What amount to raise in your next funding round? The straightforward answer to this question is it depends on how much resources you would require to reach the next milestone—and you need to communicate this with your investors.
Determining how much money to raise is not easy, even for experienced founders. There is a lot of uncertainty as it involves assessing your capital requirements, including any contingency requirement to sail through bad times if things don’t work as planned.
Failing to assess your funding needs accurately can cause severe damage to the startup. It can lead to excessive dilution, losing control of the company, not being able to execute the growth plans, and getting outcompeted. It can also lead to the startup's inaccurate valuation—being either undervalued or overvalued (yes, overvaluation is also a problem, as you will see later in this article). In the worst case, it can cause business closure.
If you raise lesser than the required amount, you may run out of money before raising the next round of funding. You will be left with limited options for raising funds. You won't have any leverage in negotiation, and investors would ask for more equity in exchange for less capital. As you can see, it results in unfavorable terms and over dilution of your equity. In this post, we will discuss how to determine the funding requirement and justify it to your investors.
Modern VCs and startups operate on the concept of milestones. The startup should attain critical milestones to raise the next round of funds. While it helps founders slow down the equity dilution, it allows investors to minimize the risk.
Let's see how this affects your funding requirements.
To begin with, make a fund estimate for your essential resources. As a startup, you need enough funds for hiring new employees, renting office space, installing critical office equipment, etc. So, before meeting your potential investors, make sure that you have a clear understanding of your resource needs.
Reaching the next milestone reduces one or more types of risks. When you build the product, it reduces technological risk. When you build a core team, it reduces people risk. And when you reach product-market fit, it reduces the market risks.
In general, milestones are associated with traction: getting a certain number of users or reaching a target revenue.
You can mitigate some of the risks by proper planning and execution. Talk to other founders about how they have done it. In our experience, the biggest of all these risks is team risk, especially for early-stage startups.
If you can attract, motivate and retain talent, you offset other risks automatically. A good team is capable of identifying the users need and building a product that meets those needs. As a founder, it is vital to do everything in their hand to make the core team.
But the biggest problem for startups is not being able to pay market standard salaries. One solution to this problem is strategically using equity-linked compensation programs, such as ESOPs, SARs, RSUs, equity shares, etc.
You can compensate early employees with these equity-linked rewards, which gives them an opportunity to be owners of the company and thus, motivates them to perform. In return, when the startup does well, the value of the company share goes high.
Instead of asking for a certain amount of money, you can show investors your next milestones and how much resources you need to reach them, and ask how much they are willing to fund. This will give a better idea to investors about the capital you require and create a scope of the discussion—rather than negotiation by haggling.
Every time you reach a milestone, you can assess how much you were off in predicting your resource requirements and can do this better while raising the subsequent rounds of funds. You will learn how to deal with items that have more uncertainty. Milestone based approach will help you to collect data behind many assumptions and have better arguments to make in front of investors. It gives you visibility into your needs and thus helps you make accurate predictions. The less uncertainty your business/business model has, the more you can raise while diluting less equity.
If you’re raising VC funds for the first time, you might not know that it takes a few months to close a funding round with VCs firms. It's not the same as an angel investment round. Since most angel investors invest via convertible notes, there are just three things to negotiate: interest rate, discount and valuation cap.
But in priced rounds (VC deals), there are many more terms (starting with term sheet) to be negotiated: valuation, equity exchange, dilution, liquidation preferences, etc., which slows the deal process. While angel deals can close in a few days to a few weeks, VC deals take months.
So, you never want to start looking for raising a new round of funds when your funds from the last round are nearly exhausted. A worse scenario could be running out of money after achieving your milestone. When you are out of money, you are needy. When you are needy, you could be taken advantage of. Since investors have leverage over you, they can delay the process so that you succumb to their demands.
Where are we going with this? You should consider a buffer amount on top of your funding assessment to sustain through any contingency requirements. The startup world is full of uncertainty, where hundreds of things could go wrong. So, once you assess the capital required to support your execution through the next funding round, add 6 months of operating expenses as a buffer amount.
Even investors understand the need for padding on top of actual needs to account for unforeseen instances.
"If you have factored 2 months to raise funds based on your ability by self-assessment, then multiply that month's time by 3 for money in the bank. Plan real, practical timelines for quick closure. It always takes more time to close the round," says Sanjay Mehta, MD, 100X VC.
Investors expect a proper explanation from you for different numbers in your financial plan, so be prepared for that. They may disagree with your numbers. Dig into the details and get your hands dirty rather than just quoting the data you find on the internet.
A thing to keep in mind is though it is challenging to forecast numbers, your numbers shouldn't be based only on assumptions. Neither should it be an excuse for not doing your homework. Though it's understandable there will be assumptions; the projections must be based on sound arguments.
After all, it's easy to make claims. What builds trust is being able to justify the claims with the help of solid logic and reasoning.
For example, if you say the target addressable market (TAM) is $10 billion, how have you arrived at the number. Rather than just picking the number from a report, which anybody can do, it would be worth the time to dig deep and find more details.
You can refer to the sources cited in the report to find additional insights, such as region-wise TAM, how the numbers look like other way round, i.e., if the report uses a top-down approach to calculate TAM, then finding the bottom-up TAM or via value theory.
It makes sense to do this exercise internally with your co-founders and CFO to find holes and fallacies in your claims and work on them before going to the investors. It certainly is time taking and maybe the reason why some entrepreneurs skip it.
This exercise not only helps when discussing with investors but will also give you confidence in your projections. You can also communicate things upfront rather than giving surprises later on.
Remember when the salesperson said this would cost X amount but told you it excluded GST during the billing. Or when you suddenly see shipping charges while checking out on an eCommerce store.
As VCs are talking with founders all the time, they are more experienced in evaluating financial projections. Bluff won't work. Expect counter-questions on your answers, and investors will raise objections to see how deep your understanding is of your financial plans.
If you understand the investor's point of view, making arguments that will convince them will be easier. The whole investment thesis is that the higher the risk involved, the higher the reward should be.
As investing in startups is considered risky (as 90% of startups fail), most investors look for 100x. Your financial projections should show how the investors can take an exit. Though many entrepreneurs show the final dreamland of how the startup will take an exit in the form of IPO or M&A, keep in mind that investors are more interested in their own exits—and giving a return to their Limited Partners.
How well you understand finances play a key role here. It requires you to communicate to investors that you understand finance and hence handle the money responsibly.
Ratan Tata, who has invested his money in many startups, recently raised his displeasure for startups that don't respect investor money. He has mentioned his unwillingness to waste money on such startups. He said, for such startups, he won't give further chances. He believes, if any investors invest in a startup, they must give their hundred percent to show positive outcomes!
Fundraising helps startups to grow exponentially by realising their full potential. While it may be apparent to most founders that raising less will be an issue, what might not be clear is how raising more can cause problems.
As the size of the cheque increases, investors d0 more due diligence, and hence the process takes more time. Additionally, they demand strict investment terms, both economic and control, to ensure there is no financial mismanagement.
Deviating from the market standard hurts your investibility quotient. When you raise more money than needed (or beyond the market norms), investors either take a large chunk of your equity or are investing at an inflated valuation.
The drawback of having a higher valuation of an early-stage startup is that it puts a lot of stress on the startup if things don’t work—and in startups, things rarely go as planned. Further, new investors might be hesitant to invest as your business is overvalued when you go for the subsequent round.
Also, when you raise more money than the market standards, then investors give money in chunks, called tranches, on achieving the intermediate milestones. In case, you fail to achieve, investors might penalize you with heavy dilution or may not invest further.
A risk associated with overvaluing the startup is that the subsequent round can be a down round. In a down round, you will end up diluting even further due to an anti-dilution agreement with your existing investors. It is worth noting that future investors may hesitate to invest in those startups where founders have diluted a large part of equity.
Too much money gives temptation to expand and grow faster but creating good culture, training and integrating human resources and understanding the market takes time. In short, it gives rise to extravagant spending rather than using it frugally.
Sanjay Mehta cites raising too much money early is one of the biggest reasons for startups failure. "Too much money is like having too much time. Founders lose focus. They end up building a plan to spend not to build a business. Too much capital at the seed stage changes the startup team mindset in unhelpful ways. Shortage of capital in early-stage startups forces startups to make hard choices about what they will build and what they won't." he says.
One question that arises is: Is raising more always bad? **Should you ever raise more than you need? **
Once you have assessed your capital requirement and set the boundaries for what you can give in return, that is, what equity to cede and at what terms, you can raise more if available.
Understand that fundraising is time-consuming and distracts you from your day to day business work. There is a lot of work involved, like creating a pitch deck, reaching out, explaining your business case and negotiating with investors. Those who have done it say it is a full-time job.
When talking with investors, it isn't easy to understand if they are interested or not. It can waste a serious amount of time that could have been spent otherwise in growth initiatives. Investors, in general, don't say no. They are in the business of building relationships, so they will always be nice to you. But don't take it as 'yes'.
Don't make the mistake of not talking to other investors until you finalise the deal. Keep your options open until you get the deal finalised on paper.
Therefore, it always pays to be investment-ready. Qapita, an equity management platform, helps startups be investment ready. It keeps your cap table updated that can be shared with investors when required. (You have the option to decide what you want to share.)
While fundraising, always remembers that though external funds are required to meet various goals (build a product, core team, sustain loss till achieving positive cash flow, or growth via marketing or acquisition,) funds are a means, not the end. Money doesn't solve the problem. People do. People are assets—and ESOPs play a key role in startups to attract, motivate and retain talent.
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