Startup Fundraising Strategy

September 20, 2016

Almost every company goes through it, except for the fortunate few. Some people have gone through it multiple times. While never easy, raising money for a second or third company (assuming success the first time!) is a picnic, compared to the first time. Let’s look at what I refer to as strategic fundraising:

The questions that run through an entrepreneur’s mind with respect to capital formation are nearly endless – and of a strategic nature: Do I even need the money? Is my company fund-able, regardless of my need? How much do I need? How much should I try to raise in the first round? What’s the best time to start raising money? What type of investor should I approach and what are their expectations? How should I go about approaching them?

I could fill up the rest of a page with other salient questions an entrepreneur might have with respect to fundraising. This might be the most daunting process in the minefield of the difficult steps to forming and building a winning high tech company.

So you’re a new entrepreneur, with a great idea, maybe even a prototype or better yet, some initial sales. You also have a vague notion that you might need to raise some capital. Where do you go from here?

NO COOKBOOK FORMULA FOR STRATEGIC FUNDRAISING

Well, like most things that really matter, there’s no easy answer. It depends on what type of company you’re trying to build, your own control and risk/reward mentality, as well as the dynamics of your particular market segment.

For discussion purposes, I’ll focus on an embryonic software company. Most of the discussion will be just as relevant to a later stage business, or an early stage hardware manufacturing business. In a manufacturing business, you’ll need to raise more money to fund manufacturing in the ramp-up phase and inventory in the long run. But the initial fund-raising may be very similar.

STRATEGIC FUNDRAISING BASICS

First of all, let’s quickly cover the various categories of capital sources. There are many variations and shades of gray with respect to funding sources, but the following are representative of the basic categories available to new software companies:

1) Self-funding (bootstrapping)
2) Friends & Family
3) Angel Investors
4) Crowd Funding
5) Strategic Partners
6) Venture Capital

Hopefully, these categories are pretty self-explanatory. Next, let’s look at my definitions for what TYPE of company the entrepreneur is trying to build:

A) Lifestyle Company
B) Solid Single
C) Home Run

A lifestyle company is one in which you are often intermixing your personal life with your company life. There may be family members involved in the business, your write-offs and accounting are more aggressively aimed at reducing taxes than showing profits, and you aren’t interested in or planning to sell the company anytime soon. Solid Singles and Home Runs are similar to each other in that you’re looking to gain liquidity at some foreseeable point either via a sale of the company or IPO ; the major difference is market size/opportunity.

Lastly, let’s talk about the key things that outside investors look for in a fund-able venture:

I) Management
II) Market size/opportunity
III) Defensible differential advantage

The three items listed above are all crucial, but they aren’t equal in importance. Professional investors look for strong management teams, but if there are holes in the current team, it isn’t necessarily fatal for many investors. Many times they’re happy to help you fill out the team. Some, in fact, prefer it this way. But having a large market opportunity and strong differential advantage are non-negotiable in the eyes of most institutional investors. External investors are looking for big returns. It’s a long-held view among institutional investors such as VCs that their own scarce management time is the limiting factor in running their own money management business. As a result, VCs and other institutional investors don’t feel they can afford to invest in “solid little businesses”. If you don’t stack up as having big potential in both of these key areas, almost every professional investor will take a pass.

YOU HAVE TO LIVE WITH YOUR INVESTORS, TOO

Another important consideration that many entrepreneurs fail to consider fully is how well potential investors fit with the company’s management. Management teams are often so focused on “getting the money” that they fail to consider that you “have to live with them”, as well. It’s a bit like getting married. You may be thrilled to attract the most prestigious investor (like the best looking potential spouse), but then end up with business philosophy and personal conflicts that severely retard the company’s development. This isn’t a used car transaction where the sale is made and the parties walk away from each other. You and your investors are now intertwined, but may or may not have the same interests.

So ask yourself: Is this a good match?

Are you seeking a “hands off” investor, or someone that will get involved with the details—providing business guidance and contacts—for better or for worse? Many VCs, for example, have successful business backgrounds and networks that can make them invaluable as advisors. There’s another group, however, that don’t have the background or skills to run a particular company. Yet their arrogance (and the fact that their money is on the line) leads them to believe they are eminently qualified to drive even the most strategic of decisions, no matter their own background. Are they going to be so “involved” that it will take up much of your own scarce management time that is needed to build the business? On the other hand, are the investors so busy that you won’t be able to get their attention when you need them? Which type of investor do you want on YOUR board? Proper strategic fundraising means picking compatible investors, not just getting a good valuation.

It’s true that the money that you raise is a commodity—but the people relationships that come along with it can make or break your company. Early stage fundraising, taken as a whole, is NOT a commodity financial activity.

THE LIFE STYLE COMPANY

Now let’s look at the simplest case study. An entrepreneur has conceived a software business using his knowledge of a particular, very specific, vertical market. It’s a market he knows well, and he’s defined his business skillfully enough there’s very little direct competition. Unfortunately, the market, while attractive to him, is not large by software category standards. Yet the market is plenty big enough to support a very profitable company, particularly since there is very little competition. He’s proven to himself that he has a solution that the market will embrace, allowing the building of a business. Yet he thinks he needs a little additional capital to ramp it to the point of the business being self-supporting, using it’s own cash flow. What should the entrepreneur do?

This is the classic example of a lifestyle company in the making. Sophisticated outside investors will have no interest, unless it’s for personal/hobby reasons. And since there is little competition and as a result, little time-oriented pressure—try very hard to fund it yourself. Take out a second mortgage, use lines of credit, or get an SBA loan. If you really have to, raise some money from supportive friends or family members.

This lifestyle company example makes up the great majority of software companies worldwide. There are many, many solidly profitable software businesses that will never be on the radar screen of the professional investor community. These companies often exist quite nicely, enjoying solid and relatively stable profitability with revenues in the $ 1-10M range. That’s fine—the problem lies when the entrepreneur doesn’t know what he has, or won’t accept it. He thinks his baby needs to transform into a fast-growing player. But it’s generally true in many of these cases that the market is too small. There is little need to be distracted by trying to raise funds from outside investors—and it’s fruitless and potentially harmful to try. It will only be a waste of time for the company and investors. And if by some chance it IS funded, there will end up being a lot of turmoil and hard feeling when the company doesn’t meet the lofty expectations that were needed to sell the funding deal. I’ve seen many great little companies screwed up in the attempt to become something they’re not. So proper strategic fundraising in this instance often means deciding to raise no outside money at all.

THE SOLID SINGLE

Now we’ll examine the next step up the ladder—the solid single. This opportunity often presents itself as a larger vertical market than the life style company typically pursues. Another possibility is a horizontal, yet still niche product. These are often the situations where the most difficult strategic decisions reside. In fact, the great majority of software companies who seek outside funding probably fall into this category. The market size is just on the edge of what the professional investors will consider. And while there is a differential advantage, it’s not quite at the level that you’ll be able to “knock their socks off” in your slide-show pitch. There’s worrisome competition, but it’s not completely over-crowded with 75 venture-funded companies. What’s a management team to do? This is where strategic fundraising is MOST important.

This is a tough call. Every situation is a little different, but my general advice is to work your way up the 6-part funding tree discussed earlier in the “Funding Basics” section. Fund it yourself as long as it’s not crippling your progress. Then do a round starting with Friends and Family, as well as Angel Investors that are easily approachable via your immediate network. Crowd funding is an emerging wild card, but has been used successfully in some cases. Once you go through this funding, hopefully you’ve built a rapidly improving business with good growth prospects.

It is at this point you may be able to attract money from a VC or private equity firm that has a later stage, more conservative risk/reward profile than the typical early stage VC. Professional investors might see in your company one that may not be a 10X return, but one that may be a 2-5X return in a shorter time frame with less risk. And this later funding may work to your benefit, because the opportunity in front of the company may be such that you need to manage dilution of your stake carefully, to ensure that at the end of the day, it’s been worth your while. A strategic partner may be even a better fit here. Often a company in this situation may be able to attract funding because their product is important to the prospects of a larger partner company, filling out a total solution or providing a key technology the larger company can’t quickly or easily replicate. In this strategic partner situation, the company may even get a similar valuation to that of the “Home Run” scenario which we’ll look at next.

THE HOME RUN

Lastly, there’s the classic Venture-funded company, the one with “Home Run” potential. These are the companies that VCs are out seeking to fund. These are the hot young companies that you often read about in the newspaper or trade journals. A high profile engineer or software developer, or someone else well known has been one of the founders of the company and has some cache in their field. The technology of the company appears to have breakthrough potential. The market is new, expected to grow to be very large and is very newsworthy. But the competition is expected to be very intense due to the potential size of the opportunity, both from established players and a spate of new startups. This is obviously a very different situation from the two discussed earlier above.

In this situation, strategic fundraising means you’ve got to go get the money. Time is of the essence. Getting established in the market early is crucial, and economies of scale usually become important as well. So a company in this situation typically needs to raise as much money as possible, as early as possible. All the steps are compressed here and the time between funding rounds may be only a few months in extreme circumstances. It’s best, if practical, to skip the more casual funding sources and go very quickly to where you can raise large amounts of money very early on — the VCs, and possibly strategic partners. Care needs to be taken on how you approach VCs, however. Unless you know them personally, never approach them directly – no matter how much of a hurry you’re in. This is one of the peculiarities of the VC community and considered perverse by many people outside the VC community. The VC community has their reasons, although their rationale is certainly arguable. But no matter–it’s one of the rules of the game. Always approach them through a service provider or close VC associate (Accounting firm, Law firm, etc), or another entrepreneur who has been successfully funded by the VC firm in the past. Strategic fundraising also means HOW you go about raising money, not just how much, when and from who.

Until you can get a commitment from institutional investors, however, if you need it take money from wherever you can get it, within reason. Self-fund, friends and family money and Angels may all come into play if there is a delay in getting the institutional money to buy in. Don’t worry as much about dilution in this case. The strategic fundraising choice in this instance is often one of potentially ending up with a small, valuable percentage of a company with a large market cap, versus a large percentage of a failure. As you can see, the advice in this scenario is almost the complete opposite of what I’ve recommended in the two previous examples.

A STRATEGIC DECISION

But it’s all fund-raising, right? Why such different advice?

The advice varies so greatly because fund-raising is one of the most strategically important activities facing an early stage software or hardware company. Many entrepreneurs view raising capital as a generic operational activity, like choosing a bank or leasing office space. It’s viewed as just a necessary evil, because every business needs money to survive and prosper. This discussion was intended to demonstrate that raising money should be viewed as one of your most important strategic functions–a decision that is taken with an eye for its long-term effect on your competitive position. Strategic fundraising is really as important as choosing the best technology platform to adopt, or what marketing mix to use to outflank your key competitor.

I know that there are many of readers out there who have run the strategic fundraising gauntlet—give us the benefit of your wisdom! Post a comment below.

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