One of the major challenges that startups face is raising capital or acquiring funding to help them start or grow their business. Capital is often exchanged for equity and is used by businesses to build products, hire key staff and expand into new markets.
In this article we will cover everything you need to know about startup funding and what you can do to position yourself to get funding.
| Table of contents |
|---|
| i. Factors to consider |
| ii. Sources of funding |
| iii. Types of funding |
| iv. Series funding |
| v. What investors consider |
| vi. Questions to ask yourself before seeking funding |
| vii. Conclusion |
FACTORS TO CONSIDER WHEN SEEKING STARTUP FUNDING
Every business goes through a number of stages during its lifecycle. Just like a baby first lives on milk, before they can handle solid meals, even small businesses need to start with simple funding models and then graduate to more complex ones. It is therefore important to understand the various stages in the business lifecycle. Each of these stages has different characteristics and these will determine the kind of funding that a business can access.
Understanding the stages of business growth
1. Idea validation
This often starts with an idea, and this will need to be validated. Most ideas are validated by creating a prototype or minimum viable product which is then given to consumers to try. At this stage the business isn't profitable and thus is most likely limited to raising funding from the founders' close family, friends and other well wishers.
2. Survival
Once a need for the product has been validated, feedback from consumers helps the organisation to refine its product as well as its business model. This involves trying out various iterations of the product to find one that works best for both the business and its customers. At this stage the business is barely breaking even but has a sizeable userbase. The key is capitalising on that momentum and moving it to profitability.
3. Product/Market Fit (Success)
If all goes well during validation and initial testing, the company eventually achieves product market fit. At this stage the business(product) generates it's own buzz. Customers are raving about the product and sharing it with their friends and associates. Product market fit is where the business becomes profitable and experiences exponential growth.
4. Scaling (Take off)
Once the business grows, the next stage involves scaling the business to take advantage of any momentum. This includes expanding to new markets and widening its product range. Though profitable, the business often requires external funding to grow comfortably.
5. Maturity
At this stage the business well established and highly profitable. Its core focus becomes consolidating its position as a market leader. This includes acquiring smaller companies for strategic purposes.
6. Decline
Growing too big often comes with it's own challenges. These include bureaucracy and oftentimes the loss of that innovative drive which the initial founders had. If not perfectly handled, this leads to costly mistakes. These mistakes could lead to the company's demise. Notable companies which eventually saw decline include Kodak, Nokia and now BlackBerry.
The following infographic explains the various stages of business growth as well as the characteristics at each stage.
SOURCES OF FUNDING
• Friends and family
This is probably the cheapest and less riskiest form of funding. It is whereby a startup owner reaches out to people within their personal network to seek funding for the business. There are often no stringent conditions or requirements attached to this form of funding and the formalities are minimal. Oftentimes the startup owners offers some shares to these family members or friends in return for the funding, but in some cases (for example, Parent to child) this might not even be necessary.
• Accelerators and incubators
There are organisations which seek early stage startups and take them through intensive training for a specific period. The most common period is about 3 to 4 months but this can be longer. Startups are taken through a number of modules which could include team building, marketing and fundraising.
• Banks and Financial institutions
Most banks and financial institutions offer loans to help support and grow startups and new businesses. These funds range from simple overdraft facilities to capital expenditure loans. A prior relationship with the bank is often required before one can apply and qualify for its funding program. The entrepreneurs therefore have to be proactive and build relationships prior to seeking any funding.
• Individual investors
Some individuals keep some extra money on the side for potential opportunities. Some have funds which they might not have a clear idea what to do with. Some are looking for an opportunity to grow their net worth. Entrepreneurs can approach these individuals and ask them to invest in their business in exchange for some shares in the business. Some might be actively interested in the new idea and business whilst others are merely concerned with getting a return on their investment. It is therefore important for the business owner to understand the investor's goals and ascertain whether the business would be an ideal fit for them. In addition to injecting cash, some investors bring their network of contacts, reputation and expertise to the business
• Institutional investors
There are also a number of organisations which seek to invest in startups or innovators as part of their social objectives or for strategic reasons. These organisations often also provide some additional support to startups in the form of mentorship or business incubation services. Such organisations range from civic service organisations to major corporations such as banks and tech companies.
• Venture capital firms
These organisations provide private equity financing to potential high growth startups. Most venture capital firms are focused on growing the startup and achieving a successful exit. Most of them will invest and commit for a period of about 4 to 7 years.
• Governments
Most governments set aside funds to boost entrepreneurship and innovation. These funds are often reserved through government departments and availed to startups as loans or grants.
TYPES OF FUNDING
I.) Crowd funding
This is whereby an individual or organisation raises money for a project by receiving small contributions from a large pool of individuals. This is often done using online platforms such as gofundme.com as they make tracking and accountability easier.
II.) Loans
a.) Overdrafts
Most banks offer current account owners the option to take more money than is available in their accounts. This is often by arrangement and is a short term form of funding.
b.) Transaction-based funding
Most commercial banks provide a facility to help companies fulfill once off transactions or orders from large reputable suppliers. This type of funding is often provided through order financing or invoice discounting.
c.) Working capital loans
These are short term loans mainly given to finance the day to day running of a business and not necessarily the acquisition of capital goods. Working capital loans may be used to finance a large order, purchase stock or raw materials and to pay for the general expenses of a business. The repayment period is usually short, most likely less than a year.
c.) Capital expenditure loans
These are often medium to long term loans designated for the purpose of making fixed asset purchases or major improvements on fixed assets. This can include purchase of a building or equipment. It can also include major renovations. This is often for established and profitable businesses.
III.) Grants
There are a large number of non-profit organisations, charities and governments which set aside money to help pursue various causes. Grants are often issued without the need for repayment, on condition the recipient's mission and activities are in alignment with with the funding organisation. Grants have no interest and are probably the cheapest form of funding.
IV.) Venture Capital
This is whereby organisations invest in private companies and then restructure them. As stated above this type of capital set aside to finance startups which have demonstrated or have the potential to exhibit fast growth.
V.) Angel investors
These are high net-worth individuals who provide financial backing to entrepreneurs in exchange for an ownership stake in their companies.
Series funding
This is whereby a growing company raises funding from investors through multiple funding rounds, in exchange for ownership(equity). Each funding round often serves to move the organisation towards its next significant milestone or growth goal. There are multiple rounds and these include
• Pre-seed funding
This is the money that is used to kick off operations and get things going. This type of funding is often from the founders themselves and may include funds from friends family and even angel investors. This is often used to create the minimum viable product or prototype, as well as initial testing.
• Seed funding
Seed funding is the first 'official' equity funding round that a company raises. It is mainly intended to position the business as a formal enterprise by setting up proper business infrastructure. This includes hiring professionals such as a CTO to spearhead the development and refinement of the product. Investors are virtually saying "we think they might be something here... let's see what it could be".
• Series A Funding
Once the business has been set up the next stage is scaling up and optimizing for long term profitability. The Series A round of funding is often used to scale across different markets as well as to refine the business model.
• Series B Funding
At this stage the company has developed a successful product and now wants to take it to the next level. This maybe include hiring additional team members, refining the product and further work on the business model.
• Series C Funding (and subsequent series rounds)
When a company reaches series C stage it is highly successful and funding is often for further expansion or even acquisition of other startups. At this stage the business is consolidating its market status and positioning itself for an eventual exit.
WHAT INVESTORS CONSIDER
1. Dilution
Most investors will want to know how much power they are getting. How much influence will they have on who makes decisions and determining how those decisions are made? What are the implications of future funding rounds on their number of shares and voting rights? Do they have special privileges which give them significant control?
2. Ownership
How much of the company will they get to own? This is often a number of shares as well as that number as a percentage of the total shares of the business. Ownership determines how much they will get in proceeds as well as how much influence they have in the company.
3. Valuation
A valuation is an estimate of how much a company is worth. This is derived by looking at the balance sheet, future earnings potential, customer/user base, key market advantages such as patents and non-tangible assets such as goodwill and any hype that has been generated.
As you can tell, some of those factors can not be accurately quantified. This makes coming up with a universally acceptable valuation often a contentious issue. Startup founders will most likely attach sentimental value to the blood, sweat and tears that they invested in their businesses. Those sleepless nights have to count for something, right? Investors on the other hand, are more concerned with quantifiable values that increase their worth.
Despite not having any credible record, there are also ways and methods to come up with a 'close-to-fair' value of even a new start up. Most ideas will not be worth much, until they are validated and proven on the market.
How to come up with a company valuation
Investors will also be interested in knowing how much your company's worth. This is usually not accurate for most startups but it gives an indicator of the perceived value. An exaggerated valuation means investors will get less in terms of equity, while a much lower valuation means they will get a bigger chunk of the business.
There are a number of methods which can be used to come up with fair valuations. The most commonly used methods of calculating start-up valuations are:
1. Discounted Cash Flows
2. Net Asset Value
3. Earnings multiplier
4. 5x Your Raise
5. Comparison Method
Other factors to consider
1. The founder and management team
Most investors simply want to know whether the founders and management team have what it takes to achieve their growth goals. This takes into account the track record of the management and founding team. In addition to the skills that each one brings to the table, investors also consider what the startup founders have achieved prior to this project. Other secondary factors include likeability, reputation and 'chemistry' with the investor.
2. The relationships that the startup enjoys
Another key factor that investors consider is the relationships that the startup founders or management enjoy. Relationships that startup founders have built with suppliers, financial institutions or with key customers are crucial to them getting funding as well. For example a good relationship with a national distribution network means the startup's product distribution will be easier to rollout on a national scale. A good relationship with a banker means access to facilities such as overdrafts and special loans which could greatly help the business.
3. The board
The composition of the board also plays a role in determining whether an investor would want to invest. A decent and credible board provides confidence to the investors that they will be in good company and more importantly, that sound decisions will be made. Thus a board comprised of all students fresh out of college does little to inspire confidence, hence investors might appreciate a board with a member or two, who have successfully started businesses or have built a reputation of trust and success.
4. Ability to access markets
What barriers to entry are there in this market and is the startup well positioned to overcome those. Does it have the capacity to out-compete other market players. Investors will also be interested in the overall size of the market as well as a startup's chances of gaining a sizeable chunk of this market.
5. Probability of future capital raises
Do you plan to raise more funding in the future? If so, what are the implications of that funding on your capitalization tables, distribution of proceeds and the company's growth?
4. Distribution of proceeds
How will any proceeds be shared among the investors? Does anyone have special rights and privileges? Who gets preference when sharing profits?
5. Exit strategy.
Most investors will also want to know what you intend to do once predetermined criteria has been met or exceeded. What will happen when you achieve or surpass your goals? Will you sell the company to a larger company such as Google, Meta, Amazon or Microsoft? Or do you want grow the company and eventually list on a stock exchange?
QUESTIONS TO ASK YOURSELF BEFORE APPROACHING INVESTORS
1. Do we have a shareholders agreement?
2. What is my company's valuation?
3. What is the value of my business based on?
4. How many shares am I willing to offer?
5. Do I have a tiered shareholding structure?
6. Can the business take-on debt?
7. What will this funding be used for?
8. What are the implications of this investment of future funding rounds
Conclusion
Raising funding is one of the key activities for most startup founders. It is also a good indicator of confidence in the founding team. However each level of business growth has different needs and therefore even the funding needs will be different. There are multiple sources of funding for startups and the startup founders should choose the one that best Suite their needs. Startups need to prepare well in advance to answer the questions that investors might have, as well as to address any concerns. A good fundraising strategy also involves taking into account the implications of immediate funding on the future equity structure of the business.
I hope you found this helpful and informative. Regards.
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