Every good entrepreneur has a clear business strategy. Most likely, he has also spent a lot of time thinking about his Go To Market (GTM) strategy and how to best acquire customers. Some even go as far as having an HR strategy for when and how they recruit senior executives. The one thing that is often missing is the Financing Strategy. Financing your company should not be an afterthought (“let’s see if we can get this financed now”) or something that “just happens” to the company.
Financing rounds are among the most important milestones of a startup’s life and should be taken seriously. Moreover, the best entrepreneurs think way in advance on their financing strategy and make sure it is aligned with the business traction, GTM approach, product roadmap and hiring plans. If there is one thing you should take away from this post it is that you always want to raise capital AFTER you hit an inflection point in the company’s life. The amount you raise should be at least enough to hit an “accretive milestone” which allows to raise the next round of financing at a significant step up in valuation. This will help ensure you don’t go through the pain of down rounds and that you don’t have to rely on your existing investors to keep bridging the company towards the next real financing round.
So what is an “accretive milestone”? It is a milestone that reduces a risk factor which is associated with your startup. This can be proving the technology works for technology-intensive startups, showing that you can generate real “traction” for internet companies (there is a big difference between real traction and fake one but that’s a topic for another blog post), finding a scalable GTM model, or even getting your first paying customer. Each one of these milestones can show that you have made major progress toward eliminating a risk factor: Whether technology risk, product/market fit risk or the customer acquisition risk.
Raising too little capital creates a situation where you don’t have enough runway to make sufficient progress until your next financing round. Therefore, you are not able to sufficiently “de-risk” the company and attract higher valuations from a credible investor. Raising too much capital means that you have taken too much dilution since you could have raised some of the capital later at a higher valuation. Even worse, it most likely will result in you burning more money than you should in that point of time.
To make it a bit more clear, below are a two simplified real-life examples of bad financing strategies I have recently seen (names are made up):
AlmeraTech has a sophisticated software product which is built for very large customers with average deal size of $0.5M-$2M. The company has raised $1.5M through a convertible note to develop the product. AlmeraTech now has some small non-paying beta customers and is about to start three POCs with potential customers. The company had no problem securing these POCs and the CEO is extremely optimistic that they will convert at least one of these POCs into a paying customer within 3 months. The convertible note they have raised matures in 2 months so the company decided to raise the series A round beforehand.
This is an example of letting your financing strategy be driven by artificial milestones such as loan maturity date instead of real milestones such as winning a large paying customer. What the CEO should have done is go back to the seed investors and convince them to extend the maturity date (which is why you always want to ensure you have smart investors, including in seed rounds).
Binary Works sells SMB software and has very quickly crossed the $500K Annual Run Rate (ARR). The company is sure they have found a product/market fit and that there is real demand for the product. Most of the existing customers came from inbound marketing mainly driven from a few large PR announcements and the founders’ personal relationship. The company has decided it is time to step on the gas and build an inside sales team that will target SMBs. They are raising $8M to achieve this.
Most people who have seen SMB software plays before know that the main challenge with SMB software is the GTM model. You need to find an efficient approach to acquire customers that generate relatively low revenue and frequently churn. While the company has some good initial traction, Binary Works so far hasn’t been able to prove that they have nailed the GTM model and therefore raising a large amount is not smart. Most likely they will just burn through the money while trying to figure out that model.
The second aspect of a good financing strategy is who you raise capital from. This can be institutional investors, strategic investors, wealthy individuals, micro-VCs etc. But this will be discussed in my next blog post as it deserves a post of its own.