Determining How Much to Raise

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Updated September 15, 2023
Raising Venture Capital

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It is part of the founder’s job to make sure there is “enough cash in the bank.”* Capital is a tool used to accomplish specific company goals. How much you decide to raise needs to be directly tied to assumptions you’ve made regarding what you believe you’ll need to spend in order to accomplish those goals. This section will cover setting those goals and measuring their cost along with the costs of operations, as well as how the amount of money you raise is tied to the ownership you will retain—or lose—of your company over time.

important No matter what, you need to be ready to present investors with a realistic, believable plan for how you will use what is raised in one round to get to the next funding round or milestone.

A Primer on Ownership

“Raising money” does not mean getting money for nothing. Raising venture capital really means selling part of your company in exchange for money you plan to use to grow your business. To determine how much money to raise, founders need to understand how that amount is related to the ownership they already have and expect to have in the future. We’ll start with how ownership is measured, move on to the relationship between price, valuation, and dilution, and then discuss how to use that information to come up with an amount to raise from investors that you can live with.

Keep in mind that understanding how partial ownership is transferred is also essential to learning how to offer equity-based compensation to employees, sell your company, and more. You can visit our Holloway Guide to Equity Compensation for a lot more detail on this topic; we’ll cover the basics here.

The Basics of Equity

What does it mean when people say they own part of a company? Most companies, even when they are founded, are owned by more than one person. Ownership in a company is divided up between multiple people through stock.

Stock and equity are often used interchangeably, but they are not the same thing.

Definition In the context of compensation and investment, equity broadly refers to any kind of ownership in a company that can be held by individuals (like employees or board members) and by other businesses (like venture capital firms).

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One common kind of equity is stock, but equity can take other forms, such as stock options or warrants, that give ownership rights. Commonly, equity also comes with certain conditions, such as vesting or repurchase rights. Note the term equity also has several other technical meanings in accounting and real estate.*

Employees often acquire equity that has been set aside in a company’s option pool.

Definition An option pool (or employee pool) is a portion of a private company’s shares that the company reserves for future employees. Companies create option pools by setting up an equity incentive plan, generally before the first employees are hired. The size of option pools varies, but typical sizes are 20% of the company’s stock for more established companies and 10% or 15% for earlier-stage companies.*

The size of the option pool may be negotiated in seed round term sheets, if the founders have not yet set one. Individuals don’t automatically own part of the company when they join; they vest into their ownership over time. The details of vesting, particularly for founders, may also be negotiated in a seed round term sheet.

Definition Vesting is the process of gaining full legal rights to something. In the context of compensation, founders, executives, and employees typically gain rights to their grant of equity incrementally over time, subject to restrictions. People may refer to their shares or stock options vesting, or may say that a person is vesting or has fully vested.

Definition In the majority of cases, vesting occurs incrementally over time, according to a vesting schedule. A person vests only while they work for the company. If the person quits or is terminated immediately, they get no equity, and if they stay for years, they’ll get most or all of it.

Definition Vesting schedules can have a cliff designating a length of time that a person—including founders—must work before they vest at all.

For example, if your equity award had a one-year cliff and you only worked for the company for 11 months, you would not get anything, since you haven’t vested in any part of your award. Similarly, if the company is sold within a year of your arrival, depending on what your paperwork says, you may receive nothing on the sale of the company. This can be true for founders as well as employees. Investors will often negotiate the details of founder vesting in the term sheet, to ensure that the founders are committed to the company for the long haul.

A very common vesting schedule is vesting over four years, with a one-year cliff. This means you vest 0% for the first 12 months, 25% at the 12th month, and 1/48th (2.08%) each month until the 48th month. If you leave just before a year is up, you get nothing, but if you leave after three years, you get 75%.

Definition Outstanding shares refer to the total number of shares held by all shareholders. This number starts at an essentially arbitrary value (such as 10 million) when the company is created (formed or incorporated), and thereafter will increase as new shares are added (issued) and granted to people in exchange for money or services.

Some of these shares will belong to different classes of stock, each with different legal designations. When it comes to raising venture capital, founders need to know about two types of stock: common and preferred.

Definition Common stock and preferred stock are two classes of stock with different rights, preferences, and privileges.* Holders of common stock are able to vote on issues like board composition and stock splits. The value of common stock rises and falls with the company’s fortunes. Common stock (or the option to purchase common stock) is typically held by founders and employees. Preferred stock generally does not carry voting rights but has a liquidation preference over common stock, meaning preferred stockholders get paid before holders of common stock in a liquidity event or bankruptcy. Preferred stock pays predetermined dividends, which are more predictable and often larger than common stock dividends. Preferred stock may be privileged in other ways, such as through protective provisions that give preferred stockholders veto power over certain decisions. Preferred stock is typically held by investors.*

Common stockholders—founders, employees, and advisors—typically earn their equity in exchange for labor (sometimes called “sweat equity”). Preferred stockholders don’t earn their equity; they buy it. Except for some edge cases, investors will almost always hold preferred stock, which exists to protect investors.

important The differences in stock classes affect how VCs can control your company. When it comes to determining an amount to raise from investors, the important distinction is that preferred stock gets a preference, or preferential treatment, in a liquidity event: founders and employees don’t get paid until investors do. (If conversion rights were negotiated as part of the term sheet, preferred stock may also convert to common stock during that liquidity event. We’ll come back to this in more detail in Choosing A Financing Structure.)

Preferred stock has downstream consequences—often very confusing and obtuse ones—on your company’s valuation and your ownership stake. You can make choices to mitigate or even avoid these negative consequences. We’ll first explain the relationship between the price an investor pays for stock, the dilution of ownership that occurs when new stock is issued, and the company’s overall worth, or valuation.

Price, Dilution, and Valuation

In order to understand how partial ownership in a company is transferred—to investors, founders, employees, or others—we begin with price and dilution. Whether you raise venture dollars or not, these concepts are relevant to startup founders. But most people struggle a lot when it comes to understanding how they all fit together—and, along with valuation, how they affect the amount of money you will raise. If you can’t explain all this to your friends, keep reading (and re-reading) until you can.

Most founders encounter price and dilution for the first time when incorporating and choosing to create the employee stock option pool.

For a person to legally own shares, they have to buy them at a set price. At the beginning, the company is often basically worthless. It’s two people with an idea, and their lawyer deems $0.0001 per share an acceptable price. If the founders agree to split the company 50/50, each founder will buy 50% of the shares at $0.0001 per share. They are the first investors.

Definition When an investor agrees to exchange a fixed amount of money for a fixed amount of ownership in a company, the investor is setting a price. Price is often expressed in one of three ways: price per share (e.g. $1 per share); price of financing (e.g. $2M for a 10% ownership stake); and the colloquial price, formulaically expressed as amount raised on pre-money valuation (e.g. $2M on a $10M pre).

Over the lifetime of a company, there are many cases where the company will choose to issue new stock in addition to the stock founders buy upon incorporation. The two most common cases are offering stock to employees and selling stock (raising money) to outside investors. In either case, founders don’t personally sell their stock to employees or investors. If they did, those checks would be written to the founders, not the company. When new stock is created, it increases the total number of outstanding shares, thereby decreasing the percentage ownership of existing stockholders.

Definition Dilution is the reduction in ownership, on a percentage basis, that occurs when a company issues new shares of stock, such as when creating an option pool, or creating additional stock to sell to investors.

To ensure the company doesn’t have to create and issue new stock to founders later down the road, most companies incorporate with millions of shares. Practically, here’s how this plays out. Two founders agree to split ownership in a new company 50/50. Their lawyer advises they incorporate with 10M shares of stock. To own their half of the company, they will have to buy their shares for $500 each at a price per share of $0.0001.

In the case of offering stock to employees, some companies set aside an employee option pool of 5–20% at the time of incorporation. For example, if the total outstanding shares at incorporation is 10M, 2M may be set aside for issuance to future employees, and the founders will split the remaining 8M.

But many companies don’t issue an employee stock option pool immediately, opting instead to do so down the road. If each founder owns 5M shares out of a total of 10M outstanding, the company must issue new shares to create an option pool. When companies issue new shares of stock, existing holders’ ownership percentage gets diluted to a lower number.

danger Dilution is frequently overlooked by founders who are fundraising. There is a lot of variability around how much each company sells at each stage of financing,* but founders should be aware that the path of venture capital can involve selling as much as 15% at the pre-seed, 25% at the seed, 25% at the Series A, and 20% at the Series B. That’s 85% of the company by the Series B. Think that sounds nuts? Aaron Levie, co-founder and CEO of Box, owned 5.7% of his company at IPO.*

Any conversation about dilution without also talking about valuation won’t show you the whole picture. Publicly announced valuations are usually celebratory, and this can be misleading. You have to unpack that number to understand its implications.

Definition Valuation in the context of early-stage venture capital deals is the projected worth of a company based on its potential to grow in size, revenue, and influence. Founders and investors must agree on a valuation, which is negotiated as part of the investment term sheet. Valuation is used to determine the price per share venture capitalists pay for their equity: the higher the valuation, the less ownership founders have to sell to raise the same funds.

Founders seeking venture capital must arrive at a valuation for their company based on how much money they need to raise from investors, and how much of their company they are willing to sell in order to get it. When venture capitalists are preparing to invest in the company, they will do their own analysis to arrive at a valuation as well. Investors base a company’s valuation on the market, whether a founder has a proven track record of success, if the company has traction with customers or any revenue, and whether there is interest from other investors in the company’s industry.

Definition A company’s valuation can be expressed in two ways: pre-money is the anticipated valuation at the beginning of an equity fundraising process (i.e. before the investment is received); post-money is the anticipated valuation at the close of fundraising (i.e. after the investment is received).

Pre-money and post-money valuations can each be calculated with the following formulas:

  • The pre-money valuation can be found by subtracting the amount of money invested from the post-money valuation.

  • The post-money valuation can be found by dividing the amount of money invested by the percentage sold.

Continuing with our example where two co-founders each bought 5M shares at $0.0001 per share, the company’s valuation at incorporation was $1K post-money, that is, after the first investment, which was made by the founders. This transaction proved that someone was willing to pay $0.0001 per share in the company. The product of that price per share and the total outstanding shares (10M) sets the valuation at $1K.

It’s common to hear a valuation in terms of a deal expressed like this: “They raised $1M on a $6M post-money valuation.” Let’s break that down. The founders most likely determined they needed to raise $1M and they were willing to sell 15% of their company in their pre-seed. So they divided $1M by .15, giving them a post-money valuation of $6,666,666.67. The combination of their superstition and a desire for neat, round numbers led them to do the deal for $1M in exchange for 16.67%, leading to a post-money valuation of $6M.

All the way down at the stock level, the company created 2M new shares and sold them to investors at a price per share of $0.50 (2M multiplied by $0.50 = $1M). This increased the total number of outstanding shares to 12M, and when you multiply 12M by $0.50, you get a $6M post-money valuation.

To summarize, in order to raise $1M on a post-money valuation of $6M, the company had to be willing to dilute existing shareholders by 16.67% (each of the founders’ ownership went from 50% (5M divided by 10M) to 41.67% (5M divided by 12M)). In order to actually do the deal—sell the shares and get the money in return—the company had to create 2M new shares and sell them at a price per share of $0.50.

confusion When companies raise money, they sell preferred stock to investors, not common stock. At the time of the transaction, the preferred stock is valued at the price per share of the transaction. Immediately following a large investment, the company must hire an independent firm to perform a 409A valuation and assign common stock a new price per share. 409A valuations typically value common stock at 20–40% less than the preferred stock price of an investment transaction. (For more on 409A valuations, visit the Holloway Guide to Equity Compensation.)

At the end of this, each of the founders’ 5M shares will increase in value. After hiring a firm to do a 409A valuation, they may find the price per share of their common stock went from $0.0001 per share to $0.15 per share (30% of $0.50), increasing the value of their stock (on paper) from $500 to $750K each.

Now that we understand the relationship between price, dilution, and valuation, let’s apply it to the example of Aaron Levie’s “small” ownership share at IPO of 5.7%. Levie’s 5.7% ownership translated to 6,378,126 shares.* The IPO price per share was $14,* valuing his stock at $89,293,764.

Of course, there are plenty of other examples of founders raising several rounds of venture capital only to walk away with nothing.* It’s true that if you build a huge company, even a small percentage will be worth a lot. But not all founders can or want to build a huge company, and not all want to grow by selling stock to many different investors. Founders hoping to maintain a significant ownership percentage of their company need to consider how valuations and investment dollars will dilute their percentage stake. While this tool may look a bit outdated, we recommend founders use the toolOwn Your Venture Equity Simulator (which calculates impact on percent ownership by size of round, size of the option pool, et cetera) to model out dilution across rounds.

contribute If you’ve come across other helpful benchmarks or frameworks for modeling dilution, please let us know so we can include them there.

Building a Cap Table

Every founder needs a capitalization table (or cap table) to keep track of who holds ownership in the company and in what form (stock options, warrants, shares, et cetera), and anything else you need to know about that ownership. In the simplest form, it is a list of securities.

If you’re raising your first round, you don’t want to wait until even more investors come along before building a cap table. Start building your cap table now, recording any founder or employee equity or stock options you have granted. Everything you negotiate in your term sheet related to how ownership in your company is held by various investors, including things like who has protective provisions or pro rata rights, can be recorded in your cap table so that you have only one place to look when making financing or sales decisions. Keeping track of your company’s ownership will keep you from making big mistakes when it comes to dilution.

There are many ways to build and maintain a cap table, and depending on your financing, at different stages you might have a simple spreadsheet or a sophisticated management tool. Simple cap tables might just be a list of investors and employees and the number and kind of shares or stock options they hold. More complex cap tables would be current on the value of shares held by all shareholders, dilution percentages, vesting schedules for employees, and more.

Read up on the purpose of cap tables and how to build one from former founder and current startup attorney Noah Pittard at Cooley.

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Deal Size and Valuation

No one knows exactly how much money they need to build their company, but once you’ve gotten your head wrapped around the interplay between dilution, price, and valuation, there are several best practices for backing into a target amount of money to raise.

First, you’re raising money because there’s something you want to accomplish. If you’re going to raise money, investors will want to see how accomplishing that goal will translate to increasing the value of your company.

Second, you need to estimate what it will cost to accomplish that goal.

Third, you need to determine whether you can raise enough money to more than cover your costs in achieving your goal—and do so on a valuation that doesn’t over dilute you or make it impossible to raise again.

Choosing Milestones

Every business sets different goals. We can’t tell you what to tell investors. What we can tell you is that you must create a compelling story as to how you will use your investors’ money to create meaningful progress and increase the value of your company. Chris Dixon calls these “accretive milestones.”*

At the seed stage, your goal might be to reach product-market fit. After the seed, maybe it’s to create enough revenue to reach cash-flow break-even. Or maybe it’s to grow from $1M in annually recurring revenue (ARR) to $10M in ARR. One key question to ask yourself is: if you achieve your goals, will you be able to raise your next round on a valuation twice as high as this round? Even better, can you be profitable enough to not need more VC money, in order to limit dilution of your ownership and the value of your stock?

But be careful about pegging your milestones to rumors about what venture capitalists will invest in. One well-circulated myth is that seed-stage companies need to get to $1M in ARR before raising a Series A, but Semil Shah, founder and GP at Haystack, points out that many companies raise a Series A before $1M in ARR.*

Modeling Your Costs

Once you’ve set a goal—which, should you reach it, will demonstrate meaningful progress and increase the value of your company—you need to figure out how much money it will take to accomplish that goal. Unless you have an MBA or love forecasting expenses, this is going to feel daunting, as it has to nearly every entrepreneur you’ll talk to. In fact, Sir Richard Branson, founder of the Virgin Group, didn’t know the difference between gross and net profit until he was 50 (well after he founded a media company and airline).* That doesn’t mean you should skip learning some basics of finance, however.

Your ability to reasonably forecast revenue will vary depending on stage, from damn near impossible at the early stages to slightly less impossible at the Series A round and beyond. Although you’ll need to estimate your revenue for your pitch, when determining how much to raise, it’s wise to start by assuming your company has or will have no revenue and only calculate your expenses.

Definition Burn rate (or burn) is the amount of money a company loses each month after accounting for any revenue. Given that most startups do not have any income in the early stages of the company, a burn rate can simply be the amount of money a startup spends each month.

You can use your burn rate to tell how much money you need to raise in a given period—your operating runway. Your runway can be calculated as your bank balance divided by your monthly burn rate, then multiplied by the number of months you’re calculating for.

Most investors, including Fred Wilson* and Mark Suster,* recommend raising enough to sustain 18–24 months of operations; others recommend 12–24 months. There are a couple of caveats:

  • Raising angel rounds, friends and family rounds, or other first money rounds might provide for only a few months of runway.

  • The type of business you plan on running will have a large impact on the amount of capital needed. The variance is high enough that it’s difficult to generalize guidelines, but the difference in time required to get FDA approval for a biotech company vs. testing a consumer mobile product is likely to be pretty different.

Entrepreneurs tend to overestimate what they’re capable of accomplishing inside a period of time, so make sure you’re being realistic. Ask yourself what meaningful progress you believe you could demonstrate inside of 12–24 months, and then list the people you believe you’d need to hire in order to do that.

If you’re completely new to spreadsheets and financial models at the seed stage, you can back into a burn rate by estimating the cost of key hires using broad figures ($100K per employee outside the Bay Area and NYC and $200K inside NYC and the Bay Area) or specific figures (using compensation data like AngelList provides).

As early as the seed stage, you should consider contracting with an external CFO to help with basic financial planning and analysis (referred to as FP&A). This person will help you build a model that you can easily plug new hires and corresponding salaries into, in addition to accounting for things like health care, taxes, and more.

Going High or Low

controversy An abundance of nuanced and seemingly conflicting advice exists on why founders should raise more money than they think they need and how raising too much can actually be damaging.* It turns out there’s a Goldilocks zone for how much you raise. It’s probably more than your first pass at covering expenses for your team, but it’s probably not double that figure.

At some point, you’re certain to run into this platitude: “No founder ever wishes they took less money.” The idea here is that founders almost always fail to account for some kind of big expense that blindsides them along the way. For example, you’re likely to make a bad hire, have to fire them, give them severance, hire a recruiter, and spend months finding a replacement. Or maybe someone on your team will start sharing images owned by Getty and you’ll get a bill for copyright violation.

Mark Suster lists several reasons why raising too much money can hurt,* and we’ve included a couple key reasons here:

  • Money burns a hole in your pocket. Few entrepreneurs have the discipline to raise a pile of cash and not spend it. Whether you choose to raise $2M or $10M for an 18-to-24–month period, you’re likely to spend it.

  • Lack of money can create discipline. Consider the $2M vs. $10M scenario further. In the former, you’ll be forced to make more thoughtful decisions about what to spend your money on because you won’t have enough to do everything you want. This will act as a forcing function for thoughtful conversations about prioritizing only the highest-leverage work.

One nuance to keep in mind when determining how much to raise is how you communicate this to investors. We’ll bring this up again in our section on meeting with investors, but when providing investors a target raise number, giving a lower number than what you actually hope to raise makes you appear closer to achieving your goals, which can help create a sense of urgency by making the investor think they have less time to get in on the round. That said, especially if you’re new to fundraising, you probably can’t get as much as you think.

Picking a Valuation

With achievable milestones set, costs modeled out, and a target number to raise, you must determine how much of your company you’re willing to sell in exchange for that amount of money, keeping in mind the effects of dilution.

Paul Graham encourages companies not to sell more than 15% in what he calls “phase 1 (‘a few tens of thousands from something like Y Combinator or individual angels’)” and no more than 25% in “phase 2 (‘raise a few hundred thousand to a few million to build the company’),” for a total of no more than 40% before the Series A.* A general rule of thumb is that companies should expect to sell around 20–25% at the seed stage.

The next step is to assess the viability of the deal you’d like to make. Just because you want to raise $1M on a $6M post-money valuation does not guarantee you’ll be able to do so. You need to learn to look at your company the way an investor will, and our favorite system for this comes from Leo Polovets.* He calls startups “risk bundles.” Can the founders work well together, hire a team, manage a team, ship a product, get people to pay for the product, and get people to pay for the product in a scalable and profitable way? Each of these things is a risk, and for every subsequent “yes,” in that line of questioning, an investor has a reason to increase the valuation of your company.

Benchmarks for typical valuations vary from year to year depending on the funding climate (see Mark Suster’s bear vs. bull market ranges*). This makes reliable data hard to come by. In 2014, Polovets published the ranges* he saw for B2B SaaS startups.

  • Pre-product or alpha version of a product. $3M–$10M; notable, strong teams raising on the high end

  • Beta version of product. $6M–$9M; $1K–$20K in monthly revenue

  • Post-launch. $7M–$14M; $25K–$100K in monthly revenue; unrepeatable sales process

  • Mature product. $15M+ (Series A likely); $100K+ in monthly revenue; repeatable sales process

It’s also worth checking out “Pricing A Follow-On Venture Investment”, Fred Wilson’s piece on how Union Square Ventures thinks about pricing a follow-on investment.

contribute If you have or have seen more recent or comprehensive data, please let us know so we can include it here.

Just because you can raise on a high valuation, however, doesn’t mean you should. The deal you put together today, whether it’s a pre-seed, seed, or Series A, will have implications on whether you can raise money again in the future. For example, if you somehow raise $2M on a $20M post-money, you need to create enough value to be able to raise money at a much higher valuation than that $20M valuation in the next round—this is called clearing the valuation hurdle. Founders often underestimate how hard it is to get a company off the ground. If you’re committed to taking venture capital, you should plan ahead and seek a valuation that is reasonable, one that’s tied to reality, and one that sets you up for success in your next round.

Whatever valuation you choose, you’ll bring it to the negotiation table when you meet with investors to set the terms of the deal.

Figure: Bay Area Pre-Money Valuations (Series Seed)

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Source: Silicon Valley Bank and PitchBook Data*

Figure: Bay Area Pre-Money Valuations (Series A)

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Source: Silicon Valley Bank and PitchBook Data*

A Moment for Product-Market Fit

Product-market fit means being in a good market with a product that can satisfy that market.Marc Andreessen, co-founder and General Partner, Andreessen Horowitz*

Understanding where you are on the product-market fit continuum is an extremely helpful way to think about how much money you really need to raise. Early-stage companies likely won’t have reached product-market fit, but the earlier you start thinking about how you plan to reach it, the more confidence investors will have that you’re the right founder to invest in.* When you pitch investors in your seed round, your task will be to show them that the amount you raise will help you reach or progress significantly toward product-market fit. Understanding product-market fit and its components—products and markets—can be the difference between working for eight years only to discover no one wanted what you were building and creating a company that produces immense value for the world, your employees, your investors, and you.

What Is Product-Market Fit?

Product-market fit is a relatively new, yet essential concept that startup founders at any stage need to understand. This section synthesizes the best resources out there on what it is and how it works, from business professors, venture capitalists, growth experts, and entrepreneurs. Product-market fit can mean different things to different founders. Here’s our definition of the concept:

Definition Product-market fit (product/market fit or PMF) refers to the notion that there is a point at which a given market responds so positively to a company’s product that the product “fits” the market’s needs. A precise point at which “fit” has been achieved does not exist. Instead, product-market fit represents a continuum of traction that ranges from absolute clarity that a company does not have product-market fit to maybe they have product-market fit to experts disagree whether they have product-market fit all the way to it’s beyond all doubt they have product-market fit.

This may feel dull or even juvenile, but grab a piece of paper or open a Google Doc and write down the following two questions:

  1. What is a product?

  2. What is a market?

Without reading ahead or Googling around, write out a definition.

Each of these terms is something we all have an intuitive sense of, but when it comes to defining the two, people can have a wide range of differing ideas about what each means. Understanding product-market fit is dependent upon a shared understanding of both products and markets.

Products are straightforward. They are anything produced or anything that people trade with or for. Markets, on the other hand, are more challenging to define and more widely misunderstood. Our favorite explanation of what makes a market comes from Bill Aulet, an author and managing director at the Martin Trust Center for MIT Entrepreneurship and Professor of the Practice at MIT’s Sloan School of Management. In his book, Disciplined Entrepreneurship, Aulet lists three conditions that define a market:

  1. “The customers within the market all buy similar products.

  2. The customers within the market have a similar sales cycle and expect products to provide value in similar ways. Your salespeople can shift from selling to one customer to selling to a different customer and still be very effective with little or no loss of productivity.

  3. There is ‘word of mouth’ between customers in the market, meaning they can serve as compelling and high-value references for each other in making purchases. For example, they may belong to the same professional organizations or operate in the same region. If you find a potential market opportunity where the customers do not talk to each other, you will find it difficult for your startup to gain traction.”*

Product-market fit is widely misattributed to Marc Andreessen by bloggers and writers, but Andy Rachleff coined the term. As of Spring 2019, Rachleff is the President and CEO of Wealthfront, a lecturer at Stanford Business School, and the co-founder of Benchmark Capital. In a 2007 article, “The only thing that matters,” Andreessen credits Rachleff for the term and synthesizes much of Rachleff’s thinking, which has inspired the thinking of investors and entrepreneurs alike for more than a decade. Andreessen highlights three important frameworks:

  • Rachleff’s Law of Startup Success. Rachleff says, “The #1 company-killer is lack of market. When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens.” This idea is critical for founders to understand, especially when considering raising venture capital. If the market for your product is not big enough, you will struggle to raise venture capital. Many companies lie in the startup graveyard because good entrepreneurs unintentionally chose to build products for small, crowded, or shrinking markets.

  • Rachleff’s Corollary of Startup Success. “The only thing that matters is getting to product-market fit.”

  • BPMF and APMF. The lives of startups are divided into two categories, “before product-market fit” (BPMF) and “after product-market fit” (APMF).

important So much of the venture capital ecosystem is built up around these three concepts. Early-stage funding is designed to help founders get their companies to product-market fit; investors at this stage are looking for a company to demonstrate progress toward product-market fit. After a certain point—usually but not always by the Series A—a company that cannot demonstrate some progress toward product-market fit will seriously struggle to raise venture capital.

Measuring Product-Market Fit

To show investors—and determine for yourself—that you’re on the right track, you want to be able to measure your progress toward product-market fit. These takes on measuring product-market fit from Andreessen and his business partner at Andreessen Horowitz, Ben Horowitz, show that experts in the field of venture capital don’t always agree on what they’re looking at:

You can always feel when product-market fit isn’t happening. The customers aren’t quite getting value out of the product, word of mouth isn’t spreading, usage isn’t growing that fast, press reviews are kind of ‘blah’, the sales cycle takes too long, and lots of deals never close. And you can always feel product-market fit when it’s happening. The customers are buying the product just as fast as you can make it—or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling because they’ve heard about your hot new thing and they want to talk to you about it. You start getting entrepreneur of the year awards from Harvard Business School. Investment bankers are staking out your house. You could eat free for a year at Buck’s.Marc Andreessen, co-founder and General Partner, Andreessen Horowitz*

I am sure that Twitter knew when it achieved product-market fit, but it’s far murkier for most startups. How many customers (or site visits or monthly active uniques or booked revenue dollars, etc.) must you have to prove the point? …[There] may be multiple sub-markets, each of which need their own product. I show below that [Fred Wilson] himself didn’t realize that Loudcloud had achieved product-market fit even though we had. It’s usually not black and white.Ben Horowitz, co-founder and General Partner, Andreessen Horowitz*

So how can you measure progress toward product-market fit when no one agrees on what it means to reach it? First of all, many don’t agree with the “BPMF/APMF” approach. Rather, some founders (and investors) see product-market fit as a continuum, something you can move closer to and farther away from over time. So the idea of reaching product-market fit and then taking it easy is completely moot. It’s more important to find a way to figure out how close you are. Fortunately, several entrepreneurs have wrestled with the challenge of measuring product-market fit and come up with data-driven approaches for understanding where your company is on the product-market fit spectrum.

Finding Fit: The Vohra Model

Building on earlier work from Sean Ellis and Hiten Shah, Rahul Vohra, co-founder and CEO of Superhuman and, previously, Rapportive, published “How Superhuman Built an Engine to Find Product-Market Fit.” We’ve summarized the key points below, but this is an absolutely essential essay that we highly suggest every founder take the time to read. Vohra created a simple four-question survey companies can send their users to gauge their satisfaction with the product:

  1. How would you feel if you could no longer use [product]? (Set possible responses as A. Very disappointed, B. Somewhat disappointed, or C. Not disappointed.)

  2. What type of people do you think would most benefit from [product]?

  3. What is the main benefit you receive from [product]?

  4. How can we improve [product] for you?

Vohra then recommends a four-step process for optimizing product-market fit, using the survey data:

  1. Segment. Research the respondents. What job title does each person have? Are there commonalities in those who selected option A (very disappointed)? Vohra recommends using Julie Supan’s High-Expectation Customer Model to build personas for your most ardent supporters, so you can get a better idea of who loves your product.

  2. Analyze. By looking at the feedback from users who selected option B (somewhat disappointed), companies can get an idea of what they need to build to turn option-B users into option-A users.

  3. Build. Start with high-impact, low-cost features that option-B users are asking for while making sure the experience that option-A users love doesn’t degrade.

  4. Repeat 1–3. On a regular basis, send this survey to your users and repeat the process so you continue to deliver new value—not only to the users who love you already, but also to those who are on the fence.

Finding Fit: The Balfour Model

The Never Ending Road to Product-Market Fit” by Brian Balfour is another essential piece on how to measure product-market fit. Balfour was previously the vice president of growth at HubSpot, is currently the founder and CEO at Reforge, and is a prolific blogger on product-market fit and how to grow a startup. He believes there are four checkpoints for knowing where you are with product-market fit.

  1. The Leading Indicator Survey. Balfour wrote this piece before Vohra published his (he references the same work by Sean Ellis that Vohra does), but we’re confident he’d have included Vohra’s piece as a suggestion for how to gather data here. What companies are looking for when gathering leading indicator data is signs that people like the product. Ellis’s and Vohra’s surveys are great options, and Balfour also recommends using Net Promoter Score (NPS) surveys.

  2. Leading Indicator Engagement Data. In this step, companies should be looking for data on what users are actually doing and whether they’re doing it with any kind of regularity. Do users only use one part of the product? Do they come back daily? Once a week? These data complement the leading indicator survey because they back up the idea that people like the product with proof that they’re actually using it.

  3. The Retention Curve. If people like a product, they use it repeatedly. Retention curves are a critical tool for measuring a product’s success. A retention curve is a graph of what percentage of your users use your product (y-axis) over time (x-axis). If some segment of your users keep coming back, your curve will flatten out and that is a good indicator you’ve found product-market fit within a group of users.

  4. The Trifecta. Balfour’s trifecta includes non-trivial top-line growth, retention, and meaningful usage. Companies that can prove they can grow the number of people using their product, that those who use the product once continue to use it, and that those users are consistently enjoying the product, can say they’ve reached product-market fit.

Figure: Balfour’s Product-Market Fit

Source: Brian Balfour*

Finding Fit: The Mochary Model

One last model, which is much looser than Vohra’s or Balfour’s, is from Matt Mochary. Mochary is an executive coach who has worked with clients at Kleiner Perkins, Sequoia, Reddit, and more. In The Great CEO Within, he defines product-market fit thus:

[Having] created a product that customers are finding so much value in that they are willing to both buy it (after their test phase) and recommend it. Metrics that show whether PMF has been achieved include: revenue, renewal rates, NPS (net promoter score).Matt Mochary, CEO, The Mochary Group*

The frameworks from Vohra, Balfour, and Mochary should give you the tools to understand where on the product-market fit spectrum your company lies. Many companies take years to find product-market fit; this story about the project management software company Notion is a great example. These tools should enable you to understand your users well enough that you can iterate and build new features until you can proudly proclaim you have reached product-market fit.

Building Toward Product-Market Fit

At the Series A, companies may be expected to have reached product-market fit, be generating revenue, and more. But at the earliest stages, a highly experienced team with a vision for how to capture value in a huge market may be enough to get investors excited.

The partners at Floodgate, the venture capital firm that invested in the seed round of Lyft and many other notable companies, has a framework called the “three insights”—and Ryan Walsh, formerly a Partner at Floodgate and VP of Product at Beats (acquired by Apple), was generous enough to share this framework with us. These three insights, regardless of stage, will demonstrate to investors your current thinking about product-market fit.

Keep in mind that the purpose of your seed investments is to help you make progress toward product-market fit. These three insights, together or separate, are by no means enough to guarantee your business is successful or whether you are able to convince investors to buy a piece of your company. They don’t mean your company is a good investment, either. But investors are looking to hear a team reason their way through these insights in order to prove their understanding of the market and their ability to think through complexities. Demonstrating knowledge of the three insights will show investors that you are aware of the kind of information and understanding you need to gather in order to be successful. Investor Chris Dixon, of Andreessen Horowitz, calls this the idea maze. The best teams (which are the best investments) will evolve along with the ever-changing world.

These insights correspond to elements in your pitch deck, which might contain research that demonstrates these insights, and/or plans to capture these insights:

  1. Market insight. Be sure you understand the current market size, potential for growth, and portion of market share you can expect to claim in a given period of time. What do you know that the market does not know that provides a venture scalable opportunity? Based on how you see the future, what category emerges based on your market hypothesis? Many venture scale companies come from new or emergent categories with characteristics that clearly show the possibility of a new, large market or product category. (For example, cloud computing in 2003 was a new category with emergence characteristics.) Also, don’t fudge your numbers. For example, if you’re starting a new car company, the entire car market may have one value, but claiming you can capture the entire portion would be dubious.

  2. Product insight. In what emotional way does the product capture and keep the audience’s attention? How defensible is the strongest feature from noise and competition? What’s the core value the current audience sees in the product and how will that scale with technology?

  3. Distribution insight. What do you know that others don’t about reaching your market? Is there something about search engines everyone else doesn’t understand because your team worked on search for ten years? Do you know something unusual about how to reach influencers on social media? How will people learn about what you do? How do you quantify the impact of each tactic you plan on trying to test your assumptions here?

Another way to think about these insights in a way that can be relevant at any stage is: who are you selling to, what is it that you’re selling, and how are you going to get it into your customers’ hands?

Answering these questions can help you set the milestones that will inform the amount of investment you’re looking to raise. Sizing and picking markets, developing go-to-market strategies, and building and iterating on products to address those markets are the subjects of countless books, and may be the devotion of future Holloway Guides. If there is one book we recommend founders read to make sure you’ve been diligent about your exploration of market, product, and distribution, that book is Disciplined Entrepreneurship by Bill Aulet.

Further Reading on Product-Market Fit

Rachleff, who coined the term product-market fit, believes Steve Blank’s The Four Steps to the Epiphany is “the old testament” and The Lean Startup is “the new testament” (as he says in a audioDorm Room Tycoon interview) of knowledge on the subject. Both are lengthy books, but are also considered to be full of important ideas about how to build a company.

For those interested in a more advanced framework for growing a company, we recommend Balfour’s “Four Fits” series, in which he goes beyond product-market fit to consider the other “fits” to pursue for a truly successful business:

Andrew Chen, currently a General Partner at Andreessen Horowitz, worked on growth at Uber, and has been a prolific blogger and angel investor for years. His writing on product-market fit is helpful. Some of it may be redundant to other material we’ve already included, but it’s worth reading if you’re diving deep on the subject and want to cover every base.

  • When has a consumer startup hit product-market fit?”: This piece is a classic, as it’s where Chen outlined his ideas for using Google Keyword Tool for estimating demand along with other foundational ideas for thinking about what makes a market and how to pick one.

  • Zero to Product-Market Fit (Presentation)”: Chen shares his benchmarks for what PMF looks like for a consumer startup vs. a SaaS startup, strategies for choosing a market to enter, common mistakes entrepreneurs make when chasing PMF, and ideas for scaling a startup that has achieved PMF.

Reader Submitted Resources

Readers submitted the following resources. While we have not gotten a chance to integrate them, we thought you might find them useful. Thank you to Jeff Bussgang (Flybridge Capital), Kevin Connolly (Preferred Networks), and Ido Ivry (ZenCity) for sharing.

Choosing a Financing Structurean hour, 56 links

If you have chosen to seek venture capital to fund your business, there are important choices to make regarding what type of investment structure suits your company’s needs. Venture capital investments, all of which provide capital to private companies in exchange for equity, can fall into one of three possible financing structures: priced equity (commonly referred to as “priced rounds”), convertible notes (also referred to as “convertible debt”), and convertible equity. Together, convertible debt and convertible equity are sometimes referred to as convertible instruments or convertible securities.

Until the mid-2000s, nearly every venture capital deal was done as a priced round. In 2010, Paul Graham of Y Combinator shared that every investment in the current batch of Y Combinator had been done on a convertible note.* Over the next three years, the convertible note became widely adopted beyond Y Combinator, until 2013, when Graham announced a new vehicle that would be favored, a type of convertible equity called the safe.* While the safe has overtaken the note in popularity in Silicon Valley, notes still remain popular across the rest of the United States.*

There are drawbacks and benefits to each of these financing strategies—not to mention strong opinions on all sides—and they’re not always easy to anticipate or understand. So before you make any decisions, spend some time here understanding the differences between convertible notes and convertible equity, and their terms (which may be negotiated during a financing deal). At the end, you’ll find some template documents available for both.

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