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The How-To of Business Funding (Part One)

Posted by Catherine Yushina on Jul 3, 2017 11:10:00 AM

Part One. The Basics of Raising Capital

Starting and growing a business requires capital. But what if fundraising is your worst nightmare? Here are some tips that have been used by successful entrepreneurs to fund their companies.

 

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Most startups raise outside capital. The amount of money needed to take an early stage company to profitability is usually beyond the financial ability of the founders and their friends and family. Usually, high growth companies need to burn a lot of capital to sustain their growth, typically by hiring experts and finding better service providers, all in an effort to expand into new markets. At the same time, successful fundraising can be a competitive advantage that shows a belief in the concept and helps build partnerships which could potentially boost growth, especially if a top-notch investor backs you.

When to start raising money?

Investors happily write checks when they believe in the idea, see the opportunity, and when they are persuaded that the team can turn vision into reality. But what does it take to persuade an investor? Here is the check-list:

  1. You have a product/prototype that generated some amount of customer adoption and market interest;
  2. You know your perfect customer and your competition;
  3. You understand the market opportunity and have a go-to-market strategy;
  4. You know how much money you need to raise and what terms you are ready to accept.

How much capital to raise?

The golden rule is for startups to raise enough capital for the 12-18 months runway or launch - and then go for follow-on rounds of funding. When determining the actual dollar amount you need to raise, keep in mind two things:

  1. How much progress does that amount of money give you?
  2. Do you meet the requirements?
  3. How credible is your potential investor?
  4. How much ownership are you willing to forfeit?

Best case scenario, you only have to give away 10% of your company in your seed round, but most rounds will require up to 20% dilution (try to avoid 25% and more). The amount you are asking for must be tied to a believable plan - this shows investors that their money will have a chance to grow and builds trust in you as a founder.

If you are taking a loan or similar funding model,you want to make sure that you raise enough capital but with acceptable interest rates - you don’t want to end up running a business for the sole purpose of paying off the debt. A number of new funding players are pioneering royalty-based funding which have flexible repayment terms. You basically pay-as-you-grow, and if your sales are low this month/quarter, your payment falls as well. Likewise, if your sales are high in any particular month/quarter, you are able to pay off more of the principal and thus shorten the term of the loan.

What are funding rounds?

Funding a company usually happens in “rounds”: a seed round, then a Series A, Series B, then C, and so on until acquisition or IPO. None of these rounds are mandatory and all have different standards. Most early stage rounds are structured as either convertible debt or simple agreements for future equity (SAFE). Convertible debt is a loan an investor makes to a company: it has a principal amount (the amount of the investment), an interest rate (usually a minimum rate of 2-5%), and a maturity date (when the principal and interest must be repaid). This note would convert to equity when the company does an equity financing.

These notes will also usually have a “Cap” or “Target Valuation” (the maximum effective valuation that the owner of the note will pay) and/or a discount (usually 20%). A SAFE agreement is like the convertible debt but without the interest rate, maturity, and repayment requirement. Sometimes startups raise an early equity round, but there is a catch: you have to set a valuation for your company and a price-per-share, and then issue and sell new shares of the company to investors.

What is your company worth?

Your valuation is…Well there is no magic formula that will give you an answer. So why do some companies seem to be worth $25M and some $3M? Largely because founders convinced investors that this was what they were or will be worth. To get a ballpark number, you can choose a valuation by looking at comparable companies who already have valuations.

But the best valuation is the one that you are most comfortable with and the one that will allow you to raise the amount you need with acceptable dilution. Of course, investors have to find it reasonable and attractive enough to invest too. In the end, there is a fine line between valuation and ownership - would you rather own 99% of a $1 business or 1% of a $99 million business? It is important to keep in mind that funding your business is not about valuation, it is about growing a successful business.

Funding without giving up equity.

Today, there are many new ways to fund a business while keeping 100% control over the shares. Depending on your business model, some of these options might be better for you than traditional capital:

  1. Reward-based crowdfunding;
  2. Revenue-sharing crowdfunding;
  3. Royalty-based funding.

These options are based on your ability to deliver either a product or a growing volume of sales but this could also be the opportunity for you to finance your business while boosting your customer reach.

Part Two would be about Different Sources of Capital.

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Topics: Business Funding