Why should you raise funds?
Nowadays, startups are composed of a variety of sizes and teams, but they all have in common the need for scaling. To achieve that, the costs are much higher than what an individual would be able to cover on its own (outside of very few, lucky cases). Raising money from other means is, as such, an invaluable tool in the start-ups arsenal and one that must be careful with.
When should you start raising?
Basically, the answer depends on the company phase and needs.
- At the very inception, when one needs money to test an idea and develop initial MVP, the most common choice is FFF: Friends, Family, Fools. This is the riskiest phase, and professional investors try to avoid investing capitals under their management at that stages. This phase is usually known as “pre-seed” and the default fundraising choice is self-funds or funds from the relatives.
- After 6-12 months of initial development, once you have something in your hands (market validation, initial traction, MVP, team, or all the above), the best choice would be private angels and/or accelerators.
- Angels are usually wealthy individuals from corporate or venture domains; their investments are ranged from tens to hundreds of thousands of dollars. Our advice would be approaching Angels with an expertise in your ventures’ domain, e.g. if you are doing a telecommunications startup, reach to ex-VPs of top telecom corporations or entrepreneurs that exited from their telecom business.
- Accelerators are a great option to boost your startup. You can benefit from their reputation, facilities, connections with investors and customers, mentorship programs and more. Though we would advise to deeply explore their reputation and terms & conditions; some charge disproportionate amounts of equity vs services provided. We believe that 7% of a company is the maximum an accelerator should charge. Regarding their reputation, the best way to check it is by looking into the ratio between graduations and funds raised.
- As you graduate an accelerator or seal your first customer agreements, you become “seed” and it is about the right time to approach professional VC funds. The more traction and growth you have, the more attractive you will be in the eyes of a VC. Though first impressions are very important, in many cases you will be given a second chance if your revenues and their growth are not sufficient.
Our investment criteria include the presence of an MVP. Alongside an MVP, here at Sabra Capital we like to see signs of growth and adoption, for example a consistently growing user base since a product’s launch or high volume sales. This are always good indicators of a positive future for a start-up.
From the perspective of the average start-up, it’s always better to focus on product and customers development. Hence once you provide promising results, investors will find you themselves.
How much should you raise?
The amount that is necessary to be raised really depends on the scope of the company. The larger the team and the more ambitious the next funding milestone is, the highest the fund to be raised is. The correct amount really depends on how lean the leading figures in the start-up’s team are; the average cost of an employee ranges between $10k and $20k a month. If you multiply that value per the number of employees, and then the number of months you would need to reach your next funding milestone including 30% extra, you would have an approximate amount to be raised. Usually, that means a runway between 12 and 18 months depending on your needs. As a rule of thumb, pre-seed startups usually raise 6-figures rounds; seed $1-$3M and A stage $7-$10.
Keep in mind that it is always good practice to be able to weather future problems and raising some extra capital can help.
In every entrepreneur’s career comes a point in which they are asked how much their company is worth and the answer is never black and white. The process that leads to an answer starts from several estimations, but it is never set in stone and its always opinion and demand-based. What really ends up being the determining factor in a valuation is to what extent the investor agrees that the company can reach the degree of success presented in the pitch. However, it needs to be kept in mind that a higher valuation does not equate to a higher chance of success and vice versa – what the valuation does is set a baseline value to determine the price of shares.
As a rule of thumb, for software-based tech companies (not DeepTech):
- The pre-seed phase is rarely evaluated above $2M
- The Seed phase (MVP, first traction) is evaluated at about $5M
- The Late seed/Round A (Growth, revenues) are evaluated with the following formula: seed phase cost + (MRRx100). Hence, the faster the growth rate is, the higher the resulting valuation
The same company will be evaluated differently based on its location. The most expensive startups are in the valley. Another startup, selling the same product in the same territory, yet founded outside of the US will be valuated 15% to 40% less.
Also, it is important to remember, that high valuation might be problematic for the next rounds. In the future, you will raise again and will have to justify a valuation that is even higher!
The other part of the agreement between an investor and a start-up that needs to be brought forward is the type of financing itself, of which there are three common ones: convertible notes, SAFE agreements, and equity rounds.
Notes that are structured in the form of a loan. The start-up borrows a set amount of liquidity (principal amount) at an interest rate and with a maturity date for repayment. Usually, the idea associated with convertible notes is that they will be re-payed with equity come the next round of financing. This means that the value of the investment (if the company does not face a downward round) will be increasing based on the interest rate agreed on financing.
Associated with convertible notes comes also a Cap, which is the maximum valuation that the note can be paid back by the start-up alongside a possible discount in the next round, leading to a lower valuation of the startup for the investor in the next round. Mind that the cap is not a set valuation at the point of signature, but future expectations.
A simpler type of agreement that has replaced most convertible note agreements. It is essentially the same as the previous category, without a maturity date or interest rate. As such, the only three negotiable aspects of a Safe agreement include the cap (though it can be uncapped at all), the amount and the discount. This leads to shorter negotiation times.
The most common type of financing – but exceedingly rare for seed rounds. It consists of the start-up attaching a valuation to its operations and a per-share price. The company then issues a new set of shares to investors proportional to their investment, leading to a dilution of the share pool. This method is by far the most time-consuming and legally involved process and requires more resources from the start-up’s end. We always strongly recommend hiring a lawyer when new equity is issued.
The negotiation for an equity round does not end at an agreement on the valuation and investment amount: several other factors need to be considered. This includes, but are not limited to, option pools, liquidation preferences, anti-dilution rights and similia.
When it comes down to negotiating, one needs to consider that VCs are almost always more experienced than entrepreneurs and that they (almost always) have the best interest of the ecosystem and their reputation in mind. As such, the terms moved forward by VCs are fair most of the time – make sure you understand every minutia of the deal before rebuking. And remember: the VC you are talking to is almost guaranteed to have had more negotiations than yourself in the past, so take your time with every step but do not delay it to the point the deal falls through.
For cross-border negotiations, we strongly recommend working with a local representative to make sure that local mentality is considered for better results.
Overall, for every start-up founder that is planning to raise, we would recommend the following steps:
- Make sure you have assets (MVP, customers, team etc) and not only an idea
- Research the VC/angel you are approaching to make sure he will bring added value to your venture (smart money)
- Research the VC/angel you are approaching to make sure that your venture’s vertical and stage are in the scope of his investment criteria
- Have a plan for the use of the investment ironed out, with multiple options in case you fall short of your investment goal
- Have your deck, pitch and supporting documentation in tip-top shape
- Never lie in the pitch
- Close deals quickly, but assure yourself you understand all the terms of the deal fully