When Should a Startup Raise Money?
This post covers topics such as when is a good time for a startup to raise money, whether it is a good thing or not to raise money, and what to do if your startup is not generating enough revenue to survive. The article is based on the Codementor Office Hours hosted by renowned investor and the founder of Techstars, David Cohen.
When Should Startups Raise Money
“Should I raise money?”
Maybe you’ve got a thing that works. Maybe you’ve got customers. There are many ways to finance a company to grow and get bigger. One way is through this thing called “revenue”. Many people forget about it. I’m a huge fan. I find it very sexy when you have revue. You actually may not even need to raise money.
About my first company, we raised $100,000. It’s not a $50~60 million/year business─it’s part of a public company. We only needed $100,000 in funding. We needed to keep three people alive for a year, we paid ourselves, and we got it to $33,000 a year. It was enough to survive. We were bootstrappers. That company did not need to raise money. It was selling a product to a market that was willing to pay for it, and I’m tell you, it’s a very lovely feeling to own a hundred percent of your company at exit.
“Should I raise money? Do I need to raise money?” Not, “Oh, I’m going to go raise money because I’m doing a startup.” That doesn’t make any sense. So the right thing at the right time. If you can bootstrap, if you can build it on revenue, you should.
Raising Money: a Temptation or a Good Thing?
I’ve been using the phrase, “It is summer for startups” since startups are having a good time right now. There’s more capital in the market for seed investment than there has been in some time. These things come and go, and the market will turn at some point, but in 2014 we raised more venture dollars raised than in any previous year.
What’s interesting is we now have four times the amount of seed capital available than what we had few years ago. When it is easy to raise money, valuations go up. Moreover, you’ll have more temptation to raise money as well. If I can raise two million at ten million pre-money, why not?
Raising more money is generally a good thing because it is more fuel for your company. The potential bad thing that will happen to you is to raise money at too high of a valuation.
Because the market is speaking, you may say, “Well I’m going to take money from these unknown people because they’re offering me ten million pre”.
That may be a huge mistake in a couple of dimensions. You’re diluting yourself, and you may not be getting the best investor. The best investor might’ve added more value and might have helped the company grow or exit or whatever. Believe me, I’ve seen plenty of investors double and triple exit values a day helping companies negotiate the exit.
There’s real value in who your investors are. At the same time, you are setting the bar for the next round of funding even higher. If you are raising two million on ten pre when you have an idea, then you are going to need to raise your next round on fifteen or twenty pre – potentially when the market is down when you do not have that kind of progress, and when there’s not the same multiple “series A” capital available for you. So the expectation you create for momentum is an up round in the next round. It is much easier to have an up round at six or eight million than at twelve.
My advice is to raise more money from the most value-added investors if you can. Be cognizant of the right pricing for your company at the right time in terms of the valuation. Valuation is a hard thing to keep up with and live up to, and it makes the next rounds very hard.
Once again, take Uber as an example. In its angel round, the pre-money was around sub-five million dollars for 1.5 million dollar round. Today Uber would probably be able to command 10~15 million dollars based on who’s involved before they even have a product. I distinctly remember this – I mean Travis & Garret are well-known and they were like, “Hey, let’s get a good, diverse group of angel investors who are going to help us launch in different markets. Let’s get them to be geographically diverse. That is going to matter to us. Let’s get ones that have shown that they help companies.” And they did it at some totally reasonable sub-five million dollar pre-money valuation. So they sold a big chunk of the company early on. As Uber grew, you all have been reading about how they’re raising billions of dollars at $18~40 billion valuation taking part in any dilution, and how they’re easily taking money off the table if they want to.
Thus, the first round of funding is not the only round that matters. In fact, it hopefully matters the least. You want to motivate your investors to help as much as possible by owning a real chunk of the company. Construct a capital foundation without caving into the opportunity to raise at much higher prices than you are actually worth today.
Other Ways to Finance a Company
Again, taking my first company for example – we sold that $100k product to a customer who paid us $100k before the product existed. That was the money we raised.
Our deal was to pay the customer back that money, the customer would get to use our software free forever, and we’ll pay the customer 2.5% of whatever we sell in the future. So that was their upside. That was our financing. That was a twenty X for them. We eventually paid them back two million dollars. That number was going to be a lot bigger, but we negotiated it to two million dollars.
Forever royalties are a bad idea. You should try to channel. And we had to do that while we were exiting. We had to say, “Look, guys, you’re going to have a 2.5% royalty. The acquirer doesn’t want it. So will you just let us buy that out for two million?” And they said yes, which is very nice. They didn’t have to.
All in all, getting customers is a great way to finance your company as is royalty-based financing. Then, you get to angels and venture capitalists, which are an expensive way to finance your company by comparison.
If Your Company is Dying…
If you’re working on a consumer-facing project on the internet, that’s going to take a huge audience before you have money coming in and you can’t monetize it early on. If your company isn’t making enough revenue, you can probably a target for venture capital or angel capital.
At that point, you should focus on getting to the next meaningful milestone with the company.
For example, if you’re building a consumer company, how do you get 100k customers? If you’re building an enterprise software company, how do you get 3 lighthouse or pilot customers that you can reference? Those are meaningful milestones, where you’d need enough capital to do that and no more.
So many people go out to the market and they over-ask. They’ll walk in the office and say, “David, I’m raising five million dollars,” and I’ll be like, “Oh, cool. I don’t do that. You should go talk to those other people.” They don’t need that much money─they just think that’s what they’re supposed to do. Raising a half-million~750 thousand or whatever dollars might be plenty of money for you to get to the next milestone. However, be conscious about what it is and what you need to get there because the over-ask is the killer, and it’s also a killer in terms of your ownership.
Other Posts in This Series
- What do Investors Look for in Startups?
- How to Negotiate Ownership with Cofounders, How to Protect Your Idea, and more.