How Much Capital Should Your Startup Raise?
Startup founders often ask “How much money should I ask for?” The simple answer is, the absolute minimum amount you need to make your business plan work. Some entrepreneurs try to start with a huge number, hoping they can negotiate and close on a smaller one, while others understate their requirements, in hopes of getting their foot in the door with an investor.
Neither of these strategies is a good one, as both are likely to damage your credibility with potential investors even before they look hard at your business plan. Here are the parameters you should use in sizing and justifying your request to investors:
- Consider implied ownership cost. If your company is early-stage and has a valuation under $1M, don’t ask for a $5M investment. The investor would be buying your company five times over, and he doesn’t want it. If your valuation is around $1M, you can legitimately seek $200K-$300K and offer 20%-30% of your company in exchange.
- Type of investor. Angel investment groups usually won’t consider a request over $1M, while venture capitalists won’t look at anything under $2M. Amounts of $100K or less, are usually relegated to “friends and family.” Approaching any one of these groups with a funding request outside their range is a waste of your time and theirs.
- Company stage. If your company is still in the “idea” stage, you have no valuation, so size your investment request on the basis of “goodwill” that you have with your rich uncle, and your business track record. Angels might be interested during “early-stage” if you have a prototype, but VCs won’t bite until you have a product, customers, and revenue.
- Calculate what you need, and add a buffer. Do your financial model first with the volume, cost, and pricing parameters you expect. See where your cash flow bottoms out. If it bottoms out at minus $400K, add a 25% buffer, and ask for $500K funding. The request size must tie into your financials to be credible.
- Investment terms. The most common case is an equity investment, but there are many terms that can impact what request size is credible. I’m talking about things like anti-dilution clauses, preferred versus common stock, valuation tied to a later round, warrants, and bridge loan options. More restrictive terms reduce the credible investment amount.
- Single or staged delivery. In many cases, a single investment request may be scheduled for delivery in stages, or tranches (often misspelled as traunchs or traunches), based on milestone achievement. Obviously, this reduces investor risk and allows a larger commitment, since they can limit their loss if you fail to meet key objectives.
- Use of funds. Investors expect to see a “use of funds” list, and they expect the uses to apply only to your core mission. In other words, don’t tell investors that you intend to buy a fancy office building or executive cars with your funding. Even executive salaries should be minimal at this stage.
- Projected return on investment. Most entrepreneurs skip this step, but it helps your credibility to include it. Estimate a return on investment (ROI) by projecting company valuation at exit to show the investor who has 20% what he will get back for that initial investment. He’s looking for a 10x return since he assumes only one in ten survive.
Obviously, determining the proper size of a loan or investment in a business is a non-trivial exercise, but it’s one of the most critical factors for investors in making a decision to invest or not to invest in your company. You need to get it defensibly right the first time because changing your request under pressure definitely will kill your credibility.
The days are gone, if they ever existed, when you could present an idea and a vision, and have investors throw money at you. Now you have to do your homework. Get busy, and have fun.