This phase is all about positioning your company well before starting to raise funds. We will focus on the things that are most important to investors, and on short-term improvements that can make a real difference. Depending on where you stand, this phase can be immediately skipped or take months of hard work.
Is a conventional financing round the right thing?
Depending on your company stage, industry and location there may be alternative ways to a conventional startup financing round. Here are some to consider:
Building a successful tech company usually requires massive funding. However, there are many great companies that have never raised any equity. If you have a product that generates healthy revenues and margins already now – or if you can add consulting or other revenues – this may be an option.
Once you see strong traction you can still decide to go for equity financing at a later stage. Here is a good article comparing the different options for SaaS businesses.
Some accelerators such as YC provide some (pre-seed) funding. They also provide insights how to raise money. Applying at an accelerator may be an attractive option especially if you are a first time founder with an early stage startup.
Try to walk into a bank and ask them for debt: In most cases they will throw you out before you have told them your name. But while debt is not really an option for early stage tech companies, there are exceptions. If you have substantial accounts receivable (which you probably don’t) you could go for factoring. If you have “hard assets” such as production facilities (which you probably don’t) you may qualify for a loan.
And once you are generating substantial revenues and are getting closer to profitability, banks will start rolling-out the red carpet for you.
Unlike conventional banks, venture debt companies understand the needs of startups. Plus, they are much less risk-averse. Having said this, venture debt is usually only done in context with equity rounds: You may get USD 10m if a renowned VC invests USD 20m.
Additionally it may be an option in later stage financing. Be aware that unlike in the case of equity, the money needs to be paid back. This can lead to severe issues in upcoming rounds: new investors will want to invest into the future rather than paying back credits. So venture debt should be used very carefully – e.g. in situations where you are close to reaching a value inflection point or break-even.
This is an interesting one! Considering that most governments understand the importance of innovation, there are massive public funds available for tech startups. Besides that and especially in certain areas (e.g., healthcare) or in certain geographies (e.g., developing countries) you have the option to get financing from foundations and NGOs. Check whether this is possible. Most often you can try to get such funds in parallel with equity financing.
If your startup is using the blockchain you can consider raising funds via crypto currencies. While the ICO-hype is definitely over (some high-level bankruptcies have shown that the fundamentals of an ICO should not be any different from conventional equity investing), an ecosystem with solid regulations is currently been created. Professional investors may invest via a SAFT (Simple Agreement for Future Tokens). Discuss the feasibility of such instruments with an experienced lawyer to make sure you don’t close the possibility for conventional equity financing or an exit in the future.
Don’t laugh! It is true that you will need a valuation of at least a few hundred million USD to do a Nasdaq-IPO. However, there is a number of stock exchanges around the world where it is possible to IPO with a valuation as low as USD 10m. While most often this does not make sense, it is an option to keep in mind. Further information can be found here.
Make sure your runway is long enough
Most entrepreneurs start funding rounds too late: You should have a runway of at least 9 months when you start a financing round – ideally 12 months.
The more money you have the higher your flexibility, and the stronger your negotiation power towards investors. The message “We are going to make this a success in any case. But with further financing we could accelerate growth” will resonate much better with investors than “We can’t pay salaries anymore in three months and urgently need money”.
So the first thing to do is make sure that you have an up to day cash flow statement. A template for such a document – including our opinion about startup finance in general – can be found here. Be on the conservative side at this stage, and don’t include any assumptions you are not convinced will happen.
The runway has an impact on your fundraising timeline:
- 9+ months: Great! You have plenty of time to position your company optimally for an upcoming fundraise. Take your time for the steps below, and kick your round off at an ideal time slot: In the Western world this is typically January (with the objective to close the round well ahead of the Summer break) or in August (with the objective to close before Christmas). Note: It can be frustrating if the final phase of your fundraising falls into a major holiday season, as investors are out of office / not able to take the needed decisions.
- 6-8 months: Good! Follow the process described here, and you will make this a success. Make sure you move forward efficiently.
- 4 or 5 months: Hmm … things can become very tight. If the fundraising process is going well – especially if you have high growth rates – you should be ok. But be aware that you are on a risky path: One mistake could mean that your company goes bust, or that you need to accept terrible funding terms.
- 3 months or less: You are in trouble. Don’t follow the process described on this website. Basically there are two options: You talk to a handful of (existing) investors who know your company well, and may be willing to support (they will typically propose to do a bridge round). Or you radically cut your cost to survive without external financing. Note: Cutting cost and at the same time going for a financing round usually does not work, as cutting cost reduces traction (you will have less people and/or less marketing budget). And traction is what investors want to see.
Prevent gaps in your team
The four most important points for investors are team, product, market and traction. Let’s start with the team.
You have heard it before – early stage investment is all about the team. Considering that pivoting is frequent at this stage, investors will rather put their money into a great team with a mediocre project than into a mediocre team with a great project.
But while all entrepreneurs agree that the team is crucial, most startups are terrible at team building. This starts from the very beginning, with most founder teams severely lacking diversity. And it continues once the team starts to grow, with many hires being erratic and unambitious.
Here is the question you should answer: Would an investor rank your team among the best if she compares it with the other 100 startups in her pipeline?
A “great team” is specific to your company stage and strategy. If you want to launch an innovative medical device in Germany you will want to have at least a great CTO, CMO and COO. A CFO with IPO experience is not (yet) needed. And all the best advisors, board members, consultants and distributors in the world will not make up for the three positions mentioned.
If a key person is missing you need to react asap. Telling investors that you will hire them once you have the money is not the right strategy: If potential candidates are not up to taking some risks and buying into your vision before the funding round closes they are not the right fit afterwards either.
As with any hires, here is the high-level process you will want to follow:
- Be highly ambitious: You will only conquer the world with the very best people
- Consider doing a global search: Physical location is getting less and less important. Covid has shown that virtual teams can be as efficient. If you are open regarding location, your talent pool typically increases dramatically.
- Run a great recruiting process: You want to get 100+ qualified applications, do 15 minute calls with the top 10, run in-depth interviews incl. case studies with the top 3-5, and take a considerate final decision.
- Remuneration: You will most probably not be able to pay competitive cash salaries. But you can (and should!) be generous in terms of ESOP. If you don’t have one yet you will create it in Phase 5.
We feel that the hiring process should be run by the CEO and not by an executive search company (administrative support from a recruiter during fast growth phases is ok, and of course also support from your HR department if you have one). After all, hiring great talent needs to be a core competence of any ambitious startup.
Create excitement around your product
Nothing is more powerful for fundraising than a great live-demo of your product.
Unless you are building a biotech company or a nuclear fusion reactor you should try to have a demo product. Go for a 3D print, a beta-version or at least a solid animation if you are in development stage. And of course your real product if it is on the market.
Try to look at your demo from the investor’s angle: Is there a way that could really excite them? Can you showcase a product feature that is directly relevant for them? Structure the demo in a way that the benefit immediately becomes clear?
If your product is on the market you need to be ready to discuss product/market fit. There are various ways to evaluate whether you have it – with NPS probably being one of the key concepts to measure it in a structured way: How likely are your customers to tell others about it? Another concept is asking your customer how disappointed they would be if they had to stop using the product: You want 40% of them to say “very disappointed” (here is a great article with more details).
Unlike customer reviews, which you want to actively influence, it is in your best interest to measure NPS or “disappointment score” as transparently as possible.
Whatever instruments you use to evaluate product/market fit, sophisticated investors will want to understand how you think about it, where you stand, and what you do to further improve.
Demonstrate that your market is attractive
Investors love large, growing markets. However, there is no such thing as “the market” in practice: It is dependent on your definition and assumptions. To get this right it is important to have a realistic view of your TAM, SAM and SOM.
Start with your TAM: It should be USD 1bn+ to attract renowned investors. The ideal case is to have a renowned source which you can quote, highlighting that the specific market you address is very large.
Unfortunately, in many cases such a source does not exist. Say you are developing a drone to inspect bridges. Most probably you will need to come up with your own bottom-up calculations to come up with a market size in one country – ideally backed by an expert in a road traffic authority. Then you extrapolate to a global figure.
Great if you can show with some credible data that your specific market is growing (annual growth of 3% is good, 10% would be fantastic).
Obviously you will break down TAM into SAM and SOM. But this will be done in Phase 3. For the time being it is important to have a good understanding of your TAM.
Make sure you have "traction"
Investors want to see traction – and rightly so: An idea itself is not worth much. It is the execution that creates the value. Traction is a proxy for the speed of execution. If you want to create a valuable company you better be good at execution.
But what kind of “traction” is it that investors want to see?
The most powerful traction is revenue that is growing from month to month. If this is the case you should not have much trouble finding interested investors. At least not if your valuation, marketing cost and NPS are reasonable. If you don’t have revenue growth you will need to work very hard to get there, as getting financing is very tough in such a situation.
If your company is pre-revenue you may show alternatively metrics such as unique monthly visitors, MAUs, DAUs, retention, clinical studies or any other milestones relevant to your business.
Fundraising with traction is so much easier. Or put differently: You can have the best story in the world – if your numbers don’t look promising it will be very tough to close a financing round.
One of the best resources to learn what kind of traction is relevant in what company stage is Reid Hoffman’s “blitzscaling” class at Stanford.
Be visible for investors
The best investors in the world go out to companies proactively, rather than waiting for them to reach out. They have investment theses (e.g., “Healthcare is going to be digitalized over the next decade”, or “Future logistics will be based on blockchain technologies” or “The number of people going vegan will increase massively”). They have teams researching the most innovative technologies and companies in these spaces, and make sure that they are part of a number of winning teams that fit their thesis.
Many founders on the other hand are afraid of too much market exposure, especially in early stage. Be it because they are afraid of getting on the radar of competitors, or that they are afraid that their product is not ready for prime time yet. How wrong. You need to start building market exposure early on, and never stop doing this. You want to be quoted in the TechCrunch articles about your industry, be part of the key market reports written by Gartner, Forrester, Business Insider and the like, and be invited as a speaker at the leading conferences in your space. This is not something you do over night, but a product of constant work over time.
Being on the radar as an innovation leader within your industry is crucial, and makes fundraising much easier. And it will be the basis for a successful exit – whether you go for an IPO or a trade sale.
Define organizational responsibilities
For early stage companies there is only one right answer – the CEO. In case you are several co-founders with different roles you will need to decide who takes the lead. Ideally, the co-founder who is responsible is also the CEO or Co-CEO.
(Note: In later stage the CFO or an advisor may drive the process, and only involve the CEO in key meetings.)
We strongly suggest to have one person (typically the CEO and/or one Co-Founder) be fully responsible for raising the round, and keep all other team members out of it. Obviously many investors like to meet all founders / the entire (executive) team, but you don’t have the capacity to do this. You may at best bring them to a call or meeting as a last step before they sign the term sheet.
Expect that fundraising will take at least 50% of the CEO’s time over a time period of six months.
Many early stage teams where the CEO is still driving many key projects herself are in trouble if she starts spending the majority of her time on fundraising. Growth/traction decreases – exactly in a time where this is of highest importance to make the funding happen.
So make sure that you actively talk about the organizational setup in the exec team. Fundraising should be the CEOs key OKR/objective during two quarters, and there is only limited time for other projects. Make sure you have a strong team besides the CEO, and that you keep performing!
Make sure you have an experienced lawyer
While the first legal tasks (company foundation, standard work contracts etc) are simple and can be done by any lawyer, things start to get more challenging once you do financing rounds: Drafting shareholders’ agreements, incentive schemes for employees etc. that don’t backfire in later financing rounds is complex.
So you definitely want to have a lawyer on your side who is experienced with startup financing rounds.
How do you select a great lawyer if you don’t have one yet?
- Step 1: Ask a few entrepreneurs or investors in your ecosystem with which lawyer they work. Check their website and shortlist 3 lawyers where you see the best match.
- Step 2: Setup 30 minute video calls with these three lawyers, and make sure you discuss their experience with startup financing (how many comparable rounds have they done?), incentive schemes (experience in international context?), network to investors (would she do intros?), cost structure (hourly fees, ready to accept cap for entire financing round?) and team composition (make sure you understand with whom you will work on a day to day basis).
- Step 3: Select based on the the information you got from Step 2. Include your gut feeling in the decision: You will spend substantial time with the selected lawyer, and need a great partner in negotiations – so personal match is as of equal importance.
Some startups have one law firm for all legal questions, others work with different specialists (besides one for corporate finance they may have one for IP, one for employment related matters in each country they are active in, one for FDA-related questions in the US, one to setup a licensing deal in China, etc). Both ways have pro’s and con’s – but you definitely want to make sure that you do the upcoming financing round with a highly qualified lawyer.
Once you have selected a lawyer, have her review your current shareholders’ agreement. Make sure you have a solid version in place. Typically the shareholders’ agreement of an upcoming financing round will be based on the current one, so having a good starting point is valuable.
Review Phase 1
Take the following anonymous test to check whether you are ready to move on to the next phase: