The subject of this article might seem counter-intuitive to most founders. After all, isn’t the immediate goal to raise capital is to buy runway for the companies?
While that is technically true, that more money in the bank means more months of runway, one shall never, however, confuse runway with time, especially in the early stages.
Simply, runway is internal. It’s the time until a company runs out of money. In early stages it’s largely controlled by the founders. It’s an estimation of the worst-case scenario.
But no VC invests for the worst-case scenario. We invest in growth, which is measured as the increase in KPI over time.
The relevant KPI might be active user count, transaction numbers or revenue. It can be literally anything that’s measurable and that matters to the company’s vision and narrative.
Time, on the other hand, is of the only one kind, whether one uses weeks, months or years to denominate it.
In other words, one can be strategic, argumentative or ethically flexible about which KPIs to measure and present, there’s no debate about time. Every single second in a company’s life flows by as fast as that in a homo sapien’s life.
Alternatively put, while runway is internal, time is external. Every single week or month that the company is not progressing or growing, it’s one week or month that the competitors might be progressing or growing. Even in the absence of competitors, which is rarely the case, it’s still one week or month less to prove the product-market fit or grow the market share.
It’s this externality that I am referring to when I say “Money can’t buy time”.
To make my point more clear, let’s assume two startups competing in the same market. Both have 6 months of runway on similar burn rates and both have come out to raise a Series A of $10M about two months before (when the companies still had 8 months of runway). The $10M will extend the runway to 24 months, i.e. 18 months on top of the current 6 months.
Now let’s say Startup X chose to take a term sheet on the table now from a lead investor at a $20M pre-money. It spends another month rounding up the remaining investors, getting paper works done and closing the round completely. During the month it continues to execute the original business plan so that the growth is on track as originally planned.
Startup Y, on the other hand, is more ambitious and confident. Knowing that it has 6 months before running out of money, it assesses the interest from the capital market and feels confident it’ll get multiple interests from investors, even though at the moment it has the same 1 term sheet on the table.
Startup Y decides to negotiate back and forth, using the term sheet to try to excite the other VCs to offer a competing term sheet. By the end of the month the company has 3 new term sheets and 1 expired one (the original one at the start of the month). It decides to negotiate back and forth between the 2 better term sheets of the 3, trying to iron out more favorable terms regarding founder share re-vesting, size of option pools, etc.
It takes another 2 weeks for them to eventually decide on the best term sheet, which is a pre-money of $25M, 25% more than that of Startup X. After that it takes 1.5 month to round up the remaining investors, get paper works done and close the round completely. (It takes more time because some interested investors pass due to the higher pre-money valuation.)
All in all Startup Y spends 2 months more than Startup X in closing Series A. Meanwhile it continues to execute its original business plan so everything is on track.
By the time Startup Y closes its Series A, both startups have 3 months left in its original runway, plus the newly acquired 18 months of runway, which equal to 21 months of runway.
From a linear point of view, Startup Y got a better deal than Startup X, as its pre-money valuation is 25% higher and less dilutive for the founders and existing investors. Given that everything else is on track for both companies, Startup Y makes a better decision, right?
Well, assuming nothing changes externally, this conclusion will be correct. But things always change. And they change usually faster than the founders could imagine.
Here are the couple of things that might happen in the 2 months where Startup X has the $10M while Startup Y doesn’t, both internally and externally:
- Startup Y’s principal AI engineer had been with the company for 2 years. Having be granted options that represent 1% of the company as a early hire, he — it’s always a he — now wanted a 20% salary raise or he would take his vested 0.5% of the company and go back to work for Google at 2X the salary. Startup Y’s founders tried to comfort him, telling him that the new round was closing soon and they’d be able to discuss his demands. Having limited information during the first 1 month of founders’ term sheet negotiation (and limited bandwidth to attend to him), the principal AI engineer decided to leave anyway and take the otherwise expiring offer from Google. Startup Y now has 0.5% of its ownership owned by a guy now working for a formidable giant and it has to find another talent to replace him.
- Startup X, fresh with the $10M capital in the bank, got an inquiry from a major Silicon Valley client that decided all of a sudden to want to start a pilot program with them. The program would require 2 FTEs and $200k initial capital investment, which Startup X was in a position to take advantage of. After 1 week of internal debate, Startup X moved forward to sign with the client. Startup Y received the same offer but was in the middle of fundraising. The founders, conscious of the runway versus the risk of the project, decided that they better focus closing the round and declined the opportunity.
- Both Startup X and Startup Y received a formal letter from the corporate lawyer of Qualcomm, accusing them of infringing a certain patent of the latter and demanding immediate legal reply. Startup X discussed this in the Board Meeting and decided to hire a lawyer specialized in this field with former experiences of dealing with Qualcomm to start the negotiation. Startup Y, on the other hand, debated long and hard whether to disclose this new info, which might or might not turn out to be material to their business, to investors that had offered them term sheets. Among the subject of the internal debates is whether the investors might take the new event to drive down the “hard-earned” higher pre-money of $25M back to $20M.
- The failed IPO of WeWork hit the financial market. All of a sudden all venture loan financing providers were asking a lot more assurances from the founders for them to provide venture loans. Having secured $10M in fresh equity capital, Startup X was able to move forward its original agreement with Silicon Valley Bank and obtain a $4M venture debt on pre-determined terms. Startup Y continued talking with Silicon Valley Bank but sensed that the sentiment of the latter changed. SVB now asked them to provide proof of the $10M Series A being secured in 2 months and also asked to speak with the lead investors. Startup Y was reluctant to do such intros fearing that lead investors might discuss with SVB, take the new event to drive down the “hard-earned” higher pre-money of $25M back to $20M. Startup Y decided to play tango with all parties, while rumor mills ran faster and faster inside the company.
If all the events above sound frightening familiar to you, congratulations, you’re an experienced entrepreneur that will benefit from reading this article. You will also immediately figure out 10 or 20 more likely scenarios where Startup X would fare better than Startup Y, despite the paper advantage that Startup Y seems to have.
Those of you who are better versed in finance shall know by now what I meant by “Money can’t buy time”.
What I meant by time is actually option, specifically real option.
The 2 months where Startup X has the $10M while Startup Y doesn’t enables the former to make different decisions when faced with unexpected events. And unexpected events are the normal daily life of a startup.
With the benefit of hindsight, we could say that the founders of Startup X essentially gave up 25% of the value of the shares they own in exchange for the real option to act against the unexpected during the 2 months. To the extent that founders — at this point still dominating decisions of the company over shareholders — care more about the shares they actually own than the full-diluted shares of the company, we can calculate the value of this option to the founders of Startup X.
Assuming the founders still own 75% of the company before Series A in both companies, the founder shares for Startup X and Startup Y would be worth:
Startup X : 75% * $20M = $15M
Startup Y : 75% * $25M = $18.75M
The price of the option that the founders paid for is then the difference, $3.75M.
$3.75M sounds like a lot of money left on the table, until you realize that any of the 4 internal or external events that I described (or the 10 or 20 more an experienced entrepreneur could imagine) might seriously derail the company, rendering any optimization of valuation or specific terms worthless.
Not to mention the $3.75M is but paper money and that real cash payout, if ever, is still many years down the road.
For those nerdy entrepreneurs that would like more mathematical descriptions on what I just argued for, you can refer to the Black Scholes model for pricing options.
As complicated as the equation might seem like, essentially the option value is positively related to T (time to maturity) and sigma (volatility). The longer the time gap between events, e.g. the 2 months between Startup X and Startup Y, the higher the value. Likewise, the higher the volatility, the more expensive the option is.
The difference between an option on financial assets (such as stocks or bonds) and a real option (such as the case in our non-tall-tale) is that the former has a clearly defined T (as long as counter-party risk is non-existent) while the later might have an uncertain T.
In our example, one can argue whether the extra 2 months Startup X got is worth $3.75M. The problem is, once Startup Y takes the mentality of negotiating unnecessarily to get better than reasonable terms, 2 months is but a minimum value of T.
Any of the 4 unexpected events might lengthen the T beyond 2 months. Also as Startup Y nears the end of its original 6-month runway, it has less and less leverage over its investors while exposing itself more and more to the liquidity risk.
In other words, in this particular case of real options, even T has its own sigma (volatility). You don’t need to be a Fields Medal winner to understand that this only makes the option more expensive.
For those already confused, the idea is very simple:
- Money doesn’t buy time, which flows constantly whether one has money or not — remember that in our non-tall-tale both startups have exactly the same original and new runways.
- Money does buy real options, in the way where closing a round earlier grants the startup real options to make different decisions in the face of the unexpected.
As for the actionable principles, I would argue that founders have to keep a mental clock while doing everything.
There are merits in being patient and optimize for certain things, especially if one has a lot of choices on the table and could pick and choose. A good example would be a deep client pipeline so that one doesn’t waste too much time negotiating a single contract with a single client.
Unfortunately for most early-stage startups, choices are usually limited. An entrepreneur might think of himself or herself as a good negotiator but the clock continues to tick while he or she show off various negotiation skills and tactics.
More importantly, unexpected things happen all the time and it’s always good to have options than not. Given any chance to close a round of fundraising earlier than later, always go for it rather than wait and optimize.
Because money can’t buy time.