If you are an entrepreneur, you are probably wrong about how much money your startup will need, and you are almost certainly underestimating your capital requirements. The stuff you want to do will likely take more money, and more time, than you estimate. Products will launch late (they always do), partnerships will take longer to implement and will launch later than you forecast. More importantly, opportunities to spend and invest will come along that you couldn’t foresee when you built out your plan — whether that’s a product opportunity you see, a great VP to hire, or a new marketing strategy to deploy, it will be easier to adapt to circumstances if you have the capital to take advantage of them. Unfortunately, most founders don’t have a clear picture of how much to raise, how much to spend, investor management or the laws that affect the raising of capital.
Here’s a brief look at 5 errors founders make.
1. Raising too little money
Most successful startups take funding at some point. But the real question is: How much should you take? Every startup that isn’t profitable (meaning nearly all of them, initially) has a certain amount of time left before the money runs out and they have to stop operating. This is often referred to as runway, as in “How much runway do you have left?” It’s a good metaphor because it reminds you that when the money runs out you’re going to be airborne or dead.
Too little money means not enough to get airborne. What airborne means depends on the situation. Usually it means advancing to the next level, i.e. if you have an idea, the next level is a working prototype; if you have a prototype, the next level is launching; and if you’re already launched, the next step is significant growth. It depends on investors, because until you’re profitable and cash flow positive that’s who you have to convince.
So, bottom line, how much runway? 12-24 months of runway is a common answer. But remember, raise it when you can, not when you have to!
2. Spending Too Much
It’s hard to distinguish spending too much from raising too little. If you run out of money, you could say either was the cause. The only way to decide which to call it is by comparison with other startups. If you raised five million and ran out of money, you probably spent too much.
Burning through too much money is not as common as it used to be. Founders seem to have learned that lesson. Plus it keeps getting cheaper to start a startup.
The classic way to burn through cash is by hiring a lot of people. This bites you twice: in addition to increasing your costs, it slows you down—so money that’s getting consumed faster has to last longer.
One general suggestion about hiring: pay people with equity rather than salary, not just to save money, but because you want the kind of people who are committed to the success of your company.
3. Raising Too Much Money
It’s obvious how too little money could kill you, but is there such a thing as having too much? Yes and no. The problem is not so much the money itself as what comes with it. VCs will tell you that once you take several million dollars of their money, the clock starts ticking. If VCs fund you, they’re not going to let you put the money in the bank and take a vacation. They want that money to go to work.
Perhaps more dangerously, once you take a lot of money it gets harder to change direction. Suppose your initial plan was to sell B2B. After taking the money you decide that you should be selling B2C – what happens then?
Another drawback of large investments is the time they take. The time required to raise money grows with the amount. When the amount rises into the millions, investors get very cautious and you end up spending more time talking to the VCs than you spend working on your startup. Unfortunately, while you’re doing that, your competitors are moving ahead of you by leaps and bounds.
The best advice is probably to take the first reasonable deal that comes along – assuming it’s from a reputable firm, at a reasonable valuation and no onerous terms. Go ahead and take it and get on with building your company. Who cares if you could get a 30% better deal elsewhere? Bargain-hunting among investors is a waste of time.
4. Taking Money From The Wrong Investor and Letting Them Run Your Company
Here’s an important rule: Only take money from someone you like and respect. You will be with your investor for two to seven years. You will go through heaven and hell together. Make sure he/she will be good company in both situations. In addition, you need a partner who understands the industry sector your company serves.
Make a list of 10 financiers who understand your market or product and have worked with companies at the same stage as yours. To find financiers, search the Internet for “venture capital,” “micro loans,” “business loans” or “angel investors (in your geographical area)”. Approach the top five on your list.
As a founder, you have to manage your investors. You shouldn’t ignore them, because they may have useful insights. But neither should you let them run the company. That’s supposed to be your job. How hard you have to work on managing them depends on how much money you’ve taken and if it’s a lot, the investors get a great deal of control. If they have a board majority, they’re literally your bosses. Bottom line, be careful who you choose as your investors!
5. Running Afoul Of The Law
There are a few things you should pay serious attention to when raising capital for your company. You can lose everything you’ve worked hard for if you violate Federal SEC laws. For example:
A) Advertising/Soliciting Investors: With very limited exceptions, startups are prohibited from “general advertising” or “general solicitation” in connection with raising capital. “General advertising” includes any ad, article, notice or other communication published in a newspaper, magazine or on a website or broadcast over television, radio or the Internet. “General solicitation” includes any requests via mail, e-mail or other electronic transmission, unless there is a “substantial and pre-existing relationship” between the startup and the prospective investor.
B) Selling securities to non-“accredited investors”: The rule of thumb for startups is to only offer and sell securities to “accredited investors” under SEC Rule 506. There are eight categories of investors under the current definition of “accredited investor.” The most significant of these for startups is an individual who has a net worth (or joint net worth with his/her spouse) that exceeds $1 million at the time of the purchase or income exceeding $200,000 (or joint income with a spouse exceeding $300,000 ) in each of the two most recent years – and a reasonable expectation of doing so again in the current year.
C) Using an unregistered finder to sell securities. Startups often make the mistake of retaining unregistered finders (known as consultants, financial advisors or investment bankers) to raise capital for them. If the finder is receiving some form of commission or transaction-based compensation (which is usually the case), he will generally be deemed a broker. If he’s not registered with the SEC and sells securities on behalf of a startup, though, the offering may not be valid and the startup will have violated applicable securities laws.
If you like this information, you’ll really like “Top 10 Mistakes That Cause Investors to Shoot Down Deals”.
About the author: David Brode is the Principal of the Brode Group. An economist by training, Brode has over two decades of experience helping ventures develop and communicate business strategies through financial models so they can launch, grow, and sell businesses. Brode’s financial forecasting models have been through due diligence dozens of times and have been successful in securing over $11 billion in financing for projects worldwide. Brode has a B.A. degree in Economics from the University of Michigan.
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