Most founders are very excited when they successfully raise their first round of funding. They’re very optimistic that they will be able to meet all their Excel projections now that they can start implementing their business plans. They are confident they will be able to get traction, and raise a Series A in a few months, at a much better valuation.
In reality, this usually doesn’t happen, because most founders underestimate the complexity and the difficulty of running a startup . Timelines in the real world are much longer than they anticipated, and everything’s a lot more expensive and complex than they thought it would be.
This is why they start running out of money before they have met their projected milestones. When they realise that their bank balance is dangerously low, they start scrambling to raise what is euphemistically called a “Pre-Series A” or a “Bridge Round.”
This can be hard to do, you’re not in a very strong position for negotiating effectively when you have no money in the bank. However, you think your valuation should be far higher than it was during the Seed round, because you have accomplished some of your milestones and been able to partially prove that your business model works. Because you have made some progress, you feel that you deserve a higher valuation. You want investors to give you credit for your accomplishments, and give you more money.
This is very naive. The reality is that this is a market, which means the right price is a balance between supply and demand. When you’re running out of money, your ability to negotiate is markedly impaired. This can create tension blood because founders feel that investors are taking unfair advantage of their helplessness.
However, from the funder’s point of view, you’re the one who created the projections; you’re the one who asked for a certain valuation which was given to you; and you’re the one who’s failed to deliver on your promises. Therefore, you should be penalised for not being able to implement successfully. The only way to do this is to reduce your valuation so you need to accept a down round. This is hard for most founders to swallow.
Related Article: Raising Your Next Round Of Funding
The Right Number For Valuing The Bridge Round
It’s very hard to know what the right number is for valuing the bridge round is. The reality is that valuing any round – whether it’s the seed round, or the Series A, or the bridge round is equally hard. Everything is intangible and nebulous, and there is no metric or formula which you can use. Beauty lies in the eyes of the beholder, and the price depends on gut feel; and your judgment about the capabilities of the founders.
It’s hard for existing investors well. You don’t want to be seen as greedy and unfair, especially if his heart seems to be in the right place; he is chugging along in the right direction; but has failed to meet his revenue targets because of the external environment.
This is why this scenario can create a lot of bad blood. It sucks up a lot of the founder’s energy, who has to scramble in order to raise the next round. When the initial investors are not willing to give him more money, he’s going to find it extremely hard to get new investors to give him any.
One solution is to discuss this scenario when funding the Seed round and saying, ” If you are not able to accomplish the following targets, then we give you more money only if you are willing to accept a reduced valuation.” A clawback provision could also be included in the agreement. The chance for possible conflict further down the road is reduced because the founders have agreed upfront that this is a scenario they’re comfortable with.
Making sure that the founder’s and the funder’s interests remain aligned is extremely complicated when things aren’t going well.
What Do You Think Is A Fair Way Of Dealing With This ?
Actions have consequences, and if you cannot meet the goals which you set for yourself when raising funds, then you should be willing to accept the fact that you will pay a price for this.
How steep the price will be will depend upon many factors, including how good the chemistry between you and your investors has been so far. Have you been open and transparent with them? Do they trust you? Are they convinced that you have put in your best efforts?
Most investors will have an anchoring bias, and will use the valuation you accepted when raising your seed round as their benchmark. They will want to reduce the pre-money valuation, because you have failed to deliver as promised. This is what causes the tension and friction, because while you may feel that you have made progress, they feel that you have failed to live up to your promises. As a founder, you have to be flexible – when you desperately need oxygen, you cannot afford to be picky and choosy. Otherwise, you may find that the bridge you need to cross is too far off !
One way in which angels can overcome their bias is to treat the request for additional funding as a completely new investment opportunity.
If you hadn’t invested earlier, would you invest in the company at this stage? Start with a clean slate. If you believe that even though the founder could not generate the projected revenue, if he has run experiments successfully which demonstrate that he has improved his product- market fit, then you should be willing to be more forgiving, and continue backing him. However, if you feel that he is not reliable, then it’s best to cut your losses, and look for other investment opportunities.
[This post by Dr. Aniruddha Malpani first appeared on LinkedIn and has been reproduced with permission.]