Deciding How Much Capital to Raise
The first question which arises in the context of capital-raising is how much money should be sought. The company's ability to attract future investments is always uncertain, due to the volatility of the capital market, as well as the uncertain success of the company on its own merits. Therefore, as a rule of thumb, it is recommended the firm will raise capital, so that at any point, it has sufficient cash for at least 12 months. However, the amount of any potential investment is obviously always limited, as explained in the previous chapter, by the amount of money which investors are willing to risk at that stage of the financing process, and by the measure of dilution of the holdings which the existing shareholders are prepared to accept. The minimum amount which should be raised in each round is that which will enable the company to reach its next milestone, thus enabling additional rounds as well as the necessary time frame required to make such subsequent investment rounds (which could last many months). When making these calculations, the most pessimistic cash burn rate scenario should be used. A large round of investment enables the company to reach the market faster, to join a large number of investors who can contribute added value to the company and to pull through hard times. In that respect, a public offering is not necessarily the last capital raised before investment realization. Entrepreneurs should keep in mind that companies which are traded on NASDAQ were also afflicted with cash crises after the changes which became apparent in the market from the second quarter of 2000; their ability to raise cash on the stock markets was infringed, while their business plans called for ever-increasing cash investments (for a discussion of business planning and forecasting of expenses, see Chapter 3).
Valuing the Company for the Purpose of Raising Capital/Determining According to Which Value Capital Will be Raised
Whereas the amount of money required can, at least in theory, be calculated with reasonable accuracy based on the expense forecast, valuing the company for the purpose of capital raising is far more complicated and is one of the main issues faced by entrepreneurs, especially in the company's early phases. Entrepreneurs are usually not equipped with all the tools and knowledge possessed by investors (Chapter 9 reviews common methods of valuating startups).
Some entrepreneurs opt for the fastest financing, even if it is not based on the highest possible valuation, if they estimate that time is a crucial factor acting against them and the likelihood of success of their business. Other entrepreneurs, according to their character, choose to seek the highest possible price in each round, in consideration of the cost of diluting their holdings. Every startup and team of entrepreneurs take into account different parameters in making this decision. When deciding upon the timing of the financing in relation to the value, they are guided by considerations such as the identity of the investors, the degree to which the entrepreneurs are dependent on outside financing at each stage, and their assessment of the dilutions they expect to face in the future.
The average dilution in high tech companies is around 40–60% after the first round (including seed financing), 20–40% in the second round, and 10–30% from the second round until the IPO (in which 10–30% of the share capital is issued). Another 15–25% is allocated to employees. In other words, the group of entrepreneurs who starts out with 100% will hold approximately 40% after the first round of investment, approximately 25% after the second round, and approximately 15% of the shares before the IPO. These values tend to dramatically change when the round is done at a valuation lower than the previous round (down-round), as became common during the crisis of 2000. In a down-round, entrepreneurs' equity may be significantly reduced. To avoid such a situation, which could leave the entrepreneurs and top executives without incentives to continue with the company, investors tend to compensate the entrepreneurs with additional equity to maintain a minimum holding level (usually around 5% per entrepreneur).
Investments which are based on a high valuation may not only limit the amount of money invested (due to investors' refusal to take part in it), thus denying the company necessary funding, but may also cause friction between the company and its investors. Investors expect to see their investment increase in value from one round to the next. If a subsequent round of investment is made according to values similar or lower to those on which a current round is based, this could be interpreted as a failure, prejudice future investments, and cause tension within the company. Entrepreneurs need to understand that they will be diluted all along the way, and their only consideration should be to what extent any current round, and the dilution it involves, will generate a rise in the long-term value of their holdings. For instance, it is often preferable to raise capital from reputable investors for a relatively low price than from less reputable investors based on a high value.
Entrepreneurs are always subject to the whim of the markets, and sometimes it is almost impossible to raise capital for projects in fields which the financial community considers "cold." However, good projects and smart entrepreneurs may usually be displayed in the appropriate light, even if the company's business direction remains unchanged. As explained in Chapter 3 on business planning, a good managerial team and reputable financial backers and advisors are essential for raising capital, especially at times of crisis in the market for investments in the relevant field.