It’s tempting to raise money when you have a brilliant idea that’s a little out of budget.
But are you really ready to look for funding and bring new partners on board?
Let’s look at the five milestones every start-up should consider before raising funds.
Product-market fit is that “magical moment where your customers become your biggest salespeople”. It’s the first thing you need before seeking investors as it forms the foundation of your investor pitch and fundraising strategy.
If you haven’t found a good fit yet, you simply won’t be able to raise enough money.
When you’ve achieved product-market fit, money rolls in, you attract considerable investor interest and your customers are genuinely excited about your product.
If you haven’t reached it yet, there won’t be much investor interest and it will cost you a lot more to find customers.
But of course, this is a somewhat subjective description of product-market fit. And investors don’t care too much about feelings. They want proof.
The usual method to measure product-market fit is through a customer survey known as the Sean Ellis test, named after entrepreneur, angel investor and start-up advisor Sean Ellis.
This test is pretty simple. Ask your customers the following question:
How would you feel if you could no longer use (this product)?
Let participants answer with one of these multiple-choice responses:
1. Very disappointed
2. Somewhat disappointed
3. Not disappointed (it isn’t that useful)
4. N/A – I no longer use (product)
You want to see at least 40% of current customers responding “Very disappointed” if they can’t use your product or service any longer. Any percentage below that means you have some work to do.
1. Sustained growth: You see evident, sustained growth for your company.
2. Positive feedback: Customers recommend your product to other people in your target industry.
Finally, observe your business performance. While using a survey gauges your customer’s dependency and excitement for your product, it doesn’t validate actual product-market fit. Look at your company’s growth trends and feedback.
If you constantly have to question if you’ve achieved product-market fit, you may not have it.
Make sure you have enough cash reserves to look for funding without having to worry about paying the bills next month and the months after.
Start-up runway is the total number of months your start-up can stay in business before running out of money if its income and expenses remain the same.
At a minimum, you should have 8-12 months of financial runway before raising money. However, a 2017 analysis of venture capitalist data by Sebastian Quintero suggests start-up founders should aim for a bigger buffer.
Quintero summarised his findings in this table.
He recommends start-ups have at least 18 to 21 months of runway, depending on their fundraising stage.
Ultimately, the right amount of funding buffer depends on multiple other factors like your business model, product and other revenue sources. If you’re unsure, it’s better to err on the conservative side to ensure your start-up stays afloat.
Tip: If you’re raising a Series A round or beyond, prepare for additional out-of-pocket expenses associated with raising funds: Engaging professional services like lawyers, tax advisors and accountants costs an average of 5% of the total funding amount.
To calculate your runway, you need your startup’s income and expenses for the past months or years.
A simple formula for startup runway
Current cash balance / monthly or yearly burn rate
Here’s an example of how to calculate it step-by-step.
1. Know your starting cash balance: Money at the start of April 2020: 368.000 USD
2. Know your ending cash balance: Money at the end of April 2021: 156.000 USD
3. Calculate your net burn rate: Your net burn rate is how much money you lose per month after considering income and expenses.
Text callout: Use the formula: (starting cash balance) - (ending cash balance) ÷ number of months.
(368.000 USD - 156.000USD ) ÷ 12 = 17.667 USD (quote)
4. Now, you can calculate your start-up runway. Take your current cash balance calculated in Step 2 and divide this by your average burn rate.
156.000 USD ÷ 17.667 USD = 8.8 months (quote)
This means you have about eight to nine months of runway.
While raising capital, you’ll get a lot of questions, and you’ll need to be extremely well-prepared if you want to make fundraising a success. Clarify your ideas on these five topics.
1. Why are you raising funds?
2. Who are you raising funds from?
3. How much are you raising?
4. When are you raising funds?
5. What will you do to raise funds?
The main reason to look for funding is to grow your company. But this is the same for all start-ups. So how will you differentiate yourself?
Think about how the investment will help your business capitalise on its growth. Are you looking to hire new talent, invest in product development, expand into a new market or achieve profitability?
Avoid raising money too early
Bringing external investors onboard has its disadvantages. You lose equity and decision-making power. Your investor becomes your business partner who may have a different vision for your company.
Besides, if you can grow your business a bit longer on your own, you’ll be able to raise more capital when you finally decide to look for funding.
There are multiple methods of start-up funding. Are you looking for friends and family with money on the side? Starting with an angel investor? Or are you aiming directly for venture capitalist (VC) funding?
Consider building a comprehensive fundraising strategy with current and future plans before reaching out to investors.
If you wish to get external investors involved, make sure they’re the right fit for your business. Look at factors like the size of the investment, geography and target industries.
It’s a rookie mistake to start looking for funds without knowing how much you need.
Here are three ways to figure out how much you should ask.
Your monthly burn rate is how much you spend each month to stay in business.
On average, your next fundable milestone is in 12-18 months, but you need to include 6 months of extra buffer for unexpected costs and marketing funds.
So based on this method, you’ll need enough money to cover about 24 months of expenses.
But don’t forget that costs will probably increase as your business grows.
Taking your business to the next level may require a serious investment. In some cases, it’s not just about keeping the business running for another two years but about adding new assets too. So be sure to include costs for hiring, research, acquiring new physical locations and other operational needs.
The valuation process analyses your business on operational and strategic levels to create assumptions about your future earnings and growth rates.
Why is this important to get funding?
The funding deal usually works two ways: You get capital, but the investor gets equity. Your valuation is essential to determine how much money you deserve and how much equity the investor should get in return.
If you’re unsure how to calculate your start-up’s value, use the development stage valuation approach to get a quick target valuation without delving into complex calculations.
The typical start-up fundraising process takes about three to six months and often a little extra to sort out due diligence, legal agreements and other paperwork. Start in time so you can close the deal before you run out of money.
Think like a project manager and build a tracker to measure your progress. It should clearly outline the names of your target investors, points of contact and dates of your planned outreach/meetings. Review this regularly to update where you’re at with each target investor.
For later-stage funding efforts, you’ll need to prepare documentation for your investors. Examples include:
Raising capital takes longer than you’d expect. You’ll need to run your business while approaching investors, pitching and doing paperwork. It’s more than a full-time commitment.
Prioritise your company over investors. If you have a co-founder, discuss a temporary handover of operational duties so one can focus on raising capital. Prioritise business success and keep your company moving while you seek funding.
When you keep growing the company during your investor outreach process, it will increase your attractiveness and benefit your investor conversations.
The best time to seek funding is when you’re seeing incredible business growth. You want to present your start-up as a substantial investment opportunity.
On top of product-market fit, find and gather data points that will get your investors excited about your business.
These are some of the metrics and tools to look for:
1. Growth rates like the number of sign-ups or downloads
2. Revenue numbers
3. Customer testimonials
4. Achievements: essential product launches or note-worthy milestones
Investors will expect to see associated progress based on the following factors:
Raising capital is a substantial step for any start-up, so set aside sufficient time to analyse your business and make sure you’re ready to look for funding.
When you’ve met these five milestones, your chances of success dramatically increase.
1. Product-market fit: Make sure there’s ample demand.
2. Clear objectives: Know why you look for funding.
3. Sufficient financial runway: Have enough resources to stay afloat while seeking funding.
4. Time to raise capital: Be ready for a long-term commitment.
5. Strong business traction: Show your business is a worthy investment.