Monday, September 24, 2012

5 Questions You Should Ask Yourself Before Raising Capital

Paul Graham posted a long perspective about "going big", raising capital, growth etc. It's worth reading, even though he was off base about what constitutes a startup:
A startup is a company designed to grow fast. Being newly founded does not in itself make a company a startup. 
That's pretty much BS; it's the definition of a startup in the Graham Bubble. In the real world, a startup is in fact something newly founded with the intention of getting to sustainability.

How you want to define sustainability and the process of getting there is up to you, but pay no attention to pronouncements like Graham's. He's a very smart guy with a lot of great things to say, which is partly why it's disappointing to hear this sort of thing from him.

Marc Suster had a good post in response that is, again, worth reading in its entirety.
But I believe that without presenting the other case to my definition of startup entrepreneurs who want a different path and who are young & impressionable they might read into Paul’s post a certain religion of going for instant, rapid growth. 
I agree with Marc.

He references another post of his in talking about whether to raise money or not, and that's what I'd like to talk about today.

At the end of next month, four or five startups will present at Startup Lancaster's Investor Day. That's the one day of the year we open the doors to non-founders; this is the first time. So the rest of this post is addressed to them and startups like them.

Should you raise capital? No. Yes. It depends.

First, there are different kinds of capital--personal investment, friends and family, angel, SBA loans, credit cards, and arbitrage of various sorts. Venture capital is what everyone talks about; I suspect there's a certain allure to raising capital from a venture firm--it gives the company credibility along with a pile of cash to apply productively toward growth (hopefully).

Should you raise? It depends on your business model, traction, market size, capital needs, time, risk tolerance, ability to commit to others, etc.

But business model is really the key to when you should raise--if you should raise at all. If your business model depends on ads in front of eyeballs, you're going to need to find a way to pay the bills while you grow enough of an audience to drive ad revenue.

If on the other hand your model depends on customers paying an average of $250/month, your burn is $10,000/month, and you've just sold 10 new contracts in your second month, you can likely hold out because by the fourth month your expenses are covered.

At that point, you're developing your customer base, learning from the market you're actively addressing, and scaling to grow revenue. If you keep that growth up you'll have 120 customers paying $250/month, which is $30,000/month. Not bad.

You might need to add sales staff, or increase marketing to increase your rate of growth. To do that, you could try to grow from cash through operations, which you're accumulating if you haven't increased your burn.

Or you could raise capital. And then the question is from whom and how much.

Five Questions (in service of the gratuitous headline)
But let's step back. 1) Why are you building the company? 2) What outcome do you want? Do you care about a big exit? Do you love your team and just want to show up every day for the next 10 years serving your market with your great team? Do you like discovery and development, but hate managing people?

You really have to understand why you're doing this before your raise capital. 3) What do you care about? 4) What are your values and principles? 5) And how much is enough?

It's ok to be partly driven by money, but it should not be the core reason you're building your startup or you won't make it through the rough stuff, and believe me, if this is your first time there will be some rough stuff. If you're reading this you've likely already experienced it or are mired in it.

You don't need to be a huge company. Or a fast-growth company. You just need to be the best company you can be within the framework of principles you care deeply about.

One of those principles might be fast growth and a big exit, or fast growth and a large growing company that makes everyone a ton of money. That's fine.

That's when you want to narrow the source of capital to VC. But you should understand this: the VC job--their convenant with their investors--is to deliver a return on capital, typically in the 30% to 35% range, annually over a 7 to 10 year period.

To get that return, they need you to create a liquidity opportunity. That means you have to either 1) sell your company, 2) go public, 3) buy back stock. There might be more options, but those are the big ones.

So are you up for that? Are you up for managing relationships with investors? Are you ok with allowing growth to be a driving force behind decisions about people, product, and customers?

These aren't easy questions, but you really need to try to imagine what it's like when your stakeholders include investors, and by extension, their own investors.

So yes, you're a startup even if you don't meet Graham's Bubble requirement. Yes, you should raise money if you need to and can deliver growth as a result. No you shouldn't raise capital if you can avoid it early on through sales, like Greg Gianforte talks about in Bootstrapping.

But yes, if you are building a consumer-facing application that depends on tens of thousands of non-paying users to get to any kind of revenue, yes you will need to raise capital to fund you while you're growing. If you can get someone to fund your R&D, you just might want to say yes.

In the end, you'll be better off obsessing about serving customers and growing your company than obsessing on funding, especially venture capital. And pay no heed to the messages coming out of the rare air of Graham's Bubble.

And now it's your turn...below the fold.

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