The fundraising stages are not about dollar values — they’re about risk

You’ve likely heard of pre-seed, seed, Series A, Series B and so on and so forth. These labels often aren’t super helpful because they aren’t clearly defined — we’ve seen very small Series A rounds and enormous pre-seed rounds. The defining characteristic of each round isn’t as much about how much money is changing hands as it is about how much risk is in the company.

On your startup’s journey, there are two dynamics at play at once. By deeply understanding them — and the connection between them — you’ll be able to make a lot more sense of your fundraising journey and how to think about each part of your startup pathway as you evolve and develop.

In general, in broad lines, the funding rounds tend to go as follows:

• The 4 Fs: Founders, Friends, Family, Fools: This is the first money going into the company, usually just enough to start proving out some of the core tech or business dynamics. Here, the company is trying to build an MVP. In these rounds, you’ll often find angel investors of various degrees of sophistication.
• Pre-seed: Confusingly, this is often the same as the above, except done by an institutional investor (i.e., a family office or a VC firm focusing on the earliest stages of companies). This is usually not a “priced round” — the company doesn’t have a formal valuation, but the money raised is on a convertible or SAFE note. At this stage, companies are typically not yet generating revenue.
• Seed: This is usually institutional investors investing larger amounts of money into a company that has started proving some of its dynamics. The startup will have some aspect of its business up and running and may have some test customers, a beta product, a concierge MVP, etc. It won’t have a growth engine (in other words, it won’t yet have a repeatable way of attracting and retaining customers). The company is working on active product development and looking for product-market fit. Sometimes this round is priced (i.e., investors negotiate a valuation of the company), or it may be unpriced.
• Series A: This is the first “growth round” a company raises. It will usually have a product in the market delivering value to customers and is on its way to having a reliable, predictable way of pouring money into customer acquisition. The company may be about to enter new markets, broaden its product offering or go after a new customer segment. A Series A round is almost always “priced,” giving the company a formal valuation.
• Series B and beyond: At Series B, a company is usually off to the races in earnest. It has customers, revenue and a stable product or two. From Series B onward, you have Series C, D, E, etc. The rounds and the company get bigger. The final rounds are typically preparing a company for going into the black (being profitable), going public through an IPO or both.

For each of the rounds, a company becomes more and more valuable partially because it is getting an increasingly mature product and more revenue as it figures out its growth mechanics and business model. Along the way, the company evolves in another way, as well: The risk goes down.

That final piece is crucial in how you think about your fundraising journey. Your risk doesn’t go down as your company becomes more valuable. The company becomes more valuable as it reduces its risk. You can use this to your advantage by designing your fundraising rounds to explicitly de-risk the “scariest” things about your company.

Let’s take a closer look at where risk appears in a startup and what you can do as a founder to remove as much risk as possible at each stage of your company’s existence.

Where is the risk in your company?

Risk comes in many shapes and forms. When your company is at the idea stage, you may get together with some co-founders who have excellent founder-market fit. You have identified that there is a problem in the market. Your early potential customer interviews all agree that this is a problem worth solving and that someone is — in theory — willing to pay money to have this problem solved. The first question is: Is it even possible to solve this problem?

A great lens through which to examine this is to design an organization that fails as fast as possible. Imagine you are planning to build a complex new AI-powered drug discovery platform. A few of the questions you might ask yourself:

• Can an AI discover drugs?
• Is there a way of determining whether a drug discovered by an AI can have efficacy?
• Could you get a drug designed by an AI produced in the real world?
• Could you produce this drug in small batches for testing?
• Could you get one of these drugs tested for safety?
• Could you get one of these drugs into human trials?
• Could you get one of these drugs past regulatory frameworks? Is there anything about a drug being designed by an AI (in other words, where humans don’t have a full grasp of why the AI decided to design the drug in this particular way) that might make it impossible to get regulatory approval?
• Could you produce this drug in large batches for broad market adoption?
• Could you market and sell the drug?
• Could you license the drug to a large pharmaceutical company?

That’s a line of inquiry that makes sense if the main risk in your company is product risk. For other companies, the product itself is relatively trivial, but the question is whether anybody would be willing to pay for it. Famously, that was the case for Dropbox. Developing the product itself would not have been completely trivial, but it wasn’t hard. The question would be whether anyone who wasn’t a hard-core nerd coder would use such a thing. Dropbox solved that problem not by building its product, but by creating a video it could show to customers and then asking them if they would be interested.

In the case of Dropbox, the line of inquiry might be:

• Can we create this as a product? (Yes, almost certainly — because a bunch of coders had already used AWS buckets to create essentially this product.)
• Can we find any customers who might be willing to pay for it?
• Can we find enough customers who might be willing to pay for it to make this make sense as a business?
• What would people be willing to pay for this?
• What will it cost us to deliver this service?
• What are the unit costs for delivering this service?
• Is the amount of money people are willing to pay greater than our cost?
• How much will it cost us to attract new customers?

Failing fast

The highest risk in each of these examples is different. In other words, if you wanted to fail as fast as possible, you’d have to ask yourself: “If this company was going to fail, what is the most dangerous unknown?” Or you can approach it from the other side, and ask, “Which of my assumptions would have to be wrong for this company to collapse?”

If you’ve ever sat through a VC pitch meeting, questions like that will sound familiar; that is the sort of thing VCs love to ask.

Let me share an example. In a past life, I ran Triggertrap (which, incidentally, TechCrunch’s Devin Coldewey wrote about back in 2011, and which crashed and burned six years later). Our company coincided with a wave of smart cameras — compact cameras like the Samsung Galaxy Camera running Android. We started developing software that tied in deeply with the Android operating system and the camera. We had an app that could do things with time-lapses and remote triggering, facial recognition triggering, sound triggering, etc.

We invested heavily in this app. It was only a question of time before all the camera manufacturers would have “smart cameras” running Android and able to run apps. Then Nikon launched a camera that ran Android, and we were one of the only companies in the world making apps that deeply integrated with the camera. Our assumption was that, over time, every SLR and compact camera would be running Android and that our innovations would be relevant to all photographers. I remember writing on a big whiteboard in our office, “The future is Android!” We ended up hiring several Android engineers just to take advantage of this. Of course, these days, nobody even really remembers these cameras, and our assumption turned out to be wrong. It didn’t kill our company, (a Kickstarter campaign that imploded did), but we definitely invested a lot of resources into the wrong thing.

All of this is to say: Examining your assumptions and finding a way to prove whether they are true or false is one way to de-risk a business.

“For our company to be successful, these three things have to be true” is a potent phrase in the earliest stages of starting a company. As your company grows and matures, some assumptions will be proven wrong, some will be proven right. Some will have nuances that you didn’t appreciate when you first started. Sometimes, macroeconomic influences change everything. Nobody could predict the COVID-19 pandemic, for example, and few people had, “My company will be wildly successful if everybody suddenly has to do virtual conferences from home” on their 2019 bingo card, but that’s how Hopin suddenly found itself with a huge amount of wind in its sails.

https://techcrunch.com/2021/01/07/hopin-might-be-the-fastest-growth-story-of-this-era/?utm_source=internal&utm_medium=WPunit

The inverse is also true. Anybody starting a travel startup in early 2019 wouldn’t have, “What if nobody can travel for two years?” on their list of risks, but a lot of travel companies obviously faced a tough time.

What’s the longest pole in the tent?

Bringing all of this back to fundraising: If you are raising money today, you are probably trying to raise to solve a number of problems that exist in your company right now. Can the product be built at all? Can we build it? Can we find customers for it? Are they willing to pay for it? How much? How do we find and convert customers? What does it cost to develop our product?

The journey of a startup is answering all of these questions one by one, and for every question you get a definitive answer for, you are making your company less risky. There’s a chasm between “Can we build this product at all?” and “Can we reduce our customer acquisition cost (CAC) from $26 to $22 over the next 12 months?” A negative to the former can kill the company before it even gets started. A “no” to the latter has a thousand potential solutions. If you can’t influence the CAC, you can increase pricing, increase your viral coefficient, launch additional products so the overall value per customer goes up, or reduce churn so your customer lifetime value goes up.

When thinking about fundraising, be honest with yourself about what’s actually hard about what you are doing and how you can address the biggest risks directly. If you can identify the two or three biggest risks within your company and create milestones that remove those risks, tying that to how much money you are raising in your current round, you’ll see the value of your company skyrocket.

Just remember: You’re not trying to increase the value of your company; that’s a fool’s errand. Instead, focus on de-risking your startup. The value goes up automatically as a result because you consciously approach the highest-risk assumptions about your company and run it so you remove as much risk as you can along the way.