Raising Capital: The Value in Raising Less Capital
Justifiably, founders always value their creations very highly; they shouldn’t embark down the path of startup entrepreneurship if they are not passionate about the high value of what they are bringing to the market! But, for the founders who identify a need to raise capital for their business, how much to raise is an important question.
Not every founder needs to raise capital to support the development of their business idea. Many great companies are boot-strapped, meaning they are built using sales revenues. For the most part these tend to be services companies. Most product based technology businesses are capital intensive right from the start, long before revenues are possible. Unless the product development can be supported by an existing business, an outside source of capital will be required if the company is to succeed.
IT sector companies are among the more demanding of capital, perhaps only surpassed by pharma and biotech. By definition, technology implies and usually means doing original and unique things that have not been attempted prior. This usually means high-risk as there is a high degree of unknown in developing the product that eventually becomes the company, but that high risk also implies high reward for the shareholders of the companies that are successful.
Raising Capital: How Much is the Right Amount?
Presuming your business idea has credibility, and that the idea can be developed into a viable product for a defined target market that has a problem requiring a solution, how much capital do you need to execute? This is a tough question, and if anyone argues they can give you a credible response for an early stage business, move on! The correct answer is the final real need is unknown. What you can determine however, is how much cash you need in the bank to be able to reach a milestone that represents the next phase of your business.
Some entrepreneurs think they should raise as much money as they can because they believe that having more cash in the bank will provide a longer runway 1) before they need more money; 2) have to ask for more money; 3) need to generate revenue from the product. They believe that getting more capital early on validates their idea, and that this validation only means the next round will automatically be for a higher valuation. For the first time and very early stage entrepreneur, this is the wrong attitude with which to approach early-stage fundraising. The reasons why are plentiful, and I doubt we could scratch the surface in one article. At its simplest it is all about setting and meeting expectations realistically.
Because there are so many unknowns early on, milestone based financing is very much in the very early stage entrepreneur’s best interest. Some entrepreneurs may think this type of financing is more work, and sometimes they are right. But, it is in the shareholders’ best interest, and I will attempt to explain why.
If you are not sure what milestone based financing is, the definition, simply put, it is all about raising just the right amount of capital required to reach the next milestone. It means raising less money at any one time, but each tranche should cost the company less equity.
This model of raising capital is best suited to very-early stage firms, and thus would fall into the seed and angel rounds. It also is not particularly suited to the institutional investor, as their investment model / method differs.
For the entrepreneur and the seed / angel investors however, milestone based financing offers high value. For the entrepreneur, the focus on the “necessary next steps” to accomplish a milestone is clear, and delivering on the objectives means continuous validation of the financing valuation. For the savvy entrepreneur, this will mean that each tranche of capital costs the company less equity overall, and less dilution for the founder / team. For the investor, less cash outlay with each round means the risk is lowered.
Pros and Cons to Milestone Capital Raises
If the entrepreneur and investor agree to a patch of milestone financings, it is rare that the agreement is limited to a single round. While it is possible to approach this model as a series of discrete and completely independent rounds with different investors at each stage, it is more likely that the entrepreneur and investor(s) will agree at the outset that an initial tranche of financing will be followed by a subsequent capital if the company achieves some milestone. consequently, failing to meet a milestone will result in differing terms, or no follow on funds. This is high-risk for the entrepreneur who is unable to achieve the promised milestone. Presuming the milestone is met, the valuation of the subsequent tranche is normally on terms more favorable to the company. The less risky the investment (or the more proven the team), the more comfortable the investor is with the company.
Fundraising is Fun!
No, it is not. Fundraising is not fun; you will certainly get rejected more often than you expect no matter how great your idea is. Deal with it! Fundraising is sales, and sales always involves some rejection. Every time you ask for money you are inviting that rejection, something we as a species are programmed to shy away from. BTW… That potential rejection is the same reason most of people don’t ask the really cute girl / guy out. No one enjoys the chance of rejection, let alone the real thing!
But the fundraising process for an early stage company is actually the sales process in absence of a customer discourse. Many IT companies are built to create solutions before the problem the solution is addressing is widely enough recognized for most potential customers to know they need the product. Often, the very earliest stage of these startup companies even have a hard time identifying competitors that help the market validate the need for a solution. That’s part of the reason why these are often called ‘bleeding-edge’ companies. In the absence of actual customers, the investors are the entrepreneurs’ first sales. Instead of acquiring your product, they are acquiring a right to a portion of the proceeds of your product.
This is the first marketplace where the viability of your idea is tested, analyzed, challenged, and hopefully accepted. Earn an investment, and you’ve made a sale! But, if your business is a very early-stage startup, or in a nascent vertical, neither you nor the investor can likely cannot peg a fair value on the investment. As mentioned at the outset, founders always value their projects very highly, and setting a value on an early stage startup makes this challenging. After all, what market validation is there for the valuation? Conversely, the investor is making a very high risk bet, and they know that only a few of their high-risk investments will pay off. Not only does the entrepreneur need to convince them of the opportunity, but they also need to objectively assess the market size, and assure the investor that they can execute on the opportunity.
This last part is perhaps the most critical to justifying the valuation to an institutional investor. As companies grow, so do the teams. The founder in this case needs to be able to demonstrate they can objectively perform a SWOT (Strengths Weaknesses Opportunities and Threats) analysis on their organization and on themselves. They need to identify what roles needs to be filled / added, and when.
The Value in Small Round Fundraising
There are very few ideas that are obviously a billion-dollar idea from the start. Everyone knew there would be more than one billion-dollar opportunity in search (Google, Baidu, Yandex, Yahoo!, etc), but who would have picked Facebook, Uber, Tesla, Sybase, Hotmail, Skype, Instagram, Snapchat, Slack, or Netscape? Consider how many of these are free, and it means picking the winners is even more difficult.
As the entrepreneur starting off, we all expect that our idea is the next billion-dollar idea. More often than not, we are wrong. But, so what? Get your fundraising right, and you can make more off a $10MM company than you would a $1B company where you mess up by raising too much capital for too much & too soon.
Think about it this way. If someone provides you with lots of capital early on, they will expect a large upside if you win. But if you only take on the minimum amount you need to execute to the next milestone proof-point, then you are limiting everyone’s exposure to risk. This de-risking strategy means you take less capital, but you also give up less equity at each step of the way.
If you clearly establish the milestones you are going to accomplish with the capital you raise, and you achieve them, your company is worth more, and you are asking for more reasonable capital to get to the next stage. Confidence in your company and your ability to execute is higher, and your valuation is stronger.
Some will say it is riskier to raise less now, as the capital may not be available later when you need it. This is true, the capital you could need may not be available, but that’s only likely to happen if you have not executed AND the addressable market disappears.
If you are confident in your ability to execute and you believe that the market is viable, and you are correct on both fronts, then the necessary capital to achieve the next milestone will be available. If you are wrong, then you likely should not have raised the initial funding anyhow. If the market is there, but you are unable to execute, the company may still get funded, but you likely will not be part of its future success. That’s a different story however!
Part 2 – The Challenge with Milestone Capital Fundraising, and why it is not for everyone.