The Rule of Two
Transcript
All right. So last time we were talking about how convertible debt and SAFEs compare to equity when it comes to fundraising.
And a bunch of people emailed me and said, hey, why are you so negative on debt and SAFEs? And I'll call them debt going forward just to make it simpler. Why are you so negative on debt?
And of course, there's the issue of uncertainty around the transaction. You don't know what the actual price will be, how many shares, etc.
And a bunch of entrepreneurs said, hey, that's exactly the point. I don't know how much my company is worth today.
So I'd rather just raise some debt, put a cap on it and be done.
And I'll deal with that down the road.
But what you're missing is the other gotcha.
And the other gotcha is what I call my rule of two.
And let me be specific about this.
What it is, is that for every dollar of convertible debt you have on your balance sheet,
I believe to make the transaction go smoothly, the next transaction,
you need to bring in 2x, twice as much new capital.
Take that at face value.
I'm going to walk you through an example and then I'm going to explain why you need that 2x.
So the example is you have an early stage startup, you're raising money, you think you can raise a million dollars on a $3 million valuation.
And the goal is to use that money to get enough traction to get your next round, which will be a $3 million round.
Since you're well within the parameters of the rule of two, $1 million to $3 million, you say, I'm going to do it quickly and easily.
I'm going to do it on a safe.
You raise it on a safe, you got your million bucks.
Turns out, surprise, surprise, it's harder than you thought.
It's going to take longer than you thought.
Always happens.
You have really supportive investors who are in on your safe.
They say, oh, we'll give you some more on the same safe.
We'll give you another half a million bucks.
You spend through that half a million dollars.
You're almost at the point where you're getting to the traction,
the numbers that you need to raise your $3 million round,
but you realize you need some more.
And now you've got a conundrum.
Because if you bring in another half a million,
you now have two million on that safe by my rule of two you now need to raise four million of new
money which means you need more traction to warrant that additional investment and you get into this
vicious cycle of oh i need more traction so i need more money but then as i get more money now i need
even more traction and you spiral out of control let's revisit that same scenario if you had chosen
a different path initially if in that first round you had done one million in equity on the three
million not instead cap valuation you'd have a company you did a four million post-money valuation
you sold a quarter of the company there's a little bit of of stock options you probably still own 65
if it got harder and you needed a little more runway before you're ready for your next round
of course you could raise 500 on a safe if it still was harder you could raise that second 500
on your safe you only have a million out you're going to raise three million you got lots of room
within my rule of 2x life is much simpler you can see that that first move that first fundraise
being equity put you in a much stronger position for the future one of the things i like let's make
tomorrow better than today now why is this 2x thing important well given the scenario i just
gave you if you had actually raised the 2 million on a safe the 3 million cap and then you went out
and got to the traction you needed to get your three million dollar raise we'll say it's at the
same ratio so nine million dollar pre-money 12 post you feel like hey i just sold a quarter of
the company three million on a nine pre however at the end of that transaction when you account for
the converted debt and the option pool it turns out that you as the founders only own 35 of the
company it turns out that the new buyers who thought they bought a quarter of the company the
new investors they only got a sixth of the company 16.67 percent what happened to the rest of the
company well it got taken up that stock got taken up by the debt or safe that converted into equity
where no new cash came in and if that amount that gets taken up with no new cash coming in is bigger
than half of the new money it starts to feel awkward the entrepreneurs feel like they gave
up too much of the company with not enough cash coming in and the new investors feel like they
They put in a lot of cash and didn't get enough of the company.
The transaction becomes difficult to facilitate.
So my rule of 2x, make sure that you never put yourself in a position where you have
more debt than you can handle.
By that I mean that your next round is going to be at least 2x as big.
You see, raising money, it's sort of like playing a game of chess.
The good players optimize their move, maybe think one move ahead.
The great players think two or three moves ahead.
In last week’s episode, we discussed the pros and cons of SAFE/Convertible Debt vs. Equity. This week we take a deeper dive into some unexpected problems you can run into when deciding to raise with SAFE/Convertible Debt. Make sure you are always putting yourself in the best position for your next raise, always be optimizing for the future!!
Originally published on the MATH Venture Partners blog.