as more and more financing moves to private markets).

There are no hard and fast rules with fundraising stages, but there is an informal norm with many exceptions. As a rule of thumb, 10-30% of post money equity is sold at every stage, and you need to reach some proof points before you get the next stage. The other way to think about stages is that given your projected burn rate (contractually obliged spending, like employee payroll or office rental), you want to raise about 1.5-2 years worth of funds at each stage (burn typically does a quantum step up at every stage, you see a flurry of hiring in order to meet aggressive growth targets).

Funding rounds also tend to inflate over time - $20m raised in 2010 is much much more than $20m in 2020.

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2023 edit: we now have data that says series A/B/C are the highest expected value stages from 2015

Here is a very rough, illustrative guide:

Here’s is a list of some popular names of investors that specialize in each stage: https://www.fundz.net/what-is-series-a-funding-series-b-funding-and-more

These numbers are merely illustrative and there are lots of great reasons why an individual company might not meet those situations. After all, the nomenclature of “Series A B or C” only depends on the order of fundraises. Jason Calacanis has coined the term of “Pegasus” for companies that normally would’ve raised a round at a particular stage, but don’t because they didn’t need the money, therefore they “fly” over a particular stage. Webflow is one example of a Pegasus that raised an abnormal $72m “Series A” (not at all a standard Series A by any metric).

Of course there are other reasons to reach abnormal valuation at any given stage - serial founders with proven track records, or just abnormal business results, like with Rippling’s $145m Series B.

The most aggressive VCs and high potential startups do “pre-emptive” rounds - meaning they get the money they would have received for a stage, despite not having yet met the traditional metrics needed for that stage. Pre-emptive A’s and B’s are common.

On the other end of the spectrum, if startups need a little more time to hit their metrics, they often get intermediate rounds of funding. This can be called a number of things, from “bridge” to “extension”

Given how every case is special, funding dynamics are always very difficult to generalize. You can find collated data in Crunchbase and Pitchbook. They also change over time. The amounts and valuations of each stage has almost doubled over time compared to where they were 10 years ago.

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It will likely shrink and grow together with the economy. The exits of one generation of entrepreneurs also frees up money to invest in the next, so investing can happen in waves.

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If you are wondering how fundraising has been affected by Covid, here’s some data for you - investment sizes have gone UP, numbers have gone DOWN. Massive concentration in companies that are doing well.

To be continued?

Phew that was a lot. Let me know if there are still unanswered questions and I’d be happy to add to this.

More Resources

Tagged in: #startups #fundraising #money

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