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Michael MassadSenior Associate

Bigger Isn't Better: Why Rightsizing Capital is the Best Move

In a best-case scenario, when a startup exits, both founders and investors see a nice payday. But in the world of venture capital, 90% of startups fail. And many venture investments have “structure," where founders get an even smaller piece of the pie at exit than the cap table suggests.

Many VCs are comfortable with this approach because they think about their investments as high-risk, high-reward bets. If one out of 10 goes really well and the rest fail along the way, they’re pretty happy. But what about the other nine founders?

Here at Elsewhere, we have always wanted to take a different approach. We believe there is a way to structure deals so that everyone is aligned towards an outcome that is both rewarding and statistically likely. When an exit (or a follow-on investment) happens, everyone can walk away from the table happy. There’s no reason why investing can’t be win-win, and in fact it should be.

To that end, today I want to talk about what we mean when we say Elsewhere offers “transitional capital.” It’s not just marketing speak. It’s how we approach all of our partnerships, and we believe it sets founders up for success.

Here’s what we mean, how these concepts fit into the VC landscape, and how to know if this startup funding approach is right for you.

Rightsizing funding for your business’ needs

Thanks to a seemingly endless stream of startup funding headlines, many founders have a preconceived idea of how big a check should be when they set out to raise a round, particularly if you’ve bootstrapped and are seeking outside funding for the first time. Let’s unpack that.

The best way to size a fundraise is to look at how much capital you anticipate spending over the next 18 to 24 months to reach a given milestone (revenue, scale, etc.). This is obviously a complex task. Any early-stage company that has found product-market fit is going to want to accelerate their sales and marketing efforts, so the previous quarters’ rate won’t be totally applicable.

Nonetheless, we believe that companies should avoid “over-capitalizing” the business which leads to an exponential increase in their burn rate (or in some cases actually burning capital for the first time after previously managing to break-even each year) and a shotgun approach to spending money. That investor check also comes with a leap in expectations in terms of growth rate, execution, and milestones needed for a successful exit. Sloane recently shared her experience working for a startup that faced this exact conundrum.

But why would a VC offer you more money than you really need? There are reasons for larger check sizes and increased expectations, and we have a secret for you: it’s not you, it’s them. Funds often have minimum check sizes. So the bigger the fund size, the bigger the checks need to be. This also directly affects exit expectations. Funds underwrite a certain return (3, 4, 5, 7X multiple on their investment), so the bigger the check they invest, often the higher the bar for an exit.

This isn’t a knock on big funds; there’s a place for them in this world and many startups will need a sizable war chest of cash for near-term execution. This is particularly true in any industry that’s heavily regulated or requires a huge infrastructure investment. Hardware makers or biotech companies needing to run clinical trials often require larger investments. But for software businesses, it’s more common than not for VCs to offer more than you really need. This is why it’s critical to research the fund size and style before you take an investor’s money. Bigger does not always equal better.

Not all SaaS companies require the heavy infrastructure or regulatory spend detailed above. So when you’re thinking about that next phase of growth, model out what a true acceleration of your sales and marketing efforts could look like. Don’t reverse engineer how to spend a $15 million round over two years (that’s often where you’ll see the lavish “perks” like daily catered lunches, offices that look like Dave & Buster’s game rooms, and anything else parodied on the show “Silicon Valley”). Think about where to invest in your business that will generate the highest return, and also consider that more cash will come in from customers as you start to reap the benefit of sales and marketing investments.

That’s not to say there won’t come a day when a big round is the right thing for you. We just think it’s all a matter of timing and not taking any options off the table for yourself. Just remember, when you take a big check there is more to consider than simply dollars raised and equity sold.

Transitional capital is about controlling your destiny

Too much cash too soon can be dangerous in terms of execution pressure, but you may also be selling yourself short in the process.

Consider whether a smaller check today, say $5 million, could enable you to significantly grow your ARR and make your company far more valuable in two years. At that point, you’ll be far better positioned to raise a bigger round. It’s also likely that you’ll have the growth trajectory to match the check size. Plus, you’ll have made your company more valuable. That means you as a founder will take less of a dilution hit.

Or, you may decide that you’ve had a great ride, but you don’t want to run the company for that next ~5-year period. We find this is really common with startup founders who have bootstrapped their way to scale and profitability over a number of years. They love the early, scrappy days and start to lose their passion when the business gets bigger. If you’ve only taken a small round, you’ll have the option to cash out your (valuable) stake to the next set of investors. Better yet, a $5 million fundraise leaves room for far more potential acquirers given the lower exit threshold than, say, a $50 million raise would demand.

There isn’t one right way to be successful as a startup founder, and a right-sized fundraise doesn’t prematurely take any outcomes out of the running. On the contrary, it delays the “billion or bust” decision and gives you more options to control your destiny long-term.

Transitional capital offers clean terms and no surprises

A big round with a high valuation is often looked at as the holy grail for founders, but it doesn’t come without strings. Again, this isn’t to knock larger funds; it’s just the name of the game. When big money is in play, these venture funds will want to do everything possible to lock in a return, even if founders get burned in the process. If one firm has offered a much higher valuation, look closely at the terms and structure involved.

This is where you’ll see terms like participating preferred, or a 2x or 3x liquidation preference, which means in the event of a sale the investor will get two or three times their original investment before common stockholders (e.g. you, the founders and your employees) have a shot at it. These terms are most relevant in a sub-optimal exit, and they get more hairy the more rounds you’ve raised and the more investors are in the cap table. Check out this post from Brad Feld for a helpful explainer on the different legal terms you could see creep into a term sheet.

Smaller raises in the early stages often come with cleaner terms and fewer surprises. Seek investors who are aligned with realistic outcomes and make sure you understand all of the math in your term sheet.

How to factor transitional capital into your fundraising strategy

There are a wealth of options available to founders other than the standard “unicorn or bust” path. Many founders understandably consider more traditional VC models and check sizes ($$$$) during the fundraising process. But more isn’t always better, and we encourage you to “begin with the end in mind,” as they say. In other words, start the fundraising process with a vision of the ideal outcome and a sense of what’s realistic.

This can help you choose the path that’s right for you, rather than the one that’s right for the investor on the other side of the table.



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About the Author

Michael Massad

Michael is a software investor at Elsewhere Partners where he co-leads all sourcing efforts and conducts operational / financial due diligence. Michael strives to connect capital and operational expertise with growing software companies across industries – most recently in infrastructure and cybersecurity – that are located outside of traditional VC hubs