Funding cycles and the startup story go hand in hand. Planning out the financing strategy is something that many founders overlook. When raising funds, possibilities are limited to the type of company that you have: so it’s very important to know what is available to you before you decide on a strategy, especially if the success of your company is strictly dependent on how much funding you receive. There are many mistakes to avoid regarding financing, which have put an end to many businesses, and there are ways to prepare yourself to make things easier and be more efficient at finding the right financing route.
Having said that, there is no one-size fits all, and there is no precise to do list on what needs to be done to raise funds. Because ultimately it is a decision made by people and everyone makes their own individual decision. However, having knowledge of general trends certainly helps knowing what your chances are.
The first thing to think about as an entrepreneur is not funding, the first thing you need to think of is your ideal business strategy and how you are going to validate it, and whether you need funds or not is something that comes as a result of your strategy.
When you have a clear vision of where you want to take your company, your financing strategy will go along with your company growth story.
A good strategy can accompany you for a long time and save you significant time and money in the long run. Potentially, you can also adapt your strategy to the limits imposed by the market and target specific financing opportunities with the right business model.
Financing requires having a plan in place to prove a possible return on investment, communicating effectively with investors before and after the investment and developing a collaboration that goes beyond financing. It starts with inspiring prospective investors with your startup story, your achievements so far and how much further you can go. Putting your startup story in numbers validates what you have in mind or gives you information about strategies to implement early-on.
The reason why it is important to know where your company is going and which choices are available to you, is that different strategies create different valuations, and therefore also very different financing possibilities. Value, as well as the size of the opportunity, is a function of future profit, growth and risk, all elements that change depending on the type of strategy implemented.
Investments in large companies are more likely to be driven by factual information and a ROI. Instead, a start-up or small business investment, to some degree, comes from personal interest and experience, personal beliefs and wishes about the growth of a certain sector, the personality and ability to work with the founders. So, many are unlikely to invest in sectors that they are not familiar with, unless the business can generate a short-term return and provide synergies.
Of course, a certain Return on Investment is sought for startup investments as well. A sufficient return for VC investments can only be achieved by investing in large opportunities, so many try to portray their projects this way.
In doing so, however, many forget to make their story into something realistic. A good story is important to get the attention, but it also needs to hold in terms of numbers. Demonstrating that your assumptions are realistic with data will help you gain trust.
Before you create your company, there are some factors and potential risks to review:
- VC investors typically prefer a founding team with diverse specialties, and they prefer the company‘s core skills to be within the team and not outsourced. More homogeneous founding teams can still bring successful businesses to the market and can find the missing know-how, technical, marketing, business or other industry-specific know-how, outside of the team, but that makes the company much riskier as an investment. In the same way, being a solo-founder involves a very-high risk, as the fallout from a solo founder becoming incapable of carrying on with the business, means the loss of the entire investment. It is still possible to raise early-stage funds being a solo-founder, but only in some circumstances, with a fantastic track record or very safe business model, or only through some other financing sources. Also, being able to work in a team communicates to investors your ability to lead and cooperate when the company gets bigger.
- Ensure that you are prepared for any risks materialising within the team: have a strong shareholder agreement among founders, with clauses that determine what happens if a founder leaves or no longer actively participates in the business. Ensure that any shares can be bought back cheaply if a founder leaves. Many startups have had to close because of teams falling out and the inability to find a solution for the departing founder‘s shares. Remember that VCs will likely not invest if a controlling stake is in the hands of a founder who does not participate in the company‘s management.
- In the same way, ensure that all founders are appropriately compensated for their work and involvement, in terms of shares, as the motivation and stability of the company depends on it. Investors may ask you whether you will have an Employee Stock Ownership Plan in place, or that you plan on implementing for your first employees: depending on your country, this may be expected or not, and provides investors with an indication of how much shares will be diluted in a liquidity event.
- If you have Intellectual Property, for your startup to be an investable company, this IP would need to be held in the company‘s ownership. An IP that is in the founder‘s ownership, or that is held in a subsidiary or associated company poses a great risk, especially if the company‘s success relies on the IP.
- It‘s important to measure your resources: depending on your chances of raising early-stage finance, you should consider your ability to bootstrap and grow the company with your own money for longer periods of time, and know how long it will last. Based on this, it‘s advisable to have a timeline to stick to in terms of product development, validation and market entry, together with the funds necessary to go forward and reach each milestone.
- Fundraising trends, amounts, grants available and type of sectors financed can vary widely, therefore if financing is important for your company‘s survival, you can plan your business model, operations and location to ensure that it enables you to raise funds in the short-term.
Understanding the fundraising options available helps you plan ahead. Financing takes away precious time and puts commitment and expectations on your company, so depending on how fast you want to grow, this may be part of your day-to-day operations. You do not have to grow fast in all circumstances. There is a lot of advice on the subject, but the simplest approach is to first consider the options available to the specific stage of the company, type of business, location and what type of financing fits the goals of the team.
Even before doing this, having the right attitude towards accepting and giving capital leads to better working relationships and therefore returns. As a startup founder, despite what you think, at seed stage your company will have about 90% risk of not generating a positive return on investment to the shareholder. Respecting capital and being grateful when someone believes in you, but still be able to negotiate your worth, is a great place to start. Your startup may be one in a lifetime’s investment, but risk should also be recognised to show that you have your strategy and implementation under control.
On the other side, as an investor, you may be inclined to take a high stake, sometimes a controlling stake, in the company. This does not benefit the startup in any way and as a result, it does not benefit your investment either. Taking a majority stake may make it impossible for the company to raise future investments and to have a exit. Respecting the entrepreneurs’ abilities means leaving them in charge of the company, offer guidance, support and setting rules of reporting and communication, but not micromanaging the startup on a day to day basis.
A good way to start is to understand the scope and benefits of an investment, the time to exit, the additional non-monetary benefits of an investment (for impact businesses for example) to communicate to investors. Also, a start-up or small business investment, to some degree, comes from personal interest and experience, so people are unlikely to invest in sectors that they are not familiar with. Some may even be interested in investing only in an industry where they have worked before.
Whatever financing path you choose, you should ensure that you are comfortable with the consequences. Being an entrepreneur is hard in many scenarios, so having passion for what you do is usually a must. Think about what you are prepared to do to make the business successful. If you are pursuing a lifestyle business, meaning that the main reason for being an entrepreneur is achieving your own independence, some VC funding routes may not allow that. Bootstrapping and being independent from financing sources allow you to have more freedom, but you need to adjust your business model in that case, to ensure that it can be competitive without large amounts of funding.
How long would you like to operate the business for? Some may want to get out as soon as possible, but if an exit is hard to achieve, they may not have the motivation to stick with it during the hard times. Instead, many others want to build a company that changes the world and operate it for as long as they can, without even wanting to consider an exit. Unfortunately that would make the company a non-viable investment during the seed and early-stages, because the ROI will not be sufficient.
Some founders are uncomfortable with sharing decision-making with investors and sharing regular updates, and during the fundraising process this is something that may come to light. Please remember that taking board seats and monitoring investments is fundamental in many cases, to manage investments and ensure that there is a sufficient return on the portfolio: understand and respect the fact that the investor also has a business return to generate. Not all financing sources involve sharing decision-making power, but of course these sources may provide little finance, and you may have to adjust your business model accordingly.
Planning the timing, source and stake given away in funding rounds is recommended for fast-growing startups: you can‘t plan exactly, but having a rough idea helps, because if you give away too many shares, you may complicate your exit, make future funding rounds harder, and lose control of your company.
Depending on the type of business you are building, on the competition, or on your priorities regarding lifestyle and how you prefer to grow and exit your business, retaining know-how and the brand within the company may be a priority. On the contrary, for some it may not be important. In many cases, investors play a large role in bringing your company to success by providing a network, know-how and making future financing rounds easier to execute.
The moment you accept an investment, you are bound to report to others and may have less control over your decision-making, so when this takes place it’s important that you know what you want for yourself and the company, your negotiating power and situation.
So how do you decide which financing source is right for now? This depends on the type of company (whether it’s a fast growing startup or traditional business), stage, sector and location.
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