Show Me the Money

Trying to decide how to fund your start-up? It's important that you 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 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.

You need to decide: where are you going, and who is the best partner to help you get there?

Begin with the end in mind

“If you don’t know where you’re going then any road leads you there”
– Lewis Carroll

The first question you need to consider is whether you should raise outside capital at all.

In simple terms there are three ways to approach an early-stage business:

1. The “Burn Baby, Burn!” Approach

This approach involves raising as much money as you can up-front, and then spending it aggressively in pursuit of revenue.

If you go down this road, it’s important that you are committed to it and can paint a big picture for investors. Before they give you 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 you to continue to grow, rapidly, and that you 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 you’ve taken their money there is no option for you to take your 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 you think, or perhaps it will take you longer than you thought to convince them to buy, or maybe it will be much harder to build the team you need to help you get there than you expected. Either way, there is a possibility that you will spend all of the money you raised before you get enough revenue to cover your costs into the future.

If that happens you’ll find yourself needing to move from a high-cost model to a low-cost model, which is difficult (especially if you’ve hired people you like).

And, unless you can demonstrate momentum and find a way to tell an even bigger story, you’ll probably find it difficult to raise more money down the track when that’s required.

On the other hand, if you’re successful then you can end up owning a share of a business that is much larger than you could have created on your own.

2. The “2-minute Noodles” Approach

This approach is all about keeping your 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 you can fund those early stages yourself from savings, or maybe you can find a 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:

Firstly, it’s only really possible if you’re young (or stupid!) Most of the rest of us already have too many expensive tastes and existing commitments and responsibilities.

Secondly, it can take forever, so you need to be patient. In the meantime perhaps somebody else will come along with more resources (see “Burn Baby Burn” above) and win your customers before you can get to them. Or, maybe it requires more investment (both time and money) than your limited resources can provide?

Of course, if it does work, you are left owning most of a business that’s paying for itself, and generating cash. That puts you in a strong position to talk to potential investors, to re-invest in growing the business further yourself, or to simply sit back and enjoy the profits.

3. The “Hybrid” approach

This approach involves using revenue from consulting or other part-time work to fund your venture. In other words you spend some of your time working for other people, so you have enough money to fund your own ideas.

The obvious risk is that you find it difficult to wean yourself off your dependence on the comfortable salary your consulting work provides.

Or, perhaps you find it difficult to say ‘no’ to work when it is available, and as a result the consulting work comes to take all of your time leaving little space for anything else.

Of course, if you 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.

If you talk to people who have been successful in the past, you tend to find that they recommend the approach that worked for them. So be careful with whose advice you take.

The important thing is to choose. Whatever you 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 you fund your venture or how much you raise is ultimately irrelevant unless you make something people want.

Investor Motives

“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 you have decided that raising capital is what you want, the next most important question to ask yourself 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 to your venture in the next stage and then work out what you 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 you might present the opportunity to them.

Some of the common motives are:

1. Story

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.

You need to offer these investors some recognition for their involvement.

2. Contribution

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.

You need to offer these investors a role where they feel they are involved and making a difference.

3. ROI

Some investors are simply looking for a financial return on investment.

At some point in the future they want you to give them back more than they gave you, plus some extra for the risk they took and the period of time that you 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.

You 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 you need a forecast that shows them the numbers to give them confidence that if things go well this is possible in your case.2

4. Carry

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

You need to convince these investors that you have a chance of knocking it out of the park - because they are investing in a portfolio of companies alongside yours, there is not much difference for them between a complete failure and a mild success, so they will expect you to be swinging for the fences.

5. Uplift

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.

You need to show these investors that you can steadily increase the value of your 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 appropriate for you, given the stage you’re at and your 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 you’re just getting started and need to raise a small amount of capital to cover your costs while you explore the opportunity, then you’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 your first round - in your 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 your other investors (or critically, to new investors) why they should think differently.

Conversely, once you’ve proven the venture and are ready for larger amounts of capital to help you accelerate, then you’re probably wasting your 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 your focus is on creating a great business that will pay a good salary for you and maybe a few employees, then you’re creating a future headache for yourself if you raise any money from financial investors who are driven by a return.

I’d encourage you to have the conversation explicitly in advance with potential investors. If it’s not clear which type of investor you’re talking to then take some time to understand what is attracting them to your venture.

Putting together a round

Once you’ve chosen the investors you want and gotten them excited about the potential, the next job is to work with them to agree terms that you’re both 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 you 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 you fill in whatever 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 you in the future as you need to reach out to larger and larger investors.

A lead investor will also help you 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 you as 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:

  • Expect to dilute between 20-30% per round, so that you’re making enough equity available to new investors to ensure you have their attention into the future; and
  • Plan to raise enough to cover 18-24 months' worth of expenses, based on a well documented and easily communicated plan that estimates what these are likely to be

Given those two constraints you can solve the equation and give yourself a range to start the discussion with.

It gets more complicated if you 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, whether you’re an investor or a founder. At the end of the day neither side wins because you eked the last percentage point of dilution out of a funding round negotiation, you win by working together to build a fast-growing ass-kicking name-taking business. In the not too distant future whatever valuation you 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 you’re not and don’t die in the ditch over terms that probably won’t matter down the track.

Cleared for take-off

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 you and the business and will give you the kind of help you need to get where you’re going. And focus on negotiating a fundraising round that leaves everyone feeling positive and motivated to see the business succeed.

If you do manage to pull that off, then acknowledge the applause but don’t be distracted by it, because now you’re sitting at the end of the runway, and you need to fly the plane…!

Header Image: Faster by Glenn Jones

  1. If you’re struggling with this question I strongly recommend you read An Exist Strategy by Tash Lampard (which was also the closing talk at Webstock in 2015↩︎

  2. However, be honest about your ability to predict the future accurately, especially in the early stages of your venture. Investors asking for a multi-year forecast, before you have enough data to make good assumptions, are asking you to lie to them. Call them on it. ↩︎

  3. See: Venture Fund Economics by Fred Wilson. ↩︎

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