Most businesses need to raise external funding from investors to take their company to the next level. An early stage startup will want to access funds to help further validate its business proposition.
A more established business that already has traction may be looking for funding to help accelerate growth. Whatever stage your business is in, if you are seeking investment, determining how much funding you should raise is absolutely critical.
The dangers of raising too little
Incorrectly assessing your funding need has serious repercussions on your business. It will lead to inadequate validation of your proposition, or to executing growth initiatives that do not materially move the needle. Whatever the case, the business is left in limbo.
The net effect of raising too little funding is that the company runs out of money and all growth comes to a grinding halt. There will be limited options, and you are in an extremely poor negotiation position in front of the very few investors who may still be interested. Even if you are fortunate enough to get another bite at the cherry, you can bet the investment terms will be so onerous that you will be left wondering what you are fighting for.
Raising funding is time-consuming, distracting, and expensive. The consequence of getting it wrong the first time around is that you may not have a second chance.
The dangers of raising too much
So, raising more funds than are needed is the right approach to take, right? Not necessarily. Just as raising too little is risky, raising too much funding is fraught with its own dangers.
The primary issue is a technical one. Any investor will put their valuation on your business based on a number of factors, including looking at important metrics for your business, patents, or assets. But raising too much money will cause the valuation to increase. For the sake of illustration, lets explain through a very simple example.
Let’s say the valuation an investor puts on your business is $2 million. Now, if you only needed $2 million of new funding, the investor would receive 50 percent equity. If the new funding increases to $3 million, however, they would have a 60 percent equity stake on the same valuation. Consequently, in order to maintain a 50 percent equity position when raising $3 million, the valuation of the business will have to increase from $2 million to $3 million.
A higher valuation for your business leads to greater expectations. Receiving more funding often means more due diligence and having to accept higher control provisions from investors. Further, an investor expects you to create value with every dollar they put into the business. This will put more pressure on you to identify additional value sources. A greater step change would be expected from levels of performance the business has been demonstrating to date.
The urge to spend
A more psychological issue arising from raising too much funding is the inclination to spend it just because you have it. You hire more staff than you need, become inefficient with operations, or move to bigger offices.
Operating lean should be the mantra of all businesses. The temptation to spend the extra money you have can result in you burning through a large amount of cash with a disproportionate amount of progress and value to show for it. This would also make it harder, and definitely more arduous to raise later funding rounds.
Should you ever raise more than you need?
Before any fundraising, it is important to set out what your parameters are for things like valuation (hence dilution), and terms that you would deem okay, versus those that you would consider as being too much from an investor.
The only reason you should raise more money than is needed is if you get it on terms that sit within your pre-defined parameters, and it is a deal that you would have been happy to do at the outset. Then, the only other thing you need to do is curb your enthusiasm to spend, spend, spend, and be sure to enforce the lean practices you started with.
So how can you correctly estimate what the funding need for your business should be? Initially, you should get an accurate view of the current cash position. Then, based on actual historic performance, assess what your monthly cash burn is.
Understanding your month-on-month cash burn and identifying the variables that affect this will give you a much better grasp of your business. It will also allow you to have a better understanding of the levers you can pull to extend your runway when things get tight.
Next, you must map out key milestones for the business over the next 12 to 24 months. Exactly what the milestones are will depend on your business. They could be making a senior hire, developing your product, or achieving a certain number of users for your product.
Whatever the milestone, it needs to be tangible and quantifiable. It also needs to be something that aligns with your strategy and should demonstrate how it will create additional value in the business.
At this point, you will:
- Review your forecast projections with these milestones factored in, to understand cash need in the business over a reasonable time period, say 24 months
- Add to this additional costs to run the business over the time you expect it would take to raise funds (given investor relationships you have and the feedback you have had from investors previously to approach for funding)
- Add a sensible contingency—this gives you breathing space if things go wrong
The resultant number from one, two, and three is the minimum funding you need to raise from investors.
If you are able to raise a higher amount and remain in the funding parameters you have set yourself, then it makes sense to raise more—but you’ll need to continue enforcing lean operations.
However, if the higher funding comes at costs that impact your investment parameters, it would be wiser for the long term to raise the minimum estimated.
Justifying need to investors
Investors appreciate entrepreneurs who handle their money with responsibility and respect. So, they will appreciate the approach you have taken to safeguard their interest.
Their key concern is in you maximizing value through any incremental increase in investment. Consequently, if you can talk in these terms to justify your funding, and support this with the responsible approach you have taken above, investors are more likely to be convinced.
At the end of the day, as an entrepreneur, you need to assess and balance the right funding need. While you don’t want to over-burden the company with the constraints of too much funding, you will need to ensure that the business doesn’t succumb to the threat all businesses face—running out of money.