Raise smaller mini-rounds in close succession rather than one large equity round.
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Driving down the Bay Area’s idyllic I-280 — for the third time — from San Francisco to Palo Alto made for a very, very long day. But it gave my cofounder and me time to marvel at the speed with which we were able to supercharge our business with new capital.
In just a few days, we had gone from struggling to close to having enough capital to make the hires and purchases we needed. More importantly, we were able to do this in smaller increments and at successively higher caps, or valuations.
As founders, this is an even bigger win because higher valuations for investors means less dilution for founders. Unknowingly, we had stumbled upon a novel strategy to raise money and lower founders’ dilution risk.
If you’re raising money for your startup, you’re likely spending way more time than you thought you would working and reworking your valuation. You may get offers from investors, but not often enough to fill out your round. Yet, through a simple technique, you can push your fundraising to the next level, resulting in a higher valuation that attracts the funding you need.
Adjusting valuation caps attracts money.
This is called a “step close,” and it requires you to raise smaller “mini rounds” in close succession, at ever-higher valuation caps, rather than one large equity round at a fixed valuation.
This gives founders more control over the timing and strategy of the close. All that needs to be executed is a simple document at signing.
The first key to this technique is employing the valuation cap of convertible notes to your advantage. Often, the value of notes are offset by a valuation cap, which places a maximum amount on converting your notes into equity. This protects investors if, for instance, your company becomes the next Facebook or Amazon out of the gate.
But founders can also use this instrument to their advantage. Companies can issue a variety of convertible notes at different valuation caps, meaning you can raise with a valuation cap of $5 million one week and then, owing to demand, raise the valuation cap to $6 million a week later. For the extremely daring, you can compress this time scale into a matter of days.
Close the door behind you.
The second key to this technique is the “last person in” principle. Very few investors, even the most daring, want to be the first “money in” at a company. The smartest investors prefer to wait until other stakeholders have validated the business before committing.
This is great if you have three-quarters of a $2 million round completed, but it’s quite daunting if you’ve only closed a tenth of that. Smart founders turn this problem on its head, turning a $2 million round into a $400,000 mini-round that’s already received more than half its commitment. Making the round smaller, you give investors the ability to be the last money in for that mini-round — the way they prefer.
Let’s see how these two techniques play out in practice. Say your goal is to close $1 million in seed funding. Because all investors want to be the last one in, close the first mini-round at $500,000 at the first valuation cap. Usually, this valuation cap is lower and offers preferential terms to the first investors. Luckily, you can close this small amount from close family and friends, making it much easier to gain traction.
Once the first mini-round is completed, raise another $500,000 at a slightly higher valuation cap, owing to increased investor demand, company traction and progress. With more traction, you’ll be able to close angels and seed funds. With a higher valuation cap, you get to preserve more equity as a founder as well. Continue this process until you reach your $1 million goal.
You can repeat this process over a period of weeks and months, depending on how many mini-rounds you need to reach your ultimate fundraising goal. In doing this, you’ll gradually drive your valuation up and have fewer dilutions. Best of all, several investors will get to achieve their goal of being the last one in.
Of course, if and when you exit, the opposite often proves to be true. Investors will all want to be the “first money out.”