10 Nov Thinking about financing rounds
Most high impact entrepreneurs need capital to build their businesses. The amount of capital, and the timing of the infusion(s), is mostly a function of the kind of business/business model and the time it takes to get home – that is to an exit transaction. So, for example, an entrepreneur who happens to be a programming wizard with a simple, niche mobile app might need say $10,000 to develop, validate and sell his app/business for several million dollars in say 12 months (the assumptions here being that the app is in fact something that the market wants, and the execution by the entrepreneur is outstanding). At the other end of the spectrum, a scientist with an idea for a new drug for treating cancer will likely require several hundred million dollars or more and ten years to see that that idea turn into an FDA approved drug. Further complicating matters, the exit strategy, more particularly whether the goal is a relatively modest exit sooner rather than later, or a more substantial exit of a more mature company, has a big impact on how an entrepreneur thinks about rounds of financing.
In light of how different the risk capital needs of high impact startups can be, there is no “one-size-fits-all” way of thinking about financing models for high impact startups. So I am going to cheat: I am going to talk about financing models in the context of a “typical” software startup that hopes to exit for say $500 million after achieving operating profitability on $50 million in annual revenues. I will leave it to you, the reader, to think about how this “prototypical” model might be truncated or elongated to fit different entrepreneurial ambitions.
Let’s call our new startup Newco, and let’s assume Newco is well-managed and develops more or less according to the initial business plan/model (that almost never happens, but, again, the reader should be able to fill in some of the blanks if the path to the exit includes a more common set of twists and turns). Our Newco, in this scenario, is probably looking at six financing rounds: founder/friends/family; seed; Series A; Series B; Series C/Mezzanine; and Exit. What follows is how an entrepreneur (and the entrepreneur’s investors) might think about those rounds.
First, a general note on what drives risk capital financing rounds: risk reduction. That is, a round of capital is typically timed, and sized, to supply the company with the capital needed to reach the next big risk-reduction milestone. That is, an amount of capital sufficient for the company to accomplish something tangible that will justify raising the next round of capital (which will at some point hopefully be the exit round, where founders and earlier investors can see some liquid returns on their investments) at a significantly higher valuation (say 2x).
The founder/friends/family round is usually in the tens of thousands of dollars, including as often as not credit card debt. This round is where the founder develops her “good idea” into a “good idea for a business.” For example, let’s say the entrepreneur had an idea for an algorithm that would make it easier to detect mismatches between some kind of input and some kind of related output. With this initial capital, the founder might – well, will, in our example – figure out a way this algorithm could be used to manage inventory more efficiently in retail stores with high volumes of low value products. She will probably also do a little basic market research and conclude that her “solution” addresses a “problem” such that there is a strong value proposition for the target customers. Let’s say this takes twelve months and $25k.
Next up is the seed round, where the first “outsiders” put some money into the company. The amount of money (and the terms of the deal generally) will mostly be based on an analysis of what Newco will need to do to validate that Newco can create a minimally viable product (MVP): that is a product that “works” in terms of delivering a minimally viable value proposition that will attract at least one meaningful pilot customer. Let’s say that in Newco’s case that takes $250,000 and nine months. Accomplishing these objectives will likely reduce the risk that Newco will crater by something like fifty percent.
Next up is the Series A round. For Newco, the next big risk reduction point is demonstrating that the team can produce a market-ready product that several real customers will pay real money for. Doing that will reduce the risk of Newco cratering by something like an additional fifty percent Let’s say this takes $3 million and twelve more months.
Now comes Series B. This is where Newco transitions from a small team of people essentially running an experiment to a more robust team running a “real” business. Basically, Newco has to prove that it can “institutionalize” its business model. By way of example, this is usually the phase where Newco proves that folks other than the founders can sell the product, and maintain/develop the product. Proving the business can scale takes say another fifty percent chunk out of the remaining risk. Let’s say this take $10 million and another twelve months.
Next comes the last pre-exit capital tranche, the “C” round; the round before the anticipated exit (whether C, D, E or….) is often thought of as a “mezzanine” round. The goal here is to prove out the business model to sufficient scale and operating profitability to make Newco an attractive acquisition target at the $500 million valuation bogie, or in rare cases a good IPO candidate. Let’s pencil in $25 million for this round. With this money, and let’s say another twelve months, voila, Newco has hit the proverbial home run.
For some perspective, the assumptions for our prototypical Newco involve achieving a $500 million exit in a little less than five years from initial ideation, and with total risk capital investments of a bit less than $40 million. A solid home run, if not a unicorn.
Please remember that as a case study Newco is a very specific example in all kinds of ways, most importantly development costs/stages, execution (assumed to be excellent), and market conditions for risk capital (assumed to be pretty consistent from beginning to end) to name some of the most salient. Reality is seldom that cooperative. With that caveat, though, I think Newco is a good hypothetical framework for entrepreneurs trying to get a basic grip on the way high impact businesses think about risk capital financing rounds.
More articles by Paul A. Jones
- Thoughts on why good venture investors turn down good deals
- Employee Turnover: A Cloud with a Silver Lining
- Angels and Early Exits: Sometimes, a Bird in the Bush is Worth More than a Bird in the Hand
- Beyond the “A” Round
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