Scenario B: Raising $500K

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For comparison now, let’s look at scenario B, where the founders raise $500K instead of $250K on the same $1M pre-money valuation. Now they are giving up a third of the company in the first external round.

Figure B1: Impact of Raising $500K on a $1M Pre-Money Valuation, Fully Diluted Basis

In scenario A, the founders owned roughly 70% after the first raise, in scenario B, they only own 58%. They have given up 12% of the company for the extra $250K. They would have to make a lot more progress on that extra $250K in order to bring up the pre-money valuation for the next round well beyond what they could have done with only $250K.

​founder​ Raising a large round relative to the pre-money valuation is brutal on the existing stockholders—both the founders and any existing equity investors. (Careful readers will point out that raising money is a big distraction for a company and ask if it isn’t better to raise as much as possible each time? This is a tension for the founders.)

Following scenario B for a final illustration, let’s assume that the company didn’t make as much progress with the $500K (they spent a lot of time finding a cool office and buying expensive furniture, bought a pricey domain name, hired a well-known design firm to do a cool logo, and they over-hired and over-spent in marketing before the product was ready.*)

When they went to raise another round, they could only convince investors that the pre-money was $1.5M. The post-money valuation from the first round was $1.5M ($1M pre + $500K = $1.5M). This is a “flat round,” where the pre-money valuation has not grown. An even worse scenario is a “down round” where the pre-money valuation goes down from the previous post-money valuation.*

Figure B2: Impact of Raising $750K on a $1.5M Pre-Money Valuation, Fully Diluted Basis

In scenario B, the founders give up another one third of the company on a fully diluted basis and now own less than 39% of the company. They have less than 50% of the voting shares and have lost a large degree of control of the company. The Round 1 investors have also seen a lot of dilution, from 33.33% to 22.22% ownership of the company.

​founder​The key takeaways are that raising too much money relative to the pre-money valuation causes excessive dilution, and not increasing the pre-money valuation enough as the company needs to raise bigger rounds also causes excessive dilution.

​important​ Once you have invested, you suffer the same relative dilution as the founders in successive rounds, so you are aligned in your motivation to quickly increase the value of the company before the company has to raise money again.

These two scenarios were crafted to illustrate the impacts of the dilution resulting from the ratio of the amount raised to the pre-money valuation. We could have written a scenario about a company that raised too little ($250K), burned through it in six months and spent the next six months investing all their time raising money again instead of growing the company. As we noted above, determining the right amount of money to raise should be a carefully considered decision. To reiterate the benefits of convertible notes early on in the fundraising process, the company can raise money more cheaply with less negotiations on terms, and without even setting a pre-money valuation.