Trying to decide how to fund a startup? It’s important that we ask the right questions.
Money is like gasoline during a road trip. You don’t want to run out of gas on your trip, but you’re not doing a tour of gas stations.
– Tim O’Reilly
By far the most common question we are asked as early-stage investors is not how to grow a successful business or build a great team, but how to raise more capital. It sometimes feels like getting investment has become an end in itself.
It’s now so common to think this way we’ve all normalised it, but it’s still curious to see founders congratulated for raising capital. It’s like applauding the pilot of a plane for successfully re-fuelling before take-off.
When we’re working on a startup we need to decide: where are we going, and who is the best partner to help us get there?
If you don’t know where you’re going then any road leads you there
– Lewis Carroll
The first question we need to consider is whether we should raise outside capital at all.
In simple terms there are three ways to approach an early-stage business:
This approach involves raising as much money as we can up-front, and then spending it aggressively in pursuit of revenue.
If we go down this road, it’s important that we are committed to it and can paint a big picture for investors. Before they give us money they will need to believe there is a good chance they will get a much larger amount back in time. And that means they need us to continue to grow, rapidly, and that we will have to (at some point) achieve liquidity for them by selling the business or taking it to the public markets through an IPO. Once we’ve taken their money there is no option for us to take our foot off the gas and say “this is where I’d like to stop; the team’s big enough, we’ve worked hard enough, we’re going to relax and enjoy the fruits of our labour now”.
The problem with this sort of approach is that it’s a big punt. Perhaps there won’t be quite as many customers as we think, or perhaps it will take us longer than we thought to convince them to buy, or maybe it will be much harder to build the team we need to help us get there than we expected. Either way, there is a possibility that we will spend all of the money we raised before we get enough revenue to cover your costs into the future.
If that happens we’ll find ourselves needing to move from a high-cost model to a low-cost model, which is difficult (especially after we’ve hired people we like).
And, unless we can demonstrate momentum and find a way to tell an even bigger story, we’ll probably find it difficult to raise more money down the track when that’s required.
On the other hand, if we’re successful then we can end up owning a share of a business that is much larger than we could have created on our own.
This approach is all about keeping our costs as low as possible for as long as possible (i.e. living on 2-Minute Noodles), and trying to quickly get to a cash-flow positive position.
Maybe we can fund those early stages ourselves from savings, or maybe we can find a patient benefactor who is prepared to invest a modest amount of capital. Either way, it’s all about making a relatively small amount of cash go a long way. Ideally all the way to a profitable business (or at least one that washes its own face).
However, there are two obvious problems with this approach:
Secondly, it can take forever, so we need to be patient. In the meantime perhaps somebody else will come along with more resources (see “Burn Baby Burn” above) and win our customers before we can get to them. Or, maybe it requires more investment (both time and money) than our limited resources can provide?
Of course, if it does work, we are left owning most of a business that’s paying for itself, and generating cash. That puts us in a strong position to talk to potential investors, to re-invest in growing the business further ourselves, or to simply sit back and enjoy the profits.
This approach involves using revenue from consulting or other part-time work to fund our venture. In other words we spend some of our time working for other people, so we have enough money to fund our own ideas.
The obvious risk is that we find it difficult to wean ourselves off our dependence on the comfortable salary our consulting work provides.
Or, perhaps we find it difficult to say ‘no’ to work when it is available, and as a result the consulting work comes to take all our time leaving little space for anything else.
Of course, if we can find the right balance, this is a great way to fund a business without having to constantly scrimp and save and do everything cheaply, and without having to raise money from needy external investors.
The most important thing to realise about these different options is: there is no right answer.1
There are examples of companies that have been successful using each of these approaches. So, asking which is “best” is the wrong question, I think.
When we ask people who have been successful in the past, they tend to recommend the approach that worked for them. So be careful whose advice we take.
The important thing is to choose. Whatever we do, don’t get stuck halfway between – i.e. taking on investment (with the associated expectations that brings) but not really raising enough money to really go hard, or taking a “hybrid” approach as well as taking on external shareholders.
And never forget, how we fund our venture or how much we raise is ultimately irrelevant unless we make something people want.
It is difficult to get anybody to understand something, when their salary depends on them not understanding it.
– Upton Sinclair (updated for the 20th century)
Once we have decided that raising capital is what we want, the next most important question to ask is: ‘who?’
My observation is that nearly everybody starts instead with questions like ‘how much?’ or ‘at what valuation?’ or even ‘how quickly?’
But the best founders choose their investors carefully, not only for how much cash they can invest but also for how much they can help the venture get to the next milestone. So, think about who would contribute the most in the next stage and then work out what we need to be in order to convince them to invest and join the team.
My advice is take the time to understand the various things that might motivate different types of investors to be tempted by your venture now, because it makes a big difference to how we might present the opportunity to them.
Some of the common motives are:
Some investors are attracted by the apparent glamour of early-stage ventures. They like to be able to tell their friends and colleagues that they are involved in something that seems more exciting than the other things they do to fill their days.
We need to offer these investors some recognition for their involvement.
Some investors are looking for something to spend their time on, and prefer to be able to leverage that investment with a small financial stake.
We need to offer these investors a role where they feel they are involved and making a difference.
Some investors are simply looking for a financial return on investment.
At some point in the future they want to get back more than they invested, plus some extra for the risk they took and the period of time that we had the benefit of their money - that could be shares they can sell (what is often called ’liquidity’), cash from an exit, or maybe on-going dividends.
We need to understand what sort of return they are expecting (this will likely depend on their personal circumstances, or the mandate of their fund, and also how early they are investing), and we need a forecast that shows them the numbers to give them confidence that if things go well this is possible in our case.2
Some investors who manage a fund on behalf of others are compensated based on the size of the fund and the overall capital gain they produce for their funders.
For example, a general partner in a VC fund will typically receive 2% + 20%, meaning they are paid 2% of the total value of the fund they manage every year (this is used to cover the fixed costs of running the fund) and 20% of any gains.3
We need to convince these investors that we have a chance of knocking it out of the park - because they are investing in a portfolio of companies alongside ours, there is not much difference for them between a complete failure and a mild success, so they will expect us to be swinging for the fences.
Some investors who manage a fund on behalf of others are compensated based on the current value of those investments.
For example, a hedge fund will typically pay managers an annual bonus based on the increase in value. This effectively means they buy the shares again every year.
We need to show these investors that we can steadily increase the value of the business over time and avoid any nasty shocks which could cause the value to drop from one year to the next.
So, think about what sort of investor is the best fit, given the stage we’re at and our own ambitions for the future. It’s surprising how often there is a complete mismatch between the motivations of founders and investors as a venture grows.
If we’re just getting started and need to raise a small amount of capital to cover costs while we explore the opportunity, then we’ll probably struggle to get larger investors excited, given they generally prefer to invest bigger amounts once there is an obvious way that this money can be used to remove constraints and accelerate the growth of the business.
More than this, it can sometimes be toxic to get a high profile investor on-board in the first round - in the next round other investors will take the lead from them, and if they choose not to continue investing, for any reason, then you’ll likely struggle to explain to other investors (or critically, to new investors) why they should think differently.
Conversely, once we’ve proven the venture and are ready for larger amounts of capital to help accelerate, then we’re probably wasting our time if you’re still pitching investors who are mostly interested in the story or contributing their time, but who normally don’t write big cheques.
And, if the focus is on creating a great business that will pay a good salary to founders and maybe a few employees, then we’re creating a future headache for ourselves if we raise any money from financial investors who are driven by a return.
I always encourage founders to have this conversation explicitly in advance with potential investors. If it’s not clear which type of investor we’re talking to then take some time to understand what is attracting them to this venture.
Once we’ve chosen the investors we want and gotten them excited about the potential, the next job is to work with them to agree terms that everybody is happy with.
Make sure that the bigger investors are putting enough cash in, and getting enough of a percentage in return, such that they care about the venture and will invest their time and energy and networks into making a success in the future.
A lead investor will help to shape up the round. Some investors will be happy to take the whole round. Others prefer to invest alongside others. The important thing is to start with the larger investors first and then get them to help fill in whatever amount is left for smaller investors. It is frustratingly common for founders do this in the reverse order, and that is nearly always a mistake.
A lead investor should be someone who has the capacity to invest in subsequent rounds. Ideally they should also have a network of connections to help in the future with intros to larger and larger investors.
A lead investor will also help to set the valuation.
It might sound overly simplistic, but I tend to think that this is something that the market decides – the price is whatever an investor will offer and whatever founders will stomach, and hopefully there is some overlap between those two!
For what it’s worth, these are some rules of thumb that can help:
Given those two constraints we can solve the equation and give ourselves a range to start the discussion with.
It gets more complicated if we already have customers and revenue and a growth trajectory, since that gives some basis for a valuation based on fundamentals (e.g. investors will often look at a multiple of annualised revenue when considering the valuation of a SaaS businesses). However, at an early-stage when the numbers are small that often ends up being in the range I mentioned above anyway. Be aware that numbers can easily mess up a good story!
Try not to get bogged down in this. At the end of the day neither founders or investors win because they eked the last percentage point of dilution out of a funding round negotiation, we win by working together to build a fast-growing ass-kicking name-taking business. In the not too distant future whatever valuation we agree now is likely to either look way too high (because the company is dead and therefore worthless) or way too low (because it became a big success).
So, don’t pretend too hard to be something we’re not and don’t die in the ditch over terms that probably won’t matter down the track.
Be clear from the outset, with yourself and your co-founders, about what kind of business you’re trying to build. If investment is part of your plan, choose the right type of investors, who align with the founders and the business and will give the kind of help needed to get where we’re going. And focus on negotiating a fundraising round that leaves everyone feeling positive and motivated to see the business succeed.
If we do manage to pull that off, then acknowledge the applause but don’t be distracted by it, because now we’re sitting at the end of the runway, and we need to fly the plane…!
However, always be honest about how accurate future predictions are, especially in the early stages. Investors asking for a multi-year forecast, before there is enough data to make good assumptions, are asking us to lie to them. Call them on it. ↩︎
A portfolio approach to early-stage venture investment doesn’t really help and probably hurts.
Anything vs Everything
Choose what you’re going to focus on, and then have the conviction to say “no” to everything else.
Anywhere I would have followed you. But I’m giving up on you!
Pining for the Fjords
Be honest: can we get to the next milestone with the resources we have?