One of my favorite types of entrepreneur meeting is the successful bootstrapped founder contemplating how to grow faster. Partly, this is because I was in this situation in the past, and partly because it’s a nuanced topic with no easy answer. Outside of considerations like personal dreams/aspirations, capital availability, and lifestyle, the most tactical area to drill into is the financial aspects. More specifically, how to answer the question: when does it make financial sense to raise capital?
To answer this question, I imagine a business as a machine. The goal of the machine is put money into it and generate an output that’s a more than what was put in plus a return for the effort, cost of capital, etc. Taking this one step further in the context of raising money, and the corresponding dilution to the founders and the team, the value that’s created taking on the capital has to more than make up for the reduced ownership in the business.
Let’s break it down into a company valuation formula:
- Annual Recurring Revenue (ARR) * Growth Rate (GR) * 1.5(Net Dollar Retention (NDR)) * 15 (this number goes up and down dramatically based on the public markets, gross margins, customer acquisition costs, total addressable market, etc.) = Valuation
- Example: $10M ARR growing 50% YoY with 120% NDR is roughly valued at $10M * .5 * 1.8 * 15 = $135M
- Note: BVP Cloud Index is at a 14x average revenue multiple, so this example at ~13.5x ARR is inline (this example is growing faster than the public company average but doesn’t have public company scale)
So, the primary levers are recurring revenue and growth rate with a secondary lever being net dollar retention (if net dollar retention is below 100%, it starts penalizing the valuation quickly).
For simple math, let’s peg it as costing $2 to add $1 of recurring revenue. Assuming growth rate and net dollar retention stay constant (growth rate as an annual percentage usually declines 10% per year), we now know that for every $2 we put into the business we add $13.50 in value (or $1 for $6.75 in value). A good trade! This value then compounds on itself due to the net dollar retention above 100%, making the business grow in value each year without additional investment (assuming growth rate didn’t change, which it would).
If the example startup is worth $135M and a new investor puts in $10M, the business will become $67.5M more valuable by adding $5M in new annual recurring revenue. Assuming 7% equity dilution for this new money ($10M/$145M), and a 50% increase in valuation, this is an accretive deal to the founders. Ideally, there would be a large difference between equity value reduced from dilution and equity value gained from increased valuation to account for uncertainty.
Entrepreneurs should consider a formula that takes into account valuation, dilution, and valuation changes due to capital deployment in an effort to assess if it makes financial sense to raise capital. When the engine is working well, it often makes sense. When the engine isn’t working, it’s time to fix the engine before raising money, if possible.