You are about to pitch investors for your startup and here comes the big question: how much should you raise?
A common answer many would give is: as much as you can. Yet, in many cases, more is not necessarily better.
In this article we explain how you can assess the optimal amount you should raise, and why you should not raise too much either.
Debt vs. equity: 3 key differences
Debt and equity have very specific characteristics which make them very different financial instruments. It is very important to understand the major differences between the 2 so you can form better decisions when choosing which one is best for you.
1. Access to funds
Debt is by far the winner when it comes to the time & effort required to receive funds.
Indeed, it can take a few months to close an equity round, from the moment you reach to investors and the moment when you receive funds in your bank account. In comparison, some debt instruments can be approved within 24 hours (think revenue based financing for instance).
The level of commitment for the management team when fundraising should also be seriously considered. Raising equity usually requires going through numerous investors pitches and negotiations, as well as a few weeks to draft the investor presentation and prepare your financial model.
2. Control and ownership
Again, debt is the best instrument when considering control of your business. Like any other debt instrument (your mortgage for instance), venture debt does not give the bank or debt investors any ownership in your business.
If you can generate enough cash flows to support debt repayment interest (which we will see below), debt can support your growth whilst you keep full ownership of your startup. That means you keep control over voting rights and can make strategic decision without asking for shareholders’ approval.
Equity, in comparison, comes with strings attached. By raising equity you are selling part of your voting rights to investors: they own a share of your business. This is also known as dilution. This means you might have some limitations when taking strategic decisions, especially if you do not have a majority ownership (>50%).
Ownership also impact returns at exit. The lower your equity share in your startup, the less you will cash out when selling your business. Indeed, the sale proceeds will be divided according to the different share ownership percentages of all equity investors.
Repayment is the major con of debt which will very often define whether you should opt for one or the other.
Indeed, raising debt requires you to repay it in full over time. For startups, unlike other later-stage companies, debt repayment is usually amortised over a given period of time (unlike bullet repayment).
The downside of debt repayment also is the interest rate which comes with it. Cash interest rates can easily go up to 8-10% annually. You will have to generate enough cash flows to repay the principal and the interest.
That’s why, debt is rarely an option for most early-stage startups as they aren’t yet profitable. Instead, they opt for equity as it does not bring any cash flow constraints. With equity, the cash generated by your business can be spent in growth instead (hiring, marketing campaigns, product development, etc.).
Debt vs. equity: which one is best for you?
Choosing between debt and equity depends on a few factors:
- The stage in which your business is in (early vs. later stage)
- Your business model
Whilst you can have preferences when it comes to ownership, or access to funds as we have seen earlier, these 2 factors will dictate whether or not you can consider one or the other. Let’s dive in.
1. Which stage are you in?
As explained earlier, because it comes with repayment, you need significant positive cash flows to raise debt. Unfortunately, this isn’t the case for many startups. You might already be barely profitable, yet debt repayment would wipe out all the available cash flows you need to boost growth.
That’s why most early stage startups don’t have much of a choice: they raise money from equity investors.
2. What is your business model?
Some businesses generates more cash flows than others and/or require less upfront investment. These businesses will tend to raise debt whenever possible as they keep ownership and receive funds quicker.
Think ecommerce businesses: apart from building your online shop and buying some inventory, there isn’t much left to invest into before you start generating revenues and being profitable. Ecommerce businesses typically require less investment and can repay earlier: that is why they often opt for debt financing and keep full control of their business.
SaaS businesses are good candidates for debt financing too. Because subscription businesses can accurately estimate future revenues based on historical growth, debt investors are more comfortable investing knowing revenues and cash flows will likely increase in the future. This is commonly known as revenue-based financing: investors receive a certain percentage of future revenues in exchange for their investment.
How much should you raise?
Ideally, you should raise as much as you need to reach profitability, so that you will never have to raise again.
Unfortunately, most early stage startups cannot reach profitability only with one raise. This is especially true for early stage startups.
They usually do not reach profitability by the time their pre-seed and/or seed funding has been spent. Instead, they usually need to raise additional round(s) in the future to reach profitability, and finally return money back to investors.
That is why you should raise enough to meet specific milestone(s) you promised investors.
Investors are looking for return on investment. Yet, their investment will not necessarily bring any (cash) positive return by the time the current round is depleted.
That’s why early stage investors usually ask for certain targets when participating in your fundraising instead of profitability. These targets can be: a certain number of users, churn rate, revenue, etc.
The amount you should raise is the total Net Cash Burn until you get to the target you agreed on with investors. Net Cash Burn, as explained below, is the amount of money you will spend, net of potential revenues.
How long should your runway last?
We established that your fundraising will last until you meet a certain target. Still, investors will likely not wait more than 12-18 months for these targets to be met.
That is why, even if investors typically reinvest in the next funding round, they will share the risk with investors coming in at a later stage.
That is why most startups follow the 12-18 months runway as a rule of thumb for fundraising. In other words, you are fundraising the amount that gives you enough cash to fund the next 12-18 months of operations.
This 12-18 months window is a win-win situation. It gives founders ample room to realise their targets. In parallel it isn’t too long either for an investor to wait for them to realise.
How should you forecast Net Cash Burn?
The amount you will raise depends on the amount of cash you will ‘burn’ until you get to your target. This amount is commonly referred to as “Net Cash Burn”. It is net because you subtract any revenues you would generate from the Gross Cash Burn.
This amount is not a guess. It is the result of the financial plan you must build beforehand. This plan includes your expected revenues and expenses over the next 3 to 5 years (for early stage startups, 3 years is enough).
That way, you can clearly show to any investor how much you need to raise and why. Your projections need to be well thought, error-free (goes without saying) and based on realistic, nevertheless optimistic assumptions.
More is better than less
One last (very important) thing: always factor in a buffer (and an important one). We are all optimistic, all the more for our own ventures. Problem is, most often than not, things do not go as planned (for the worse, or the better). For instance, if you estimate a $1M net cash burn for 18 months runway to get to profitability, raise $1.25 – 1.5M instead.
A good rule of thumb is allowing a 25% – 50% buffer on top of your net cash burn. Get people’s advice: co-founders, employees, angel investors or even friends, strangers. You will be surprised how people think differently about your projections. Also, don’t underestimate people’s advice who aren’t necessarily investors as they potentially are your clients, and therefore the source of your revenue…
The more optimistic you are in your plan, the more buffer you should take into account. Raising $1M to get to profitability within 18 months with a bullish plan will very likely give you headaches when, 18 months or earlier, you will have to raise again.
Keep in mind: you are better off raising more than less. Still, you should not raise too much either. Let’s see together why that is in the next chapter.
Why should you not raise too much?
Many startup founders think more is always better. It is not. Raising too much can bring serious problems down the line. The 2 major problems of raising too much are:
In order to accommodate a large round, investors need to adjust your valuation accordingly.
Let’s use an example:
Say you raise $1.5M from an investor at a $1M pre-money valuation. This means you theoretically should sell 60% of your company’s shares to this investor. Your post money valuation is $2.5M, and the $1.5M raise represents 60% share equity.
Unless you are willing to leave 60% to an investor (which you likely will not as most rounds leave circa 20% of ownership to investors), you will have to set a higher ‘artificial’ valuation of your business so the percentage you sell to the investor is lower. Assuming you want to leave 20% instead, this means your pre-money valuation is not $1M but $6M!
Unfortunately, the inflated valuation you would have agreed on with your seed investor may put a lot of strain on a startup if things don’t go well. You will need to raise money again, and it will be very difficult to justify an increased valuation at that time.
The valuation at your next round will either be too expensive for existing investors to re-invest, or worse, will be adjusted downward. Indeed, you will have to re-evaluate your company so investors are willing to put money on the table again).
Let’s now use the same example but assume you need to raise again in the future. Growth has not been as expected, and you need to use the same $6M pre-money valuation. You need $5M Series A this time which means you are leaving 50% off the table to new Series A investors. Bad news: you only own 30% of your company now. You could have owned much more if you would have set a realistic valuation when raising your seed round.
For more information on the dilution impact of inflated valuations for early stage startups, see a great article from Techcrunch here.
The more money you raise, the more confident you feel. Inevitably, the more likely you are to misuse the money you raised.
Examples are legions: loss-making paid marketing campaigns, aggressive hiring plans, product development costs for useless features you would not include in your MVP, etc. For those who have been around (or remember), see here a New York Time article on the infamous Boo.com bankruptcy in 2000 which spent $185m in less than 18 months…
The lack of focus and misspending can cost you a lot, even the survival of your business. This usually is a vicious cycle, one simple example is hiring: the more and faster you hire, the less oversight and training your employees have, the more mistakes they make, the more it costs you eventually.
The amount you should raise, whether you are pre-seed or Series B simply is the amount of cash you are short of, factoring in revenues, to get to a given target (profitability for instance) which is inherently tied to a certain timeframe (18 months for instance).
This number is known as Net Cash Burn: it is the result of your financial projections you must build before pitching investors, and should never be a guess.
That’s why building a solid financial plan is key: you give investors confidence that you understand your financials. More importantly, you show investors you can achieve your plan.