Startups that have enjoyed early success often do their fundraising in autopilot mode. That’s not necessarily a smart strategy.
Raising growth capital from venture capitalists or angels may be an exciting adventure, but you will only succeed if you can persuade your investors that your plans are going to produce phenomenal growth. There’s a substantial price tag attached too, because the cost of the shares that you issue in an investment round can easily amount to 100% or more per year. For many startups it’s better to raise funds from bank financing, revenue-based financing and smaller equity rounds. In this blog I’ll set out five essential considerations that a wise entrepreneur should take into account before they start fundraising. And I’ll conclude with a suggestion about a smart way to raise growth capital.
The entrepreneur’s first milestone
So you’ve turned your idea into a product. You’ve assembled a team, you’ve all worked hard and now you’ve got your first customers. The entrepreneur’s first milestone is the satisfaction you get from all that attention, acknowledgment and appreciation for your startup. It’s definitely worth celebrating because very few ideas actually end up generating revenue. A large portion of startups don’t progress beyond the pre-revenue phase and are either wound up or declared insolvent. So if you’ve got this far, you’re one of the lucky few...
But this is only the first step and you’re probably already noticing that your ambitions are being hampered by your rapidly shrinking bank balance. This is the moment to take heed of the following five lessons and devise a financing plan for your growth strategy.
Lesson 1: make sure that you’ve got good accounts and a sound financial plan
Excel is both your friend and your enemy. If your startup doesn’t have a team member with a strong financial background, it’s particularly difficult to monitor the figures closely and consistently. Excel is a useful tool for keeping customer records, for budgets and for monthly reports, giving you all the information you need to create an impressive pitch deck before you start fundraising. But many startups make the simple mistake of having an accountant compile accounts after the fact and not linking those accounts to the spreadsheets. As a result, a few months down the line you may discover discrepancies between the monthly actuals in your budget and the figures in your accounts. Usually those discrepancies won’t be favourable. For example, debtors may be late with their payments, VAT refunds might get delayed due to queries about the amounts claimed, and so on. This can cause concern, or even panic.
Once you reach the stage when you’re meeting with banks and investors, it’s particularly annoying if you have to correct your figures during the process. Banks and investors keep records of everything. And they check updated versions of pitch decks and budgets to see if they are consistent.
One of the benefits of being a small business is that your accounts are not complicated. So paying attention can make all the difference. Be aware of the fact that you need to reconcile your accounts with your Excel plans on a weekly or monthly basis. The main benefit of this approach is that it will give you a better sense not only of your costs and revenues, but also of your balance sheet and cash flow. And this will give you a good basis for contemplating the costs of your capital structure.
Lesson 2: think about whether profitable growth is possible before you start raising growth capital
In recent years it has become more the rule than the exception for startups to keep running at a loss far into their development phase. This contrasts sharply with the position 20 years ago and it is doubtful (a) whether things can carry on this way, and (b) whether it is a desirable approach for your company.
If you want to pursue a market domination strategy and prioritise growth over profit, you need to rely on venture capital. This type of capital is ideal for providing startups with the capital to fund exponential growth and become the new Facebook, Spotify or Adyen.
Your company might be eligible for venture capital. However, there’s also a good chance that your company won’t be the one that strikes gold. After all, no matter how good your idea is, you can assume that at least 20 startups all over the world are doing exactly the same thing.
Venture capital can only be used if a company’s value might increase exponentially. Venture capitalists always take this factor into account. They’ll invest in 20 businesses knowing that just 1 of them needs to make enormous returns.
But is this really the best strategy for your company? Or would it be better to grow more slowly and move into break-even or profitable growth territory more quickly? I’m convinced that this second option is best for the vast majority of startups. It’s better to be taking on 1 new sales executive each quarter than to be hiring 6 at a time. Does that make you a less interesting prospect for investors? Yes, if you’re targeting high-profile venture capital. But there are alternatives and different types of investors. Other forms of growth capital also cost substantially less than venture capital. Venture capitalists aim to earn back 10 times their original investment – and through shares that are actually yours (!) A structuring and negotiation round can easily cost €20,000 or more. That’s a serious amount of money. In the past it was normal to raise less capital and financing, and to move into profit more quickly – and nowadays I think that this strategy is underrated.
Lesson 3: familiarise yourself with the phenomenon of the term sheet
The first time you find yourself holding a term sheet that gives your business a high valuation, it will definitely boost your ego. Suddenly you’re a millionaire! Well, at least on paper... But don’t be fooled by the high valuation on that term sheet. A high valuation also brings with it an obligation to deliver strong results in the future. And there’s nothing worse than issuing shares at an excessive valuation: your relations with investors will suffer if your next round is a ‘down round’ in which you’re forced to issue shares at a lower valuation. Often you’ll take an extra hit as the valuation will be disproportionately low.
In contrast, if you’ve raised capital during your first round with a valuation that’s too low, you may later encounter the problem of excessive founder dilution. That’s not desirable either.
And so far we’ve only mentioned valuation. What about liquidation preference, reserved matters – there are lots of provisions in the term sheet that aren’t there just for window dressing. They aren’t necessarily bad, but you do need to give them careful thought. Fortunately there are some great books that explain venture capital and the language used in term sheets.
Once you’ve given careful consideration to the term sheet, you will also understand that venture capital rounds have disadvantages too. And you need to weigh up both the pros and cons when you’re comparing the costs of growth capital with the associated risks and opportunities.
Lesson 4: the ‘golden rule of 40’
For internet and SaaS companies that have reached a later stage of their growth strategy, it’s important to strike the right balance between growth and profitability. According to the 20/20 rule, the total of your growth percentage and profitability must be capable of producing 20% growth per year at 20% profitability. Faster growth means a lower profit or a loss, and vice versa. If you compare that 20% with the hockey sticks that are often presented in the first pitch decks, you’ll realise that everyone is ultimately going to be very happy with a company that earns €5,000,000 of revenue at a profit of €1,000,000 per year.
If you are founders with 70% of the shares, then you’ll end up with a much bigger slice of the pie than if your stake had been diluted to 25% by expensive investment rounds. So it’s important to make a fair comparison of the costs before you embark on investment rounds.
Lesson 5: profitable growth is efficient
If your products are well priced and make a positive contribution to your cash flow fairly quickly, then it’s much easier to manage the costs of acquisition and organisational development, as well operating capital. All you need is the confidence that you’ve put a good and valuable product onto the market and enough faith not to lose your nerve. It may give you peace of mind to have a few million in the bank after an investment round, but that feeling will often be short lived. You need nerves of steel to pursue an aggressive growth strategy at a high burn rate, during which you are bound to discover that you’ve made mistakes, that things aren’t turning out as you’d planned – and if you’re not careful, you might actually end up in a constant cycle of fundraising. The costs involved are enormous. Not only the legal fees, but also the time and attention required of the CEO and management team, will place a drain on your company’s development.
The five lessons all illustrate how closely your company’s strategic course is connected to its financing and the risks associated with doing business. In our investment practice we regularly recommend to entrepreneurs that they consider a different strategy than the one formulated in the pitch deck: in other words, that they think about how to use smaller investments to pursue a growth strategy. Often this will involve a lower (or much lower) company valuation or a recommendation to consider revenue-based financing. Entrepreneurs who have just started fundraising won’t generally be receptive to this idea. But if multiple investors express doubts about the valuation, this may give the entrepreneur pause for thought. That means taking the time to consider not just the valuation, but also the amount of growth capital you want to raise and the price you’re willing to pay for it. And the earlier you think about this, the better.