Tips for Optimizing your Startup Financing Strategy
January 4, 2014
This post aims to help startup CEOs optimize their funding strategy by examining how investors value startups, and explaining how to avoid the common cash management pitfalls.
(Note: The concepts in this post will likely be obvious to experienced CEOs and entrepreneurs. Despite that, our experience indicates that entrepreneurs frequently make costly, avoidable mistakes with their financing strategy. Explicitly thinking it through may be of help.)
Every smart CEO knows that they need to focus on building a compelling product, hiring a great team, maximizing sales and making their customers happy. For many first time CEOs focusing on these extremely important topics may distract them from another very important task: making sure that the company can continue to raise funding at ever increasing valuations.
In practice this means that the CEO should:
Make sure that they understand when their cash runs out
Understand what milestones have to be achieved before then to get a higher valuation
Create the right plan to achieve those milestones in the right timeframe
UNDERSTAND HOW STARTUPS ARE VALUED.
Managing to your cash out date introduces some very strict time deadlines into the equation, and requires you to examine which specific milestones you plan to achieve before that date.
To understand why milestones are so important, let’s take a look at how startup valuations change over time. First time entrepreneurs should be forgiven for thinking that their valuation will just increase linearly over time since their last round. After all, they have been putting in a ton of late nights and weekends working to make progress. However in practice, things typically don’t work that way:
Like other investments, startup valuations are based on a calculation of risk and reward. Valuations increase as the level of risk goes down (or as the size of the perceived eventual reward goes up). In practice, risk is not reduced linearly over time, but instead changes in big increments when particular milestones are reached. These milestones could be things like customer traction; the hiring of a strong management team; or in the case of an internet business, when a monetization strategy is proven to work.
THE MOST IMPORTANT MILESTONE CUSTOMER TRACTION
Usually the single biggest way to show that risk is being reduced is to show evidence of increasing traction with paying customers. If a significant number of customers are willing to pay for a product, that tells an investor many positive things:
The company has reached product/market fit
The monetization strategy is working
The technology works
The team has shown some ability to execute
However this can be a hard milestone to reach on one round of funding, so investors will look for intermediate milestones that help to tell them that risk is being reduced. Here are some steps along the way to full customer traction that increasingly de-risk a startup:
You have shown a wireframe mockup of the application to a significant number of customers and they are willing to talk to investors and tell them that they plan to buy the product when it ships.
You have shipped a beta of the product to some customers
Your beta customers are testing the product and reporting success
You have a large number of free users, and their engagement with the product is high
You have sold the product to a small number of paying customers
Your paying customers have put the product into production usage, and are reporting success
Your customers are coming back and re-ordering, and recommending the product to their friends
will know that I like to think of the lifecycle of a startup in three phases. The first phase is the search for product/market fit. Increasing customer traction is the best way to prove to investors that you have reached product/market fit. The second phase is the search for a repeatable and scalable sales model. Reaching this milestone will greatly increase valuation, and attract growth stage investors who like to invest in companies that are ready to scale.