How To Determine The Amount To Raise In Your Round
How much money should startups seek to raise in a funding round?
Skillfully and accurately deciding how much money to ask for in a fundraising round continues to be a tricky point for many entrepreneurs and startups. Some have a good idea of what they need, and what is fair. Especially, if they’ve invested in getting some solid outside input in advance. Others are far off base in what will make sense for investors.
As I share in my book, The Art of Startup Fundraising, choosing an ask isn’t just about a fantastic number your think sounds great. To not only get the money, but have it serve you and your investors well, it is vital to understand the key elements that should go into your math, and other basic considerations of how it will affect your potential.
Below are key equations to know, some rough rules of thumb to determine an efficient and profitable capital raise, and additional guidance to understand the capital that you ultimately need to support your execution.
Key Figures To Know
Your Monthly Burn Rate
It costs money just to stay in business. How much is your venture burning in cash every month to stay afloat? How many months of working capital will you need to get to your next raise, exit, or turning enough profit not to need outside money? This is your ‘runway’.
Y Combinator says “Their goal should be to raise as much money as needed to get to their next “fundable” milestone, which will usually be 12 to 18 months later.” That’s a much shorter period of time than many entrepreneurs expect.
VC investor, Mark Suster who had two successful exits of his own companies (including one to Salesforce) warns that asking for years worth of capital is likely to be a red flag to experienced investors. It either suggests you don’t know the game, or you don’t have expectations of making great traction quickly.
Make sure you have budgeted enough to cover all the marketing you will need to grow your business, as well as for marketing to raise another round of capital, and getting through the closing of that round.
As with anything else in life and business, your burn rate is likely to be more than you think. Build in some cushion. At least 6 extra months of runway if possible for unexpected costs. The last thing you want is to have to go back and ask investors for more cash to bail out their initial funding because you didn’t ask for enough.
Cost of Next Milestones
Achieving new milestones typically requires more cash. Aside from simply fueling current growth and scale, this is normally what inspires entrepreneurs to seek funding.
Desired milestones can require new hires, research, and the hard costs of development. You want to raise enough to hit significant enough milestones to justify a new raise and additional funding from earlier investors.
Key Strategic Considerations
The Impact of Fundraising on Valuation & Ownership
The amount of money a startup asks for and raises directly impacts ownership percentages.
Typically the amount that you are raising should only be included in your pitch deck once you have a lead investor that is covering at least 20% of the amount of the round. For a winning deck, take a look at the pitch deck template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Moreover, I also provided a commentary on a pitch deck from an Uber competitor that has raised over $400M (see it here)
In this regard, Seed Camp warns that you not only want to be careful about giving up too much, too early, but how important it is to leave enough of a pie for future rounds, but to be able to attract the strongest investors will a value proposition that is appealing.
Matt Moore says “you’ll be expected to give a 15–25% slug of equity at each stage.”
Control vs. Flexibility
The more money raised, the more control your investors are going to want to have. Beyond percentages this means terms and conditions which add more protections for their money and more limitations on what you can do on your own.
In earlier stages you may crave and prize flexibility and the ability to make all your own decisions far more than money. So, find a happy balance.
The Risk of Having too Much Money
There are well known dangers of having too much money. It can lead to overspending, spending on the wrong things, slacking off, lack of creativity or focus on a more profitable model, more distractions and friction between founders. Don’t come up short, but be alert to these risks.
Rough Rules of Thumb for Startup Fundraising
It is clearly important to do some serious math when approaching a fundraising round. Yet, these rough rules can help make sure you are on the right track too.
Paul Graham of Y Combinator once offered the simple formula of multiplying the number of new hires you want to make by $15,000, by 18 months. That was back in 2015, and the inflation of labor costs has been fierce since then. So, if using this formula, make sure you ramp up your numbers accordingly.
Investor Chris Dixon recommends adding a 50% buffer on top of your required funding to account for unexpected obstacles.
Managing Director of Techstars in NY, Alex Iskold recommends this basic formula for justifying and pitching investors with your fundraising ask:
“We need to achieve milestone X. To get there, we need Y people, and we need Z capital. We believe it will take us W months to get there.”
Deciding Investment Levels
You should implicitly understand the difference between needed, realistic, and ideal investment. The distinction between all three investment plans matters. You should develop a separate costing outline for each, allowing you to understand what your company needs to launch, survive, grow, and return a profit for you and your investors. It will also provide you with a clearer way to identify needed, realistic and ideal investors during the negotiation process, leading to a strong valuation of your startup.
– Ideal Investment: This investment level is the best-case scenario. This level of investment which will allow you to put in place all of your infrastructure as well as covering all manufacturing, distribution and advertising costs. Not only that, an ideal investment will provide enough capital to cover all costs and provide your startup with a substantial reserve for future expansion. Gaining ideal investment straight away, if at all, is very rare, but defining the perfect scenario will help to create a good project roadmap.
– Needed Investment: This is the investment amount you require to meet your startup’s immediate goals. Those goals will be determined by what combination of investment rounds you are pursuing. If, for example, you are looking for seed investment, then the immediate needs for your company will include market research, conceptual design, developing infrastructure and creating a prototype. Needed investment will allow you to achieve the absolute minimum to push your startup forward. Knowing how much capital is required to keep your startup developing as a going concern is imperative.
– Realistic Investment: This investment level is based on how much capital you can expect to raise overall, and how much you can expect to raise for each investor. The types of investors you are hoping to engage with will answer the latter. If you are raising capital from friends and family, their financial situation will define how much they can invest. An individual angel investor is probably going to contribute a smaller amount than a VC group. Whoever is your target investor, you need to be realistic about how much capital to expect from them. Realistic investment is a much more subjective number than needed and ideal figures, but it will give you an investment amount to aim for, and should be closer to any compromise at the conclusion of negotiations.
Knowing the difference between realistic, needed and ideal investment levels for your business will help you chart a course through each investment round, informing your negotiation decisions in terms of how much capital you need to develop your startup to different levels within best- to worst-case scenario timeframes.
From my experience in raising capital, it is important to understand how much it will take to oversubscribe the round quickly, and whether you have the people who you can tap into for capital. Once you have a clear understanding of who will invest (for certain), then determine a round amount. Normally, when you are oversubscribed, the story becomes more attractive and your round is much easier to sell.
Founder Valuation Vs Market Valuation
The valuation of your startup will also be a driver behind the capital that you will end up raising. This simply refers to how much equity you should give investors in return for their capital.
In essence there are two types of valuation which you will encounter:
- Founder Valuation: How much you believe your business is worth.
- Market Valuation: This type of valuation is essentially how much your business is worth to investors when taking into consideration investment risks. In other words, your startup is worth what someone is willing to pay for it.
Both types of valuation will usually contradict each other. This difference in agreement is where negotiation of terms takes place. In the end, the ultimate agreed upon valuation of your business will depend on:
- How much money you need to achieve your goals.
- The type of investor (angel, VC, family and friends, etc.).
- Your prior success as an entrepreneur.
- The “going rate” for similar companies (comparables).
- The growth rate of related sectors/marketplaces.
- How likely it is that your startup will reach profitability.
- The level of revenue currently or potentially generated by the business.
- The team that you have around you
- Costumer acquisition and distribution of your company
The valuation of your startup is a fluid, subjective figure; for that reason it is best to have a minimum and maximum range in mind rather than a single number. This will give you more room to negotiate.
The best way to show investors that your startup is worth your valuation is to have a well-structured plan and have as much market research in place as possible, as well as a financial forecast.
You definitely do not want to price your company too high or you will scare people off. You will need to research the market and ask around about valuations that some of your direct or indirect competitors had when they were raising money at your same stage. This type of data will be very useful, and information that you can also leverage during the negotiation process with investors.
Having A Powerful Financial Forecast
When it comes to startups it is very difficult to know where you will be in 5 years. However, having a powerful financial forecast will help you in understanding the capital that is required for at least the next 18 to 24 months of runway.
Who would have thought in 2004 that Facebook would be valued at over $400B years later? The forecast is your most effective persuasive tool, but it is also one of the most difficult to compile.
Your forecast should outline the following:
- Projected income
- Estimated expenses
- Expected growth
A financial forecast is a carefully constructed projection of company development over a given time period, taking into consideration projected sales data, as well as market and economic indicators.
Normally you would want to include at least three years so that the investor can see the key drivers of your business over the course of time. Some investors may want up to five years, but in my opinion, that’s too much.
You will need someone that is very good with numbers to nail the forecast. In my case, I had our CFO very close to me when developing our forecast. You should take the time to make sure you have the best possible help as well if forecasting is not your strength.
For potential investors, a strong financial forecast will help to:
1. Show the financial viability of your startup as a new business
2. Identify potential risks which could affect business cash flow
3. Provide a clear understanding of future financial needs, including if subsequent investment will be required
4. Allow future comparisons between forecast and business operations so that startup management can adjust the business to reach estimated goals
5. Show financial responsibility on the part of the founder
Your financial forecast is not only a critical tool to attract investment, but it will help you to show more clearly why you value your startup at a specific figure. If you can show reliably that the business should generate healthy revenue, then investors will be more likely to accept less equity in return for the same level of capital investment.
Ultimately your forecast will help the investor see how the money that is being raised will be put to use and the impact it will have in the long term plans of the company.
With fundraising it is all about speeding up the machine and the forecast should show how the new money will accelerate things down the line.
This article originally appeared in Forbes.