Robert P. Mollen, Counsel at Fried, Frank, Harris, Shriver & Jacobson (London) LLP.
I frequently get a question from early stage founders that I can’t answer: “How much should we raise from investors?”
There is no right answer to that question. In any case, it is really a multi-part question – whether, when and how much?
Here are some considerations that you should take into account.
Should we raise externally at all and, if so, when?
Bootstrapping. The first question you should ask is whether you need to raise external funding at all, and if so, when? Many startups conclude it makes sense to self-fund (including friends and family), possibly supplemented by investment from an accelerator that otherwise adds value http://bit.ly/AcceleratorValue, for as long as they can afford to do so.
Of course, “bootstrapping” in this way may affect the speed at which you can expand your team, such as by adding additional business development and marketing support. It may also affect your ability to have a place to sleep, and food to eat!
On the other hand, delaying external funding may provide a greater opportunity for B2B startups to contract with corporate clients (large corporates typically have a long contracting cycle, especially in dealing with startups), and prove product–market fit. Similarly, B2C startups may find that they can use other mechanisms to fund early stage development (e.g., product crowdfunding campaigns) while they hone their business model. You are likely to find it easier to obtain external funding, at a better valuation and lower cost in terms of dilution, if your business is at a later stage when you first seek professional investment.
Some startups find that they never need external funding – by operating on a lean model, they are able to get by on self-funding and the cash flow that they are able to develop through paid trials, grants, and sales of products or services.
External funding. Fundraising takes a significant amount of time and effort, which is a diversion for founders while you are trying to build the business.
External investors also bring their own pluses and minuses. On the one hand, they may bring contacts and experience that are very useful to your business. As indicated above, external funding also can permit your business to move more quickly, which may matter in a competitive market.
On the other hand, external investors have their own needs, objectives and views on your business. Consequently, your flexibility to run your business freely will be affected by the requirements of your investors. Additionally, your investors are likely at some point to have contractual rights to approve material changes and actions in your business.
Which approach is better? You will find heated debates online as to whether it is better to bootstrap or seek external funding. My own view is that it frequently makes sense to bootstrap if you can afford to do so, at least until you develop, and can demonstrate, product-market fit and some traction. However, there are many variables in thinking about this – any “one size fits all” answer will be wrong for some startups.
How much can we raise?
In thinking about the timing and amount of any raise, you first need to consider whether, at your current stage of development, you can successfully raise at all, and if so how much? Needless to say, that is not an easy question to answer. This will vary depending on investor perceptions regarding the business vertical that you are in, the quality of your team, the attractiveness of your business model, the size of your addressable market, your ambition for growth and ability to achieve that ambition, and a variety of other factors relating to your business. Importantly, it also will depend on the general availability of early stage finance in the relevant market/s.
In any case, it doesn’t make sense to develop a business plan that assumes a raise of $3X if you are only likely, at your stage, to be able to raise $X, or are unlikely to be able raise at all.
As I’ve written previously http://bit.ly/TenFundingFallacies, most early stage angel and venture capital funding is local, and most businesses will find it difficult if not impossible to raise early stage equity financing in a market where the founders are not physically present. Consequently, any analysis of your ability to raise, and the likely amount, needs to take into account your local early stage financing conditions. It does no good to moan about higher valuations in other markets – you aren’t there.
Network and contacts also matter a lot – while a number of factors will influence the decision of investors to invest, a key element is securing warm introductions that get you in front of relevant investors.
Assuming you can develop investor appetite, how much should you raise?
Milestones. Your milestones should be the starting point for any consideration of your funding needs. What are the milestones for your business that, if you achieve them, would result in a significantly higher valuation? How much do you think it will cost to achieve those milestones, adding in a substantial buffer (say, 20 – 25%) for false starts and cost overruns? Is that amount consistent with what you think you would be able to raise currently and, if not, are there intermediate milestones that would make sense?
Additionally, any decision as to the amount to raise is subject to a balancing of at least three key factors –valuation, dilution and runway.
Valuation. Many startup founders focus excessively on valuation. If you were only going to raise once, then achieving the highest valuation possible in that one raise might make sense, all other things (including quality of investors) equal.
However, most startups will need to raise more than once. Too high a valuation in the first investor raise may make it difficult, or possibly even impossible, to raise again, since that could require a “down round” or a “flat round”. Your objective as founders should be to achieve ever increasing valuations in each successive round. That will keep your investors happy and will also minimize your aggregate dilution over the several rounds.
Dilution. In respect of dilution, you should anticipate that each round will result in dilution of something like 15% to 20%. Too much dilution too early will worry later experienced investors, who will want to be sure that the founders retain a sufficient stake to be motivated to stick around and also be in a position to drive the direction of the business.
Runway. Finally, you should aim in each raise to secure a runway of 12 months – 18 months, preferably something closer to the latter. I recognize that is not always possible, and you may be forced at some point to raise an interim round. This is likely to be expensive money, however, since you will presumably not have achieved your milestones. In addition, the effort associated with the raise may itself divert you from the development of the business (unless, perhaps, the interim raise is provided by your existing investors).
Assessing risk. In thinking about the size of your round/s, you also need to assess different kinds of risks, and consider your own appetite for risk. For example, what is the risk that you will need to revise your business model in a material way (e.g., a pivot)? What is the risk that market conditions for venture capital finance may deteriorate, such that, for reasons outside of your control, investment may not be available when you need to return to the market? Should you raise a bit more to try to cover unanticipated risks of this kind?
Every founder will have a different view as to the appropriate balance between valuation, dilution, runway and risk. That’s fine – just make sure that you have gone through the analytical exercise.
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This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact [email protected].
You will find a listing of Bob’s weekly startup blogs on US and international expansion and early stage financing here: http://bit.ly/StartupGuidesIndex