Start-Ups

Funding a startup: Deciding how much money to raise

Raising venture capital can be a confusing process. Here are some things to think through before you raise a funding round.

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Image: iStockphoto/Sasha_Suzi

Startup communities, such as Silicon Valley, are some of the few places in the world where money isn't a taboo dinner conversation. The normalization of financial talk among founders is predominantly due to the fact that it is a necessary part of startup life. It's just part of the game.

Still, just because the fundraising process is easy to talk about, doesn't mean it's easy to navigate. By knowing the amount of money you want to raise, and what you want to to do with it, provides comfort to both the founder and the investor — founders get a plan of attack and VCs get the comfort that founders have thought it through in a comprehensive way.

Alex Rosen, managing director at IDG Ventures, said that it starts with asking a question.

"What is your goal?," Rosen said. "Capital itself is not the goal, it's the enabler to get to the goal."

Is your goal product development, product/market fit, sales expansion, market dominance, or even world dominance? In the startup world, money is the enabler to make those things happen.

Determining the proper amount of capital is often a Goldilocks situation where one amount is too little, another is too much, and one is just right. While there are many factors that can play into how much money a company should plan to raise, but there are some tips and tricks that can help the process along.

Raising a little

The concept of running lean which, among other things, promotes the tenant of raising as little capital is possible is one of the fastest growing trends in VC-backed startups. The idea comes from the Lean Startup concept made famous by Eric Ries, and there are some benefits to raising little or no capital.

The first benefit is the fact that less money typically requires less equity in exchange. This is the concept of dilution — meaning the founder's ownership is company is "diluted" by the amount of equity that he or she trades for capital. This is why early stage capital is typically referred to as "more expensive," because the risk often necessitates a higher equity trade for the money.

"You want to raise a little money as possible to prove your product/market fit, or service/market fit," Rosen said.

Limited capital also enforces discipline and focus, especially in the early stage. Less money means you have less room to make mistakes and some people thrive under that pressure.

However, you will be forced to make difficult decisions without as much money, including layoffs and restructuring. Many businesses even fail because they run out of money. When it comes to fundraising, everything will take longer and cost more than you expect. As an entrepreneur your goal should be building your company, not looking for money.

"I think that the biggest problem, to be candid with you, is most people don't raise enough money," said Jordan Levy, a partner at SoftBank Capital. "I think that most entrepreneurs are far too dilution sensitive, and forget that what's most important is giving them the runway and traction to have the opportunity to follow and fulfill their dream."

If you don't have enough money to make it to a certain milestone, you might not be able to raise more capital. According to Nick Sturiale, a managing partner at Ignition Partners, if you don't raise enough capital to get past the risk reduction milestone, you are looking at an insider led round, which is a negative signal to outside investors and a sign of desperation.

"Once there's a whiff of desperation around a company, future fundraising is probably compromised," Sturiale said.

Raising a lot

There's something to be said about the comfort money brings. Although, what is considered 'a lot' of money will depend on your company's business model and revenue model. For example, a B2B SaaS company will look different than a consumer hardware company in terms of fundraising rounds. Hardware companies traditionally require more capital because they will not be able to bring in revenue until they have built produced a physical product.

"Capital itself is not the goal, it's the enabler to get to the goal." Alex Rosen
One of the main reasons to take more money is the simple fact that it means you can spend more time working on your company and less time trying to keep your coffers full.

"You don't want entrepreneurs always being in the market raising because it's time consuming, it's distracting," said Ira Weiss, managing partner at Hyde Park Venture Partners.

Raising extra capital also gives you time to refine your product before taking it to market. There is often less stress involved and it gives you the ability to account for adjustments and mistakes. There are risks in taking extra money, but they are hotly debated.

"The most likely exit scenarios for your business can justify whatever amount of money you're raising," Weiss said. "If you think the exit can only be $50 to $100 million, you don't necessarily want to be raising $20 to $25 million."

Remember, when you cash out on your startup through an exit, the investors get paid first. So, if you take too much money relative to your exit price, you could end up with a less-than-stellar return on your hard work. But, some VCs contend this argument, as an investor will likely have the industry knowledge to not put themselves or the founder in this position in the first place. As Levy put it: "No one's ever raised too much money."

An alternative option is running lean early, until you have a product/market fit, and then taking all the money that's available. Because, at that point, you know there is a real business opportunity and you it's up to you to make it happen.

Rosen notes that raising too much too early can cause you to lose focus and be tempted to pursue too many things. He also said that while laser-focus is key, it's difficult to scale a company on a budget.

"The one mistake from which you can't recover is running out of money," Rosen said.

Raising for the right reasons

One of the most difficult parts of deciding how much money to raise is deciding how you are going to measure your capital needs. Some companies start with the amount of time you need to be operational.

Weiss said that, for most companies, a good rule of thumb is 12-18 months, or 18-24 months of operating costs in an extreme case. Much of this has to do with whether or not you have the details of the business ironed out yet. If not, a safe timeframe is probably 15-24 months.

Other VCs believe it is incorrect to look at fundraising and growth in a sense of measurable time. Investors and entrepreneurs that fall into that camp typically think of it in terms of company milestones; and those milestones can be prerequisites for future rounds as well.

When I say "milestone" what I am referring to is a specific, measurable point in a company's growth that is a metric of success. For example, a milestone for a SaaS company might be achieving a specific monthly recurring revenue (MRR). For a B2B subscription service, it could be reaching a certain number of customers and pipeline. Other examples of metrics could be measurements of engagement, acquisition, and monetization.

Sturiale, on the other hand, believes that it is a combination of both time and milestones that help make the best decisions about the amount of capital to raise.

"Innovation is very difficult to schedule or forecast and we, as a human species, are inherently biased when we forecast beliefs about the future when we're involved in it," Sturiale said. "Forecasts are inherently optimistic and forecasts are always 100% wrong at the early stage. So time does become a component because, more often than not, this is going to take longer than you think and cost more than you think."

The mentioned the idea of raising a "buffer" to account for any hiccups along the way to a milestone. That way, even if you don't make it a specific milestone, you have enough capital to keep your head above water while you figure out what to do.

Fundraising is a confusing, complicated process. It's implications are deep, but it can be the fuel you need to take your idea to the next level. It's necessary to properly think through exactly how much you need raise, but you should also consider who you are raising the money from.

"When you take a venture capitalist's money it comes with strings, irrespective of the terms," Levy said. "Irrespective of the terms the fact of the matter is, when you take our money, we control your business whether you like it or not."

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About Conner Forrest

Conner Forrest is a Senior Editor for TechRepublic. He covers enterprise technology and is interested in the convergence of tech and culture.

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