If you haven’t read it already, check out Part 1 in this series.
Last time we went through a quick primer on capital markets to provide the context for how tech company financing works. Now we’re going to look at what funding rounds mean and why getting a bunch of money from investors isn’t necessarily something to be celebrated.
What is a Funding Series?
You’ve probably heard the terms funding round or Series B, bandied around the tech press. What does it mean?
Put simply, it’s when a group of investors give a company money in exchange for some stock. They all ‘buy’ the stock at the same time, which is called a ’round’. The price they pay per share is the same (more or less) but how much they buy defines how much cash they individually give the company.
The very first round, generally called a seed round, is designed to get the company off the ground. There’s an idea, maybe a very brief prototype, that’s been developed by the founders of the company using their own money, or maybe money from family and friends (anecdotally called the Family, Friends and Fools round). Seed money may also be invested by an Angel Investor, so-called because, like an angel, all they want to do is help. Yeah, right.
The first ‘official’ round of funding is called a Series A, because A comes at the beginning of the alphabet. This is the riskiest round, because you have no idea if the company will succeed for any length of time. It also means it’s the cheapest time to invest, as an investor. If you get in early, you might be able to pay, say, $1 a share for something that, you hope, will be worth $50 a share at some point. Maybe more.
The reason you take investment is to fund the growth of the company. In a fast-growth startup, you generally aren’t making as much in revenue as you’re spending. In a hardware company, like storage arrays, it takes quite a while to invent and test the hardware before you can sell it, but even with software companies there can be a delay between inventing and building your idea and actually selling it. During that delay period, you need to pay for equipment and components, rent on offices, stationary, pay employees, etc. That’s why you take investment.
How much money you take in early is a balancing act between how much you think you’ll need to achieve your goals, how much people are willing to invest, and how much stock you’re willing to give them in exchange. Because of this, you won’t get all the money you need in the first round, so you’ll need to ask for more later on. A series B, C, and so on.
In each successive series, you need more money because the company has grown. You’ve proven you’re doing well (otherwise why would people give you more money?) but you now have more expenses because you have more staff, more offices, etc. in order to support the revenue you’re hopefully making. You may not be cash-positive yet, because you’re still investing more than you make in profit, hence the need for external investment.
Part of the reason people celebrate a successful investment round is that it validates that the company is progressing well. The valuation of the company is $ per share times the number of shares, and if you’re doing well, people should be willing to pay more per share than they did earlier. That’s another reason a series C round will be more money than a series A. (When this doesn’t happen it’s called a down round and isn’t celebrated). This is handy, because by the time you get to a series C round, you need more money because you’re bigger, as we just discussed.
The rule of thumb is that the Series E round is the last one before either IPO or trade sale. There is no reason for this to be true, but because everyone else has been doing it, that’s what people expect.
Who Will Buy?
The implications of all this is that there is a limited amount of time before you need to pay your investors back. Another rule of thumb is that venture capitalists want their money back after about 5 years (another rule of thumb, partly because of the way investment funds work, but let’s not go there).
The more money you take in investment, the more your stock needs to be worth when it’s sold to someone else in an exit. As we discussed last time, that means an IPO or a trade sale.
For a trade sale, there needs to be a company willing to buy you, and at a price that they’re willing to pay. This is where it gets tricky when you take a lot of investment. We also need a little bit of maths here to figure out the implications.
If people have invested, say, $100 million in your company, the rule of thumb says they need to be able to get between $1bn and $2bn for their stock. Unless they bought 100% of your company, that means your company needs to be worth more than that for them to get their money. If investors have 50% of the stock (and you still have 50%) that means your company needs to be worth $2-4bn. The more money you raise, the higher this figure needs to be.
Now you need to find a buyer who can afford to (and will want to) pay $2-4bn for your company, depending on how much of your company the investors own. How many such companies are there? Your company, its technology, customers, staff, etc., needs to be of value to the acquiring company.
Otherwise your only exit option is an IPO, and that means you have to convince the general market that your company is worth this much money all by itself as a going concern. Getting everything ready for an IPO takes at least six months (getting all the internal structures in place, the accounting reports, preparing the IPO documents, etc.) and while you’re doing this, your senior executives are distracted from growing the business by the paperwork of preparing for an IPO. That can be quite dangerous.
The Airplane Analogy
And all the while, the clock is ticking. You’re running out of money, if you’re spending more than you earn (known as the burn rate), and for a high-growth company that is probably true. How much time you have before you run out of money is called runway because it’s a lot like a plane. Your startup is an accelerating plane, and it needs to take off (IPO or trade sale) before you run out of runway or… kaboom.
Each funding round buys you a little bit more runway, but your plane is now loaded up with more OPM, which means it has to be going a lot faster in order to take off.
Rock and a Hard Place
In the next post, I’ll run through why I think this is going to be a challenge for companies selling storage infrastructure in particular.