Venture Capital/Opinion/

The danger of venture capital ‘foie gras’

There's more money than ever in the market and startups are getting stuffed full of capital — but that's not such a great thing.

By Check Warner and Tom Wilson

In an excellent recent episode of the Twenty Minute VC podcast, host Harry Stebbings asked a question about “capital foie gras” — a new phrase to us but one that seemed extremely apt for what we’re seeing in the market at the moment. 

Capital foie gras describes the situation of being force fed, or stuffed, with too much money until you, and the company, choke. With interest rates at an all time low, SPACs everywhere and tech being one of the only areas in the global economy that is growing with global lockdowns, there is arguably more money than ever in the market. 

Additionally, funding rounds that would have previously taken weeks to schedule due to requirements for in-person presentations or meetings are happening in days with back-to-back Zooms. All this is resulting in funding rounds, particularly at the earliest stages, happening at incredibly high velocity, with valuations rising faster than tech reporters can keep up with covering them. (Case in point: the recent fundraises of the numerous 15-minute delivery startups, like Gorillas, which became a unicorn last week after raising €245m, only nine months after launching.) 

“Being foie gras’d with capital is not necessarily a good thing.”

As with a duck being prepared for market, being foie gras’d with capital is not necessarily a good thing. Founders should be wary of the long term consequences of raising more money at higher prices before they’ve reached the milestones that would typically warrant those valuations. 

But why? Surely more money, at higher prices must be a good thing for founders? Let us explain why this is not necessarily the case, and explain why founders should beware of the temptation of taking too much capital at the very earliest stages of a company’s life. 

You’ll be forced to grow very fast

Firstly, if you are raising more capital, you are necessarily going to be raising at a higher valuation in order to avoid excessive dilution (and ending up in a situation whereby the time you’re raising your Series A round your investors own more of the company than you, the founder). For example, most funding rounds buy between ~15-25% of the company. If you raise £500k in a ‘pre-seed’ round you’ll be putting your pre-money valuation at between ~£1.5m-3m on this basis. If you raise £2m in your ‘pre-seed’ round, for the same dilution, automatically you’ll be raising money at between ~£6m-£10m pre-money. Before you take that funding and higher valuation, it’s a good idea to think through the expectations and trajectory that this puts the company on to. 

Before you take that funding and higher valuation, it’s a good idea to think through the expectations and trajectory that this puts the company on to.”

Investors expect that between each round of funding the best performing companies will increase their pre-money valuation between 2.5-3x before the next funding round. So in the example above — if you’ve raised £2m at £8m pre-money, £10m post money — a 3x uplift puts the pre-money valuation bar for the next round at £30m. If your company fails to grow at the 3-5x year-on-year rate that the top performing companies do, reaching a £30m valuation for your next round, even in this market, will be a tough ask. It will be even harder when the market inevitably corrects and capital becomes scarce again. In the US where rounds happen faster and growth expectations are higher, valuation uplifts are expected at 5-7x between rounds, not 2.5-3x — making the bar even higher. 

Your exit options will narrow

Secondly, raising a pre-seed round at a £10m pre-money valuation immediately sets the company on a course for a boom or bust outcome. Whilst it’s still incredibly early in the company’s journey, having an eye on the eventual exit is still important.

Investors expect a minimum of 10x return on their winners (often considerably higher). Any founder raising VC money will, under any circumstances, need to demonstrate a clear case for a £100m+ exit. However, if things don’t go to plan in the early years and a founder needs to sell the company, raising at a high price will severely limit their options. If the founder has raised at £10m pre-money, any exit outcome of under £100m would be deemed a failure by the investors and they will be pushing the company to raise more, spend more and take larger risks in order to try to get the company to above the £100m mark. Whereas the founder that raised £500k at £2.5m post-money valuation can still deliver a 10x return to their investors by selling for £25m. A £25m exit may not be what VC investors are looking for, but for a founder, this could mean a life-changing outcome for them and their team. 

“Raising at a higher pre-money valuation instantly narrows the exit options.”

Raising at a higher pre-money valuation instantly narrows the exit options, not to mention the universe of buyers that would be in a position to acquire the company. There are a fraction of the number of buyers that might be interested in a company at a £300m+ price tag, vs those that could pay £25-100m. Whilst founders will rightly go into any funding journey focused primarily on the potential upside, it’s important to bear in mind how the valuation that the company raises at can have a material impact on potential exit options.

Your investors just won’t care about you as much

Thirdly, the investors that are hoping to pump money into pre-seed companies at the earliest stages are typically large, multi-stage funds, who are used to investing at the Series A and Series B stages. They are hunting earlier and earlier often in order to secure an option on a unicorn style outcome. This creates several potential problems; that they are not pre-seed specialists so don’t spend all their time helping companies get from zero to one. Not only that, but they may not have the bandwidth to be hands on with your company, since most of their focus will need to be on the bigger, more material positions in their portfolios. 

“Your company may end up being collateral damage in a call option that the fund never takes.”

They are also not too concerned if one or two of these early bets don’t work out because their real objective is to get one or two of them to Series A and B where they can deploy a much bigger cheque. So your company may end up being collateral damage in a call option that the fund never takes. If that is the case, then you also risk waving a big red flag to the market, signalling that your company is not one of the top performers, just because it couldn’t jump from that £10m pre-seed valuation to £30m for seed. 

Seed-stage specialists know their onions

So what’s the alternative? You’d expect us to point out the above, given we are both partners at funds that lead pre-seed rounds. But leaving aside the fact that this is a biased viewpoint, we would urge any founder considering raising money at pre-seed to work through the potential scenarios of valuation increase between rounds of 2.5-3x. Of course, there will sometimes be cases where companies really do require huge amounts of upfront capital at pre-seed; for example if they are building flying cars or other sectors requiring very large capital expenditure.

In most cases though, the smart option is to raise the right amount needed to reach the next inflection point or ‘golden milestone’ from specialist funds that spend all their time helping companies at the same stage as yours and ensure that the company valuation doesn’t overreach the traction and stage of the company, or the investor appetite. 

So what should you as a founder keep in mind when considering what the right amount of money is to take at the pre-seed stage and the right valuation?

  • Is this round going to give you enough capital, with a buffer, to reach the ‘golden milestone’ that you need to reach to show the strength of your proposition (this milestone will be specific to your company, sector and the dynamics of the market)?
  • Will this golden milestone enable you to 2.5-3x your valuation when you next go to the market for funding? 
  • Are there other companies that have sold or IPO’d at prices that will justify the valuation you are targeting?  
  • Have you validated the above two assumptions through data and evidence in the market? 
  • Is the round (size and pre-money valuation) buying between 15-25%? 
  • Are you further ahead than other comparative companies in your industry or sector so that you can justify a price at the bottom end of that range of dilution? What is the evidence for that? 
  • Are you talking to the right type of investor that spends their time investing in companies at your stage of development?
  • Have you asked your potential investor about what happens if you don’t hit your growth trajectory, or even better, other founders in the portfolio who have experienced this first hand? 

By working through these questions you should be able to triangulate to the right round size, valuation range and investor for your company and avoid closing down your options for the future. 

That’s the best way to avoid getting stuffed. 

Check Warner is a partner at Ada Ventures and Tom Wilson is a partner at Seedcamp. 

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shrock
shrock

not a new prob, used to be called rocket fuel. good check list at the end.
btw, foie gras-ing is preparing the duck’s liver for market not the duck 😉