My plan calls for $3 million before I break even. Should I raise $4 million. That’s a 25% cushion. Seems pretty safe, right? Maybe not. General Electric started many businesses over the last hundred years, and had a rule of thumb for this. “Assume that the new business will cost three times what you expect and that it will take three times as long to get to profitability.”
How much should you raise?
Raise for The Stage You’re In – In Other Words, Take Baby Steps
Always raise money to take your company to the next level. Pre-seed to seed, seed to Series A, Series A to Series B and so on. Know what investors expect of you in each round. Another article in this blog, “The Stages of Buying,” uses Hollywood as an example of testing the market before investing millions of dollars into a new TV show. Hollywood studios make hundreds of “pilots” for TV shows that never get picked up. They test these pilots on small audiences and gauge the reactions. If a pilot tests well, a network may pick up a limited number of episodes to try out on a large audience. If the limited run goes well, the network may pick up more, or even a whole season. This is one important way that Hollywood studios manage the financial risk of developing a TV show. (Netflix, Amazon, Hulu and other streaming services have changed things, but hopefully the example still illustrates the point.)
Investors manage the risk of developing new companies using similar approaches, and founders of startups should keep this in mind when they approach investors. Just like TV networks, investors try to mitigate their financial risks because many startups fail. This is a fact that means that all of the money invested up to and including failure is a complete loss. Investors, therefore, invest in steps, or stages.
The stages to establishing a company are well established. Often, the first stage is to create a prototype to demonstrate technical feasibility. Sometimes, a founder can get investors to help fund developing the prototype, but the money often comes from the founders and their “friends & family.” The second stage is to develop a more robust product to test in the market in a very limited way. The company offers this “Minimally Viable Product” to select customers who are willing to try it out to help “prove the concept.” These select customers are likely friendly people in the founders’ network who would like to see the founders succeed.
If all goes well in the first two stages, the founders and investors may feel that the good results so far justify continuing on to the next stage of trying and sell beyond your friendly network. This is the real test run. To compare with the Hollywood example, Stage 1 is pitching a studio executive and getting the okay to produce a pilot. Stage 2 is like showing the pilot to a friendly audience. Stage 3 is similar to getting the show picked up for a limited run of, perhaps, six episodes. In Venture Capital, this stage is often called Series A financing, although the definition of Series A can be a bit fuzzy. Also, because every startup is unique, there is a lot of variety in objectives among startup companies. This article doesn’t attempt to clarify all of that. Hopefully, the TV show development example provides enough context that founders can better understand their challenges and the perspective of investors.
Just like TV pilots, most startups don’t make it past Stage 3. If Product/Market Fit is not achieved, but the concept still seems promising, the founders may try and tweak the offering to try and make it more attractive. They may continue with or without the initial investors. Some startups toil for years tweaking, inventing new versions of their product, and targeting different market segments before they find one that “hits.” This is the search for what is called Product-Market Fit.
A Brief Tangent About Product/Market Fit. Some never find it. A small company called Steel Shield makes some of the best metal lubricating products anywhere and has at least a couple of dozen high-quality products. After more than a decade, it found a Product/Market Fit for its Weapon Shield gun lubricant. Its other products are also outstanding, but the company has yet to experience the kind of success it recently found for Weapon Shield. Another company called HealtheInc.com makes UV lights that emit at a frequency that kills pathogens but is not harmful to humans, i.e., it doesn’t cause sunburn or damage eyes. Two decades after its founding, it might be considered in the middle of Stage 3 or beginning to find broader market success that demonstrates that HealtheInc has achieved Product/Market Fit. It is difficult to know for sure as an outside observer, but looking at the customer information on the company’s website would seem to indicate that its customer numbers are not “huge.”
Finding Product/Market Fit can be a nightmare for founders, especially if they are certain that their product is superior to established brands or fills needs like no other product can. They may feel that they are so close to success that they can’t give up, and they end up tinkering and tweaking, adjusting labels and images on marketing materials, developing product extensions in search of the last piece of their jigsaw puzzle. They might find new investors who are quickly enamored by the product and the founder’s enthusiasm only to never achieve break-out success. It can be a cruel prison of so-close-and-yet-so far: too close to succeeding to give up, but never achieving enough success to give the founder freedom to exit.
Product/Market Fit is a huge challenge and will be addressed in another post on this site.
Back to How Much Should I Raise?
To summarize, in the early stage, startups raise capital (money) to develop a minimally viable product (MVP). The next raise is to prove the concept is commercially viable. Then they raise capital to expand into the first commercial market that makes sense, and then raise capital to expand from there.
There are many mistakes that founders can make along the way. Place the “finish line” too far away, however it is defined, and it will be difficult to interest an investor because the founders appear naïve. In the beginning, only raise the capital required to prove technical feasibility. Once that is done, raise more capital to take the next step. Just make sure that the raise covers contingencies. Again, raising too little is worse than raising too much.
A company that already has passed Stage 3 is ready for its first real market entry at scale. In this stage, the startup must scale up many functions to be able to deliver large volumes. The founders must scale up functions like production, logistics, Marketing (including Sales, PR, Communications, Advertising), Accounting, etc., and founders must raise the next round of financing to cover the costs of these investments.
Startups in this stage face many challenges and face many uncertainties in this stage. The worst thing that can happen is running out of cash and trying to raise money. Not only does this put the startup in a dreadful negotiating position, but it threatens its ability to raise funds at all. If it can raise capital, it is likely to be a “down round,” meaning selling additional equity at a lower price per share than in the previous round. This doesn’t make anybody happy. Everyone’s equity is further diluted at an ugly rate.
Know Where You Are, and Establish A Path ForwardHow much you raise depends on where you are. Do you have a product? Do you have customers? Can you sustain your customers if competition comes in? What are the barriers to entry? Do you have intellectual property that will protect your market? If you don’t, do you have trade secrets that will prevent competitors from taking your market away. Do you have a strategic marketing advantage? Are there behemoths in the industry that could enter and make you irrelevant? Do you have a strategy to beat the behemoths should they attempt to squash you? How much will that cost? Did you include that cost when you calculated how much you need to raise?
There are a lot of questions here, and a lot of uncertainty. If you want to scare sophisticated investors away, don’t worry about answering them. If you want to raise capital, you better have answers.
What Are Investors Looking For? Serious investors want a good management leader or team more than they want a great new product. “If I have a choice between a great technology with a mediocre team and a mediocre technology with a great team, I’ll take the great team with the mediocre technology every time.” This is a direct quote from a very successful friend who managed M&A for a major US conglomerate for decades.
Does this mean that investors don’t respect the brilliant scientists that developed the product? No. It means that, in their experience, investors have been more successful when the brilliant scientists are humble enough to recognize that there are limits to their impressive knowledge base. The worst leaders believe that they are so smart that they can figure out everything that has anything to do with business. What they may not realize is that even the biggest and most profitable companies in the world with extremely successful management teams hire consultants with specialized knowledge occasionally when they don’t have the expertise in house. They are humble enough to know their limitations. (This is not aimed at getting you to hire us. Just stating a fact.)
A good president of the United States isn’t expected to be omniscient; however, they can surround themselves with experts to fill in where their knowledge is lacking. A good entrepreneur does the same thing by hiring a good executive team, or at least have a team at the ready, and by hiring consultants (thereby avoiding the fixed costs) when the company needs specialized knowledge.
This article is about how much capital a company should raise, but many entrepreneurs fail to raise any money if it is clear to investors that they don’t have the business savvy to manage the money well. Even worse are entrepreneurs who refuse to bring in expertise that is clearly needed. Be humble, admit your limitations to yourself and to the investors. Then you will have a better chance at raising the capital you seek.
Default Alive or Default Dead?http://www.paulgraham.com/aord.html This is a nice article by Paul Graham who until recently was with Y-Combinator that explains concisely why founders should always understand their cash situation and how it relates to growth and future capital raises. He references a handy tool that companies can use to approximate what they will need:
But it is only a quick reference guide. All founders should always be acutely aware of their cash situation, their burn rates and how their growth will affect their future cash requirements. In the early days of Microsoft, Bill Gates famously had post-it notes stuck all over the place as constant reminders of anything that affected cash because he was constantly vigilant about making sure that his startup would not run out of cash.
Don’t Over-optimize Your Valuation While it may be counterintuitive, there are very good reasons to avoid raising money at too high a valuation. Gil, Elad. High Growth Handbook: Scaling Startups From 10 to 10,000 People (pp. 274-275). Stripe Press. This book is full of great insights for any startup.
Exit Strategy Why are we discussing Exit Strategy in an article about determining the amount of capital you need to raise? It’s because your answer is a gauge of your sophistication in the whole process. If you say that you have no exit strategy, you’re toast. If you say that your exit strategy is an IPO, you’re toast. If you say that there isn’t going to be a need to exit, you’re toast. That’s a lot of ways to make toast. There are some very good answers to this question of exit strategy that relate to your answer of how much capital you should raise. It is too much to cover in this article, and there are too many variables to be meaningful anyway. Sorry. Some questions can only be answered with additional knowledge of a company’s specific situation.
Summary How much money should you raise? Probably 3x what you think, but for a very specific goal that is not the finish line. Be prepared, however, to answer questions that may seem unrelated. Trust that those questions are important. If you can’t answer them satisfactorily, you won’t raise the capital you need.