Back To Insights

A Start-Up's Financing Strategy

Answered by: Paul Maeder

Why Raise Outside Capital?
Most new businesses are built without raising substantial amounts of outside capital. They are founded with small infusions of cash from the founders, perhaps augmented by support from relatives or wealthy individuals. In doing so, the founders avoid the effort and dilution of raising capital from institutional investors. The vast majority of small businesses remain small, and their founders are happy maintaining family control and pursuing modest growth.
In technology, however, two factors confound this common pattern: 1) founders tend to be very ambitious about growth and liquidity, and 2) the rapid pace of technological progress makes slow growth unsustainable. Because some technology companies use capital as a competitive weapon to progress more rapidly, all their competitors are compelled to do so as well.

Recognizing the necessity to develop and grow rapidly, and the resulting need to raise large amounts of outside capital, technology entrepreneurs are faced with a range of options, each appropriate to a different stage of growth. Early in the company's development angels and founders can provide the relatively modest amounts of capital (less than $1 million) to get the business plan written, the core management team assembled, and a prototype developed. At that point, the CEO turns to professional venture investors for larger amounts of capital, and for the expertise essential to building a larger company. Finally, the successful start-up turns to major corporations or the public markets for access to even larger blocks of capital and for liquidity for the founders, employees, and investors.

How Much Capital Should You Raise?
Since a company grows in value as it progresses, the founders can minimize their dilution by raising only as much money as necessary at each stage of growth. Ideally, you would raise money just as you need it, but that would require constant fundraising and preoccupy management with selling stock as opposed to building and selling product. Because investors tie the growth in the value of the business to the achievement of demonstrable milestones, increases in valuation can only be realized in a stepwise fashion.

So the answer to the question, "How much capital should we raise?” becomes apparent. You should raise as much capital as is necessary to get to the next major milestone that will justify a substantive increase in the company's stock price. When it comes to cash, the cost of underfunding vastly exceeds the cost of overfunding. It is therefore prudent to add a fudge factor to the estimate of how much capital is required to get to the next milestone – 20%-40% is customary.

What milestones justify successively higher prices? Typically they are the completion of a prototype, completion of the management team, conclusion of beta testing for a product, selling to initial active customers, getting customers to place repeat orders, reaching cash flow break-even and profitability, filling out a fuller product line, and completing a series of profitable, growing quarters on plan.

Prudent CEOs raise more capital than they think they'll need and rarely turn away capital in an oversubscribed round. There are two reasons why taking too little cash and running out is so costly. First, it puts the company in a very weak position when negotiating price with a new investor. More importantly, it reveals a lack of ability to forecast the future and therefore undermines new investors' confidence in management's plans. Most venture capitalists believe, with good reason, that there is an inverse correlation between bridge loans and a company's ultimate success. If it is available, Take The Money!

What Is The Right Stock Price?
Once a venture firm invests in your company and joins your board, they will want to be on the same side of the table with you forever. Negotiating the price of a follow-on round for a company where you serve on the board would be awkward at best, and could fracture the trust that is critical to maintaining an effective board. So with each subsequent round of investment, a new outside investor is asked to negotiate the price, at arms-length, with the management team. Existing investors are then asked to participate in the round as an expression of confidence in the company's progress. While an inside investor can be used to signal pricing to a new investor, ethics demands that the insiders work strenuously on behalf of management to get an attractive price for the stock.

It is in fact a mathematical reality that existing investors who participates pro rata in a follow-on round is indifferent to price. Their post-round ownership will be almost exactly the same over a range of valuations. At a low price, the early investment gets diluted more, but the follow-on money buys more. At a high price, the opposite is true. The two effects roughly cancel one another.

The argument for refusing to accept too low a price is self-evident, but there is an equally compelling argument not to push too aggressively for a high price. Too high a stock price too early can have several negative effects. Investors in subsequent rounds need to feel they got a fair shake, particularly as their support will be necessary when the company hits the disappointments that inevitably come along the way. Even more importantly, employees need to see smooth, progressive stock price growth over time to feel that their efforts are well spent. Too high a valuation early on, and a consequent down or flat round later on causes employees to question why, if they're working so hard, "value" isn't being created. Employee disillusionment and defection is common when stock prices don't grow in a consistent fashion.

What About Other Sources of Capital?
Venture capital tends to be expensive capital. It is expensive because it generally brings with it free consulting, an enormous network of relevant contacts, access to additional capital, and early validation of success. There is nothing wrong with augmenting venture dollars with less expensive capital, as long as it's done at the right time and under the right conditions. Start-ups today enjoy access to several additional types of financing.

Bank debt. Warren Buffet once said that taking on debt is like driving with a spike sticking out of your steering wheel ... no problem until you hit a bump in the road. In fact, substantial bank debt has no place on the balance sheet of an early stage company, and most bankers will tell you so. In a good year, banks make less than 15% on their money. They can ill afford even one portfolio loss and tend to get jittery when inevitable "start-up hiccups" occur. Their jitters can often make things worse. However, developing an early banking relationship with a modest line is not a bad idea as long as a few rules are followed: 1) deal only with banks that have a long and consistent history of high-tech lending, 2) deal only with banks that have established long-term symbiotic relationships with your venture capitalists, 3) don't borrow more than few months worth of revenue until you're solidly profitable, and 4) over-communicate with your loan officer. This way you'll have a banking relationship with someone who has a long-term business interest in your success, just like your venture investors.

Venture Leasing. This is a popular vehicle for leveraging an initial venture investment, particularly on the west coast. Many of these firms can provide a flexible array of services that allow you to devote your more expensive capital to people rather than computers and cubicles. Venture capitalists also like this vehicle because it helps improve their return on investment as well. Price is by no means the most important factor in choosing a venture debt firm. Ask for reference CEOs of difficult accounts to learn how the lender reacts in tough times. Talk with other portfolio CFOs to find out how flexible the firm is in accommodating special service needs. And again, rely on your venture board members to advise you concerning who has built a sustained reputation for patience in the start-up community.

Corporate Partners. Corporate investors represent a double-edged sword to small companies. They can bring great resources to bear. They can also impose ponderous decision-making processes on fragile start-up companies. Venture capitalists only have one agenda in their investing, the maximization of stock value. That happens to be the same agenda as the company's founders. Corporate investors usually have a more complex and less compatible agenda in mind such as a pipeline of technology or products, or access to key people. The people making the initial investment frequently change jobs and the relationship with the company can fall hostage to corporate politics.

Finally, a corporation focuses primarily on their own success. If that company's core business takes a sudden downturn, the relationship can suffer through no failure of performance on the part of the start-up. In our view, business relationships with large corporations (such as marketing or technology agreements) should stand on their own feet without the complication of an equity investment. The higher share price a corporate investor may pay frequently comes with hidden costs that more than offset the lower dilution. These investments make far more sense as the start-up matures into robust profitability.

Revenues. The least dilutive way to finance a company is with profits. Before raising capital, make sure you've done everything reasonable to control costs and increase revenues. If your income statement can't provide any more help, take a look at the balance sheet. There is hidden cash in old receivables - and if they're old because of unhappy customers, the company will need to resolve those problems before prospective investors begin their calls

How Do We Chart The Ideal Financing Course?
Financing start-ups is a craft, not a science. The company's performance, macroeconomic fluctuations, capital market fads, and serendipity each play a role in determining what the best course of action is at any time in a young company's growth. There are many right answers, and there is never a time to rest. The best CEOs are always selling their companies, always raising money. Financing a company, like starting a company, is an exercise in predicting the future. Consult your management team, consult your board, consult your attorney, consult your spouse, and finally consult your Ouija Board. But don't run out of cash.