Unboxed #7 - Startup Funding - Why, When & How Much To Raise?
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A startup is always more than just an idea, it’s also a lot of time and effort, dedication, focus, and of course – funding.
Startup companies need to purchase equipment, rent offices, and hire staff. More importantly, they need to grow. In almost every case they will require outside capital to do these things.
What Is Startup Funding?
Startup funding is the act of raising capital to support a business venture. Funding comes in many forms and differs by company maturity, but a large majority of companies engage in some sort of fundraising to boost their growth potential.
Raising startup funding is one of the most exciting, challenging times for a company. The CEO searches for investors, loans, grants, and other forms of funding to help their business grow. If successful, the startup has the capital to continue building its products or providing new features to customers. If not, the company may have to close its doors forever.
The initial capital raised by a company is typically called “seed” capital. This brief guide is a summary of what startup founders need to know about raising the seed funds critical to getting their company off the ground.
Why Raise Money?
Without startup funding, the vast majority of startups will die. The amount of money needed to take a startup to profitability is usually well beyond the ability of founders and their friends and family to finance. A startup here means a company that is built to grow fast. High-growth companies almost always need to burn capital to sustain their growth prior to achieving profitability. A few startup companies do successfully bootstrap (self-fund) themselves, but they are the exception. Of course, there are lots of great companies that aren’t startups. Managing capital needs for such companies is not covered herein.
Cash not only allows startups to live and grow, but a war chest is also almost always a competitive advantage in all ways that matter: hiring key staff, public relations, marketing, and sales. Thus, most startups will almost certainly want to raise money. The good news is that there are lots of investors hoping to give the right startup money. The bad news is, “Fundraising is brutal”. The process of raising that money is often long, arduous, complex, and ego-deflating. Nevertheless, it is a path almost all companies and founders must walk, but when is the time right to raise?
When to Raise Money?
Investors write checks when the idea they hear is compelling when they are persuaded that the team of founders can realize its vision and that the opportunity described is real and sufficiently large. When founders are ready to tell this story, they can raise money. And usually, when you can raise money, you should.
For some founders, it is enough to have a story and a reputation. However, for most, it will require an idea, a product, and some amount of customer adoption, a.k.a. traction. Luckily, the software development ecosystem today is such that a sophisticated web or mobile product can be built and delivered in a remarkably short period of time at a very low cost. Even hardware can be rapidly prototyped and tested.
But investors also need persuading. Usually, a product they can see, use, or touch will not be enough. They will want to know that there is product-market fit and that the product is experiencing actual growth.
Therefore, founders should raise money when they have figured out what the market opportunity is and who the customer is, and when they have delivered a product that matches their needs and is being adopted at an interestingly rapid rate. How rapid is interesting? This depends, but a rate of 10% per week for several weeks is impressive. And to raise money founders need to impress. For founders who can convince investors without these things, congratulations. For everyone else, work on your product and talk to your users.
How Much To Raise?
Ideally, you should raise as much money as you need to reach profitability, so that you’ll never have to raise money again. If you succeed in this, not only will you find it easier to raise money in the future, you’ll be able to survive without new funding if the funding environment gets tight. That said, certain kinds of startups will need a follow-on round, such as that of building hardware. Their goal should be to raise as much money as needed to get to their next “fundable” milestone, which will usually be 12 to 18 months later.
In choosing how much to raise you are trading off several variables, including how much progress that amount of money will purchase, credibility with investors, and dilution. If you can manage to give up as little as 10% of your company in your seed round, that is wonderful, but most rounds will require up to 20% dilution and you should try to avoid more than 25%. In any event, the amount you are asking for must be tied to a believable plan. That plan will buy you the credibility necessary to persuade investors that their money will have a chance to grow. It is usually a good idea to create multiple plans assuming different amounts raised and to carefully articulate your belief that the company will be successful whether you raise the full or some lesser amount. The difference will be how fast you can grow.
One way to look at the optimal amount to raise in your first round is to decide how many months of operation you want to fund. A rule of thumb is that an engineer (the most common early employee for Silicon Valley startups) costs all-in about $15k per month. So, if you would like to be funded for 18 months of operations with an average of five engineers, then you will need about 15k x 5 x 18 = $1.35mm. What if you are planning to hire for other positions as well? Don’t worry about it! This is just an estimate and will be accurate enough for whatever mix you hire. And here you have a great answer to the question: “How much are you raising?” Simply answer that you are raising for N months (usually 12-18) and will thus need $X, where X will usually be between $500k and $1.5 million. As noted above, you should give multiple versions of N and a range for X, giving different possible growth scenarios based on how much you successfully raise.
There is enormous variation in the amount of money raised by companies. Here we are concerned with early raises, which usually range from a few hundreds of thousands of dollars up to two million dollars. Most first rounds seem to cluster around six hundred thousand dollars, but largely thanks to increased interest from investors in seed, these rounds have been increasing in size over the last several years.
How Does It work?
This video by The Rest of Us gives a detailed explanation of the funding process.
In the upcoming, we will look at various funding round and what it means for founders, companies, and investors.
References - HubSpot / Y Combinator
That’s it for today :-)
Hope each of you has a great start to your day. I’ll talk to everyone tomorrow.
— Amit
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