Raising the right amount of capital after a correction

The cloud software industry has experienced an incredible period of growth and success. Recently, however, we have witnessed a deep correction in the public markets. The Bessemer Cloud Index tracking public stocks across this category is down over 40% from its November 2021 high.

This reset in valuations is now rippling through the private venture-backed market, hitting late-stage companies first before early-stage startups feel the effects. That’s a big deal for both startups and venture firms. Many founders are now wondering if it is the right time to raise capital and how much is realistic.

Let’s take this one question at a time. First, if you are just getting started — or even still just dreaming about your own startup — is a downturn like this even a good time to start a company?

We believe it is an excellent time.

Why? The short answer: In the beginning you need a few, not many, customers, and you need their time so you can work with them, which they have more of now that things are slow. Since you won’t be scaling for some time, small ACVs are okay. More important at this point is to hire and retain talent, which is both easier now. Once the market goes back up, your startup will be ready to scale.

If you are further along already, have early market validation, signs of product-market fit and are ready to raise a Series A, the second question is: Can you even raise in this market?

Just a few months ago, $10 million-$15 million Series A rounds seemed to be the norm. Is that still possible? Venture firms raised record amounts of new funds in 2020 and 2021, and much is said about how much “dry powder” is out there.

What is also true, however, is that the valuation reset is working its way through the market. That means many venture firms are now busy focusing on their existing portfolios — the high-growth B- and C-stage companies that raised substantial cash and operate at high burn rates.

That consumes both time and capital. Many VC firms will therefore be less available and generally less aggressive with their investments. In Q1 alone, we saw many founders curb their enthusiasm and raise smaller rounds.

Will we still see big Series A rounds? Absolutely, but not as many as we did. Is that a problem? We don’t think so.

In fact — and that’s the segue to the third question — even if you can, should you raise a “big Series A?”

We think most companies should not, even if they can. One analogy I can draw is that of a car race and how many pit stops the car needs to for fuel and tire changes. Each pit stop takes time, but if your car makes more pit stops and takes on less fuel, it will be nimbler and more forgiving.

If you go for a big round early, you have to deal with high expectations. A $15 million Series A at a post-money valuation of $75 million gives you a flush bank account, lets you to hire big and fast and spend more freely — and you don’t have to do it in the most effective way.

It also means you must be ready to raise a Series B in 18 months. Your seed and Series A rounds are mostly raised on promise and potential, but the Series B, C and everything after are raised on hard facts: high growth and compelling SaaS metrics.

Your $75 million post-money Series A now turns into a $150 million+ pre-money valuation target for the Series B. Raise anything short of that mark, and you’re in the land of down rounds and equity dilution, which hits the founders more than anyone else on the cap table.

In the current market, to meet those expectations, you will need $4 million-$5 million ARR doubling with strong gross margins, and reasonable customer acquisition cost. How confident are you to pull that off in just 18 months?

Conversely, if you raise a $4 million-$6 million Series A at a more modest valuation, it gets much easier to reach the goal for a 2x-2.5x valuation step up to the Series B. Founders will often ask, “Doesn’t a larger raise give me more cash, and therefore, a bigger risk buffer?”

The answer is no. Raising less gives you more room to make mistakes, more time to correct course, because the pressure to perform is lower.

It’s a marathon, not a sprint, and having more pit stops gives you optionality and keeps you nimble. It will cost you a few more points of equity over the funding path, but it buys you the flexibility that might make the difference between ultimate success and massive dilution, or even an early forced sale due to subpar performance.

There are exceptions, yes. Your startup might operate in an highly competitive environment and have a limited time window to be crowned “the winner” in a very large market category where you have an unfair competitive advantage that will be hard to defend for long.

Those are probably good reasons to go big, and do that early and multiple times. But such cases are far rarer in the cloud business market than the once-frequent big A rounds we saw last year.

Experienced founders understand this. They have seen or heard about these things in their network. It can be hard for a founder to turn down the attention of a brand name venture firm pushing for a bigger round.

Why would they push for that, you ask? Because they need to invest their large funds, and often simply don’t have the bandwidth to lead investments at much smaller ticket sizes.

But founders, beware of the downstream consequences! Model it out all the way to your IPO. Plan those pit stops before the race gets serious.