The decision to raise a first round of financing is important and often unavoidable in the life of a young start-up company.
Here are some key questions to think about before raising a significant amount of capital from angel investors or venture capital funds.
1. Do I Need to Raise?
Should your team be raising capital in general? There are two main types of startups: a business with modest growth that can finance itself over the short or medium term (like a web development agency) and a business that will require significant investment to become a leader in its field (a technology start-up like Airbnb or Uber). With start-up costs at an all-time low, do you really need external capital? Are there other less dilutive ways to finance your project, either with your customers, suppliers, founders or start-up assistance grants?
2. Why am I Raising?
The main reason to raise capital is to support and accelerate existing growth. It is acceptable and even likely that you haven’t yet achieved your product-market fit quite yet, but you should see some clear signs of traction, whether in terms of sales, traffic, user engagement or subscriptions. In the absence of any measurable traction, you must convince investors that you are the best team in the world to create the new product you are offering and that the market absolutely needs it, which is a slightly more arduous task. In all cases, the infusion of new capital should serve to get you to the next milestones in your business plan.
3. When is the Best Time?
Yes, there will be a strong impetus to raise capital when you are running low on funds and need cash for growth. But the right time to raise it is when you have a good history of growth to share, and when you are able to properly define your objectives for the next level of growth as well as the path to get there.
4. Who Should I Raise From?
After deciding to raise funds, you must still find the right partner. For an amount less than $250,000, it may be better to call upon some angel investors. This does not preclude any funds that might be interested in joining the party. Ideally, you are looking for angel investors with expertise in your domain, who are able to add value and who have a network to open doors for you.
With venture capital funds, you are looking for a fund knowledgeable about your field, as well as an investor with whom you will be able to build a good relationship. This is important since these investors will sit on your board once the round is complete.
5. Where Do I Look?
You will have to consider whether you prefer to approach local investors or target international investors. I prefer to have some local investors in early rounds as they can more easily follow and help you in the beginning, meet you frequently at your office, and are familiar with the reality of your ecosystem. International investors, however, can add prestige and experience, and typically a world-class network of contacts.
6. How Should I Structure the Process?
You should probably start the funding process at the same time “in parallel” with several firms rather than in series. Raising funds takes 3 to 6 months on average. Investors often have a multi-step process (exploratory meeting, meeting with the entire partnership, etc.). Once an entrepreneur receives a term sheet, he will take a short period of time (a few days or more) to decide, hence the importance of having initiated the first steps with other funds.
Throughout the entire process, it is important to do a lot of research about the fund, its objectives, the partners, their previous investments, etc. It is also important to remain humble and respectful. Investors see many projects every day and typically have a thesis with some specific criteria, so it is not unusual for an entrepreneur to receive dozens of “Nos” before finding a lender ready to invest.
7. What Type of Financing Should I Choose?
There are a variety of financial instruments to choose from, with the main ones being equity and debt. Some entrepreneurs prefer to establish an explicit valuation of the company and sell a equity stake to investors. Some prefer raising debt, which will be converted into equity in the next round, with a discount and a “cap”. The cap is the highest valuation possible when converting. It can often approximate your company’s maximum valuation at the time of initial investment. It is good to have a conversation with potential investors about their preferences in this regard. There are also other funding options, like government grants or tax credits.
8. How Much Should I Raise?
Some would argue that the answer is often“as much as possible” (take the money while it’s available). Others will claim “as little as possible” to avoid dilution. The answer is to raise an amount that will enable you to achieve your goals and milestones to help you raise the subsequent round, that you know how to spend wisely to achieve those milestones, and that results in a level of dilution with which you and your co-founders are comfortable. Often, this amount should equal the capital required to operate for about 18 months.
Depending on your local market, a small seed round is about $100,000 to $250,000, a mid-sized round is around $1 million, and a large first round is about $3 to $5 million. The size of your round also depends on the valuations you have been offered. Typical dilution is about 10–25% in each round, but entrepreneurs need to think about how to keep enough to remain interested in the business over the long term.
9. How do I Value my Company?
Valuation is more an art than a science, especially in the start-up stage. The true answer is often “the price that other investors in the market are willing to pay”. To estimate it, you can consult AngelList. It has a section dedicated to corporate valuations.
Average valuations for a first round would typically be in the $2–8 million range, although your valuation may vary significantly based on a number of factors such as the team, market, product and growth. For future rounds, as traction accelerates, it will progressively become easier to apply a multiple to sales or profits or even to compare with other companies in the same field or at a similar stage.
10. How Do I Negotiate Financing Terms?
What should you think about liquidation preferences, pro-rata, and “shotgun” clauses? I suggest getting the advice of a good lawyer who has extensive experience working with start-ups to help navigate these clauses. To find the right lawyer, ask them which start-ups they’ve worked for and call those entrepreneurs to learn about their experience.
Investor Brad Feld’s book Venture Deals is the undisputed reference for those who would like to educate themselves about the legal terms of financing. That said, keep in mind that most of the good investors, funds as well as angels, use fairly standard models they’ve refined over the years to protect both entrepreneurs and themselves. These can typically serve as an excellent basis for your negotiations.
In any case, good luck! Above all, don’t forget that raising funds, as arduous process as it may sometimes be, is never an end in itself, but rather a beginning. The real work starts when the round actually closes!
[Note: This article was originally published in Les Affaires.]