PMF or Bust: The New Reality of Fundraising
Founders are hearing this a lot in 2023: A down-round is a terrible idea.
But it needs clarity.
A down-round is a fundraising event where the raise happens at a lower valuation than your previous investment. The VC will tell the founder that a down-round will harm morale in the company as people’s stock options are worth less than after the previous round.
I went through this with Next Games in different circumstances. We had IPOed at 8 Euros a share. Eighteen months later, the share price was below 2 euros after we’d gone through a failed launch of our highly anticipated game.
But in a startup, the down-round shouldn’t be that bad. But the VCs don’t like it. Why? The VC is investing other people’s money, and they are looking for a return. Here’s the VC math: Because startups take 5 to 7 years or longer to exit, the VCs need to show how they perform on the way to an exit. Each startup in the VCs portfolio is measured through its journey. When a portfolio company raises subsequent rounds, it creates a multiple on invested capital, which tells a tale of “success.”
I’ll give you an example:
A company raised $2m in 2021; in 2023, they raised $10m from later-stage investors. Holy cow, that’s a 5X multiple. The more the VC’s portfolio has companies that raised these up-rounds, the performance goes up. Some companies will still be at 1X after raising one round and having a long runway. Some might have folded and gone to 0X, but more have done up-rounds, so the fund is already performing above 1X. A down-round would make a company go below 1 to something like 0.8X.
VCs need to show that they can take companies toward an exit. Below 1X is the wrong direction. If the VC wants to stay in business and raise a new VC fund from its backers, the direction can’t be anything but up.
I’ll give you another example:
A startup is in trouble and needs to raise in 6 months. The VC will tell the founder they will be supportive but require the founder to get a term sheet from a new investor. Why is it essential to get the price from a new investor? Why can’t your existing investor set the price?
They could, but it depends on your perceived price: if the startup is doing well, has gone from pre-seed to seed or series A, and is worth more than before, the existing VC could issue a term sheet.
The usual scenario: a game studio raised a pre-seed of $2m, but 12 months later, without product market fit, they need to raise another round. The existing investor has to justify that this is a good move to put more money in, even if the past 12 months didn’t lead to PMF.
In the crazy times of 2021, investors weren’t worried if they could achieve PMF in 12 months before the next raise. In 2021, it felt that all companies could raise more pre-PMF.
This changed in 2023. Seed investors aren’t investing in companies that don’t have numbers. They don’t want to become a bag holder of companies that have raised but are still seeking PMF.
I’m also seeing signals in gaming that pre-seed has now changed to require early indications of PMF. It’s a normal reaction. VCs see that no PMF at pre-seed means a higher likelihood of not raising a new round in 12 months.
Investors have more leverage, but founders will benefit from the constraints to push past the adversity, not to raise without PMF. The system shock will create better startups.