Q1 2020 Texas CEO Magazine

a startup should raise and how they
should describe that to investors.
The basic formula
For startups seeking growth, the figure
below summarizes the first major steps for
deciding how much to raise. As you can
see, the amount of money raised affords
the startup a combination of time and
resources. And with time and resources,
they can accomplish things (outcomes).
The basic concept is simple. And since
we are trying to solve for the right
amount of funding to raise, let’s analyze
the other variables a little further.
Time and resources
When I say time, I actually mean an
amount of time the money will last, or
what is often referred to as runway.
The amount of runway needed varies
widely for each venture but usually
gets longer with subsequent rounds of
funding and later stages of evolution.
The most obvious type of resource is
the one every founder obsesses about,
additional headcount—regardless of
whether they are part-time or full-time.
“If we only had two more developers, we
would be in great shape.” In the same
category as headcount are contractors,
consultants, and various service
professionals like lawyers and accountants.
What many early-stage startups don’t
think about are things like increased
spending for marketing programs,
specialty tools, and software systems.
These are usually important resources that
are also needed to advance the business.
For startups, time and resources are in
competition with each other. In other
words, a startup could use all of the new
funding to gain time, but that means
not adding headcount to the team,
not adding more contractors, and not
spending more on programs, tools, and
the like. Instead, they could use all of
the new funding to aggressively dial
up headcount and spending, but that
means they’ll almost immediately have
to raise more money. Part of the trick
is dialing in the optimal combination of
extra time and extra resources in order
to achieve the desired outcomes.
Figuring out the best combination involves
creating a financial forecast model that
allows experimenting with various
assumptions and alternatives. For a preseed
or seed round of funding, the startup
will have lots of assumptions that have
no support from prior results. Because
of this, the investors will really want to
understand any information or insights the
startup has to support their assumptions.
Later, the prior track record will serve
as a basis for many of the projections.
Outcomes
Outcomes are discretely identifiable results
the startup hopes to achieve with their
newly raised funds. How about acquiring a
certain number of new customers to reach
the next meaningful revenue milestone,
or significantly reducing your average cost
to acquire a new customer? How about
securing a strategic partnership that will
provide significant leverage, or getting final
approval on a patent filing? What about
launching a new product or entering a new
market? These are outcomes that reduce
the investor’s risk or increase their upside
potential when the startup eventually exits.
The best way to understand the formula
is the way it is diagramed above, left to
right. But the best way to actually go
about the exercise of figuring out how
much money to raise is to work backward,
starting with the desired outcomes. It is
those future outcomes that the investors
want the company to achieve and,
therefore, the things they want to fund.
Once the desired future outcomes are
determined, the startup simply needs
to use their financial forecast model to
determine the best combination of time
and resources needed to generate the
outcomes. With this, they can determine
how much funding is needed for that
combination of time and resources.
Feature
There are pretty dramatic differences
in the outcomes Silicon Valley investors
expect and the outcomes investors in most
other places in the country expect. A set
of projected outcomes that are exciting
to an investor in Memphis, Tennessee,
or Denver, Colorado, could easily seem
way too safe and conservative to a Silicon
Valley investor. There is much more of
a swing-for-the-fences, build-a-unicorn,
global-world-domination mentality in
Silicon Valley, and fundraising startups
should understand this philosophical
difference in risk tolerance as they go
about setting their desired outcomes.
Time for the first
check and balance
Why not just raise enough money to last
a long time, like three or four years?
Well, ignoring whether the startup could
be successful raising that much, the
answer relates to the valuation they’re
able to negotiate with investors.
Let’s assume $10 million would fund a
particular venture for four years. The
question is, What sort of valuation can
the company earn at the time they raise
that money? As you can see in the figure
below, today’s valuation is mostly based
on the state of the business today. If
investors will only agree to a $5 million
valuation, for example, the company
will experience significant dilution and
immediately give control to the investors
due to the amount of equity they will get.
The amount of money raised compared
to the valuation they’re able to negotiate
provides a check and balance.
Because of this, the process of figuring
out how much money to raise is often
iterative. First, an uncontested look into
the crystal ball allows the startup to figure
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