Many entrepreneurs incorrectly believe that they will receive startup financing just because of a big, bright idea alone. But the fact of the matter is that they don’t necessarily have a better idea than competitors. They hardly ever are the ones coming up with the idea themselves. They happen to work on a similar wavelength of existing ideas, but with a demonstrable track record that proves their outstanding ability to execute their plan. So how can entrepreneurs receive funding? What do you need to know to approach investors? How do you position yourself and your startup?
We answer three common questions often asked by early founders regarding early investment.
What do investors look for when financing startups?
Market and management are the two most important elements in screening and due diligence for startup financing. This process describes what investors do to evaluate a potential investment opportunity.
The viability and funding probability of any project is conditioned by two paradigms:
- Have you proven that a market exists for the product/service given a revealed competitive landscape; and,
- Is your management team, by virtue of historical success, clearly capable of executing the plan given a capital infusion?
The management test asks whether the present management team appears to have the capabilities to execute the company’s business plan. Does their domain expertise cover a wide spectrum (mutually exclusive and collectively exhaustive to some extent)?
On the other hand, the market test asks one simple question: Does the business have a large, addressable market and the ability to scale? In other words, does the business have the right infrastructure in place to manage its own growth when the time comes?
When giving out startup financing, investors also look at customers, the product/service itself and the technology as well as competition, projections, channels, partners, the ability to manage cash and transaction terms. Another thing investors look at is existing commercial traction. Investors like to know that you’re not just talking but have already begun taking action to build the business.
How to raise money?
Demonstrate how much money you’re raising and what for specifically. Ideally, you should raise as much startup financing as needed to reach profitability, so that you’ll never have to raise money again. If you succeed in this, not only will you find it easier to raise investment in the future but you’ll be able to survive if the funding environment gets tight.
Eventually, if your startup or early-stage firm has some meaningful traction and you’ve decided to go for funding to scale, how much do you need? 1M? 3M? 10M? Many businesses out there pick a number out of space! You should make an effort to justify the number in a lot of detail.
The determination of ‘how much’ must be a function of your go-to market strategy. Once you have that, and few understand this essential component, relay a micro-detailed roadmap. It should show how you intend to scale, how you will apply your funds, and justify your financial projections such that the amount you need to accomplish your goal is appropriately fixed.
Understand what stage of growth you’re in. When choosing how much startup financing to raise you are trading off several variables. These include how much progress that amount of money will purchase, credibility with investors, and dilution. If you can manage to give up as little as 10% of your company in your seed round, that is wonderful. But many rounds will require up to 20% dilution and you should try to avoid more than 25%. In any event, the amount you are asking for must be tied to a believable plan.
Understand your milestones and KPIs. Investors don’t usually disburse cash all at once, but only when certain milestones and KPIs are achieved. This could range from the development or version of an app/tech to landing the first big contract or reaching a certain number of customers/users.
What is considered in company valuations for startup financing?
Many factors go into determining the value of a company. They are different from how a bank would go about a valuation to extend a loan since that depends on past and future cash flow which startups don’t have.
VCs and investors look at comparable startups and mark up/down according to different metrics. They also look at valuations of past rounds. Other criteria that go into valuations are:
- The experience and past success of the founders (so-called “serial” entrepreneurs present less risk, and often command higher valuations), the size of the market opportunity
- The proprietary technology already developed by the company
- Any initial traction by the company such as revenue, partnerships, satisfied customers, favorable publicity, etc.
- Progress towards a minimally viable product
- The recurring revenue opportunity of the business model
- The capital efficiency of the business model (i.e., will the company need to burn through significant capital before reaching profitability?)
- Whether the company/industry is trending and being pursued by other investors
- The current economic climate (valuations generally climb when the overall economy is strong, and are lower during economic slumps)
When all the back of the envelope screenings are concluded, investors go through their process and draft a term sheet, which is a non-binding agreement outlining future terms and conditions of an investment. This term sheet explainer dives deeper into the broad parameters of an investment, its “Five Documents”: stock purchase agreement, investor rights agreement, certificate of incorporation, ROFR & co-sale agreement, and voting agreement.
Later, investors go through far more detail in their due diligence. To learn more about what an ideal investment ready startup looks like to an early-stage VC, check out the last few slides (22-28) here.
Do you want to turn your idea into a business and be part of a motivated group of like-minded entrepreneurs? Applications for the High-Tech SeedLab Batch 2021 open in October 2020. If you have questions about the program or your application, please contact firstname.lastname@example.org
Are you exploring new investor readiness modules in your accelerator? We’d love to chat and exchange notes. Contact us via email@example.com