Doing the Dilution Dance with Investors

Entrepreneurs love talking about fundraising announcements from other startups. Fundraising, while it’s much too celebrated, is the most dramatic and firm number that’s readily associated with many startups. Whenever a fundraising announcement comes out, it’s fun to speculate on things like pre-money valuation, participating preferred vs non-participating preferred, stock option pool size, and other stipulations.

From an entrepreneur’s perspective, too much effort is focused on raising a specific dollar amount and not enough on dilution. After building a financial model, and plugging in imaginary numbers, it’s easy to get fixated on a specific amount as the must-have number. Only, with that number in mind, investors have more leverage in negotiating the pre-money valuation and other terms as the conversation is centered around the amount of money the entrepreneur wants to raise.

Instead, when raising money, it’s best to give a range (e.g. we want to raise $2-$3 million for our Series A) and make the conversation more focused on valuation and key terms and less about a specific amount. When we tried to raise money for Pardot in 2009, we received one verbal offer to invest $1 million at a $2 million pre-money valuation and a separate verbal offer to invest $5 million at a $7 million pre-money valuation. Both offers came from venture capitalists, and both were at the same time for the same business (we had slightly over $1 million in annual recurring revenue at the time). In one case we could sell 33% of the business for $1 million and the other case we could sell 40% of the business for $5 million. We passed on both offers.

When doing the dilution dance with investors, focus on the key terms and less on the actual dollar amount raised.

What else? What are some more thoughts on entrepreneurs focused on raising a specific dollar amount instead of more important terms like valuation and control provisions?

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