OK - so you’ve been going at this startup thing for a few months now. Maybe you have an initial product. Maybe you even have a few users trying it out. Now it is time to hire your first paid developers, to improve the design and process flow, to begin scaling - and for that, you need to raise outside capital. So how much capital should you raise? What should be your thought process when looking at seed financing?
Well, step 1 is to build a plan. I’m sure you already have a product plan - now it is time to build a financial plan. And no, this should not be top down. And it should not be 10 years out. Focus on your expenses for the next 18-24 months, bottom up! Bottom up means thinking about salary expenses, travel expenses, office space, IT… you get the point. Put all of them down in a spreadsheet - use one that has already been tried and tested by others - so you won’t forget anything (I can help provide one - just ask). Understand how much capital you need to have in order to take over the world.
And now, find that number. No - it should not be what ‘takes you 12/18/24 months out’. It should also not be ‘low because that’s how much people are willing to invest’. It should not be ‘high so the valuation will be high’. What it should be is the number that brings up a major step-up in company valuation. Let me explain…
When you look at a start-up investment (or any investment for that matter), there is a risk/reward formula. At start, the risk is very high (product, team, finance, technology all still a risk) and the reward should be somewhat quantifiable. As the company evolves either the risk is reduced (because you achieved certain milestones) or the reward changes/affirms (because you found something out regarding your target market/go to market/etc). As this formula changes, so does the valuation of the company. So when you think about your seed financing, you need to think about what you can do to change the formula. When will you reduce significant risk to your shareholders (who are founders + investors), or when will you clarify the reward better. When there is a significant change in the formula, there is a significant change in valuation. That’s what you should shoot for. That’s the amount of time you need. Go back to your excel, and see how much capital is necessary to reach that point. And… I think you just found your magic number!
Some things to think about:
- Raising capital takes time (1). So whatever is the milestone you decided on, add 2-3 months for fundraising. In other words, if your milestone is 9 months out, you need to raise capital for ~12 months so you don’t run out of cash before you manage to raise additional capital.
- Raising capital takes time (2). Not only does raising capital take time, it also takes energy and management attention. So you don’t want to be doing it every 6 months. If your milestone is 6 months out, think again about whether it’s the right milestone - because there is an inherent cost in raising capital and it should be accounted for.
- Sanity check - if your milestone is 36 months out, it’s too far out. If it takes $20M to get there, it’s also too far out. If it takes $20K to get there, maybe it’s too close, or you should try funding it through friends and family. Make sure your number makes sense.
- The amount you raise has an influence on your company valuation. The reason for this is hidden in the third component of the funding formula - dilution. There are common standards around dilution in seed rounds, and if the amount of capital you are raising is a given, then dilution & capital raised define valuation. So it’s something to think about - but I wouldn’t spend too much time trying to optimize it.
- Talk to friendly investors. Brainstorm with them. I wrote about this in a previous post - set expectations, and these conversations can give you tremendous value.
That’s my 2 cents. Now it’s time for you to stop reading and get ready to take over the world!