Raising a seed round for your startup is an exciting time. You have enough traction that you feel that your business, something that was just an idea not too long ago, is something worth a sizable investment. Raising money is also an uneasy time. While the investment is needed along with the mentorship that might come with it, it can be an extremely distracting process. Your fledgling company needs you fully focused at all times, make sure you're not wasting your time or the investors if your startup is not ready to raise money. Here are the top things that an investor is going to want to know. Make sure you know the answers before they ask.
What level of involvement is required?
The level of involvement that goes along with investing in a startup directly corresponds to the type of investment. For example, someone who invests in a startup through a venture capital firm, for instance, will probably have limited interaction with the team that runs the startup. An angel investor might be heavily involved as a mentor.
With any investment, the investor is granted an equity stake in the company which means they have the opportunity to participate in decision-making, alongside the startup's leadership. Ultimately, it's important to be clear on how much or how little involvement you'd like as part of the investment. Make sure everyone is on the same page before you decide who you want to partner with.
Would I start a company with them?
This question forces investors to think about the quality of the people as well as the founder dynamics. When sitting across from a team of founders a potential investor will ask themselves “Would I join them?” In this context, they're not thinking like an investor or a leader, but rather like a prospective employee. Trying to understand their character, their values, their capabilities, and their passions.
Why am I considering this investment?
Beware of the once burnt, twice shy investor. The romance of venture investing fades rapidly against a backdrop of investor cash calls, poor results, overly optimistic projections, and unmotivated management, just to name a few. In all cases, the full amount of a venture investment is susceptible to being lost. Security over assets (such as land, buildings, and equipment) is often granted to a financial institution to cover loans. This means those assets are not available to secure the venture investment. If a venture's assets are liquidated in the future investors are entitled to receive a return of their capital, but only after priority ranking creditors are paid. In reality, there is seldom enough cash to go around, leaving investors on the short end of the stick.
Who's on your team?
Investors are strong believers in the super ability of teams to make magic happen. They'll ask you about the other folks that have believed in your vision and have decided to join your startup team. Don’t choose to add a co-founder for the sake of investors, but it says a lot if you’ve managed to share the creation of your dream with another person. It says a lot about your leadership potential.
Do I understand this business?
This is the raw basic question you need to have the answer for. If an investor doesn't understand your business they are not going to invest. You know the ins and outs of your startup like the back of your hand. Just make sure you are making your pitch simple enough that investors can understand your business like you do.
Is there a co-founder who is no longer active and needs to be bought-out?
Hopefully, you have a buyout plan already in place in your shareholder agreement now that you have a shareholder that you would like to part ways with. You should evaluate the total value of your business (100% of the shares) and determine what the value is of the passive co-founder's holdings. Once you have an idea about the value of their holding, you should be able to figure out a reasonable offer, and in so making a reasonable offer you can find out if they are willing to sell.
What problem does your product solve?
The vast majority of new business ideas are just that, ideas. Entrepreneurs dream up solutions to problems that do not exist, or rather only exist because of a personal need or experience. They then assume everyone else has the same problem. While your business idea may be amazing, if it is not solving a problem for others, nobody else will want it and no investors will want to invest in it. To demonstrate need, you must have market research, which you can start by surveying as many potential clients as possible.
Why are you raising money to begin with?
The best reason to raise money is because you know your audience, you’ve found a problem that needs solving, and you have a growing base of paying customers who want what you’re building. Raising money in this situation is a matter of scale, it allows you to do things you couldn’t do otherwise, like hire people to help you scale faster.
How does your company make money?
You’d be surprised at how difficult it can be for many entrepreneurs to answer this question. But whether you’re a tech, food, product, or service entrepreneur, you have to be able to explain how much it costs to produce your product or service, how much you’re selling it for, and how much is left over for profit.
Are you an attractive investment?
Not all businesses are attractive to venture capital investors. Before you set out on the fundraising trail, make sure you have a business that is venture friendly. Investing in startups is risky so venture capitalists are looking for outsized returns on each of their investments to make up for the 90% of startups that do not. For early stage VCs, every investment needs to have the potential to return the entire portfolio, the desired return is at least 10 times their investment. To provide those returns, your business must have the potential to scale exponentially.
Besides looking for large returns, your investors will want to see those returns on a short timeline of five to ten years. Most VC funds are set up to have a 10-year lifespan, the first three years are spent investing the fund, and the final seven years are spent harvesting returns to investors. The point in a fund’s lifecycle at which you received investment will determine how soon the fund will expect to see a return.
To attract investment, you also need to have already proven yourself by building an initial product and by showing proven customer demand. Early product development is cheaper and faster than ever before. Even early prototypes for hardware products can be created with little outside capital. Having an initial product is now a minimum requirement for most investors.
How much funding should you raise?
You should raise as much money as you need to reach profitability so that you’ll never have to raise money again. If you succeed in this, not only will you find it easier to raise money in the future, you’ll be able to survive without new funding if the funding environment gets tight. That said, many startups will need follow-up rounds, especially hardware startups. The goal should be to raise as much money as needed to get to their next milestone, which will usually be approximately 18 months later.
In choosing how much to raise you are trading off several variables, including how much progress that amount of money will purchase, credibility with investors, and dilution. If you can manage to give up as little as 10% of your company in your seed round, that's ideal, but most rounds will require up to 20% dilution and you should try to avoid more than 25%. The amount you are asking for must be tied to a solid plan. That plan will buy you the credibility necessary to persuade investors that their money will have a chance to grow. It is usually a good idea to create multiple plans assuming different amounts raised and to articulate your belief that the company will be successful whether you raise the full amount or not. The difference will be how fast you can grow.
One way to look at the optimal amount to raise in your first round is to decide how many months of operation you want to fund. A rule of thumb is that an engineer (the most common early employee for startups) costs about $15K per month. If you would like to be funded for 18 months of operations with an average of five engineers, then you will need about $1.35M.
Early raises usually range from a few hundred thousand dollars up to two million. Most first rounds seem to cluster around six hundred thousand dollars, but largely thanks to increased interest from investors in seed rounds, these rounds have been increasing in size over the last several years.
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