One of the little known aspects of venture capitalist investing in startups is around the desire for the entrepreneurs to continually raise more money. Now, the initial thinking around raising money is that a VC would primarily want an existing investment to raise more money when it’s doing well and the VC has the wherewithal to put more capital to work (e.g. double down on the winners).
Even if the VC doesn’t have the capital to put more money into the startup, or it’s doing good but not great, there’s still a desire for the startup to raise more money as long as it’s at a higher valuation. Why the emphasis if the VC’s ownership stake will get diluted? VCs, like everyone else, have a hard time putting a value on existing investments. Most startups are losing money, so you can’t do a value based on a multiple of profits. Another common strategy is to look at comparable public market multiples (e.g. a similar software company in the same or related market) and then take a 50% hair cut for lack of liquidity. Again, it isn’t very exact.
What’s exact is the valuation a subsequent investor paid for equity with the startup. So, VCs want their investments to raise money at higher valuations so that they can show paper returns to their own limited partners. VCs can’t raise another fund without good returns, and startups are often taking 7-10 years before an exit, so many VCs go out to raise their next fund based on the value of their illiquid investments according to the most recent funding round of each investment.
The next time you hear an entrepreneur say their VCs want them to raise another round, figure out if part of the desire is to mark their investment to a higher market value.
What else? What are some other thoughts on understanding a VC’s desire for an investment to raise more money?
David Cummings on Startups 