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 the second or third time (assuming success the first
time!) is a picnic, compared to the first time.
The
questions that run through an entrepreneur's mind are nearly endless.
Do I even need the money? Is my company fundable, regardless? How much
do I need? How much should I try to raise? 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 salient questions an entrepreneur
might have. This might be the most daunting process in the minefield of
difficult steps to forming and building a winning high tech company.
So
you're a new entrepreneur, with a great idea, a prototype, and a vague
notion that you might need to raise some capital. Where do you go from
here?
NO COOKBOOK FORMULA
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
market.
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 manufacturing business. In a
manufacturing business, you'll need to raise more money to fund
manufacturing in the ramp-up phase. But the initial fund-raising is very
similar.
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
2) Friends & Family
3) Angel Investors
4) Venture Capital
5) Strategic Partners
Hopefully,
these categories are pretty self-explanatory. Next, let's look at 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; the major difference
is market size/opportunity.
Lastly, let's talk about what outside investors look for in a fundable 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. They're happy to help you fill out the team. Many, in
fact, prefer it this way. But having a large market opportunity and
strong differential advantage are non-negotiable in the eyes of
investors. They are looking for big returns. It's a long-held view among
institutional investors that their own management time is the limiting
factor in their own business. As a result, they 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 THEM, TOO
Another important consideration that many
entrepreneurs fail to consider 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 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.
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 company. Yet their arrogance leads them to believe they are
eminently qualified to drive even the most strategic of decisions. Are
they going to be so involved that it will take up much of your 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 do you want on YOUR board?
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 function.
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 there's almost no
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 almost no 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 he 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 pressure--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 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 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 grow up to be a fast-growing player. But it's generally the case 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 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.
THE SOLID SINGLE
Now
we'll examine the next step up--the solid single. This opportunity
often presents as a bigger vertical than the life style company is
attacking, or possibly a horizontal, yet still niche, product. These are
often the situations where the most difficult strategic decisions
reside. And 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 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 over-crowded, with 75
venture-funded companies. What's a management team to do?
This is a
tough call. Every situation is a little different, but my general
advice is to work your way up the 5-part funding tree discussed earlier.
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. 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 timeframe,
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 situation, the company may even get a richer valuation that 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 someone else
well known has started the company, with 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, both
from established players and a spate of new startups. This is obviously a
very different situation than the two discussed above.
In this
situation, 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 possible, to skip the more casual funding sources and go very
quickly to where you can raise large amounts of money very early--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. It's one of the peculiarities of the VC community, and
considered perverse by most 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 (Accounting firm, Law firm,
etc.), or another entrepreneur who has been successfully funded by the
VC firm in the past.
Until you can get a commitment from
institutional investors, however, 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 very much about dilution in this case. The
choice 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 because fund-raising is one of the most strategic
activities facing an early stage high tech 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 effect on your competitive position,
no differently than choosing the best technology platform to adopt, or
what marketing mix to use to outflank your key competitor.
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