What Path Are You On? – The Value of Thinking Ahead
The essence of early stage fund-raising is in knowing what you want. Your Company’s capital formation strategy should serve your personal and business objectives.
Are you chasing a unicorn? (1b plus valuation) or are you keeping your financial objectives more modest? Are you trying to achieve a public market outcome? Or is managing a successful private company more than enough? Do you require control? To what degree? Are you making a market or building a business? Do you need 5 million dollars to get to profitability or 100 million? There is a big difference.
Capital formation strategies should align with these key personal objectives, business objectives and the dynamics of the market.
Tools for Illustration
First time founders often view raising capital as an abstraction. Take a little money from friends, a little from family, and they are off! They live until the next funding milestone. A better approach is to build a realistic assessment of how much money is going to be needed and when. From there, founders should build a decision path for financing events with clear valuation objectives and milestones.
Let me share several tools that will help you to build a realistic visualization of funding paths that your early stage company might follow. In my experience, these tools can help founders to contrast options and to then make the best choices early in the capital formation cycle.
Tool 1: Funding Path Scenarios.
The first step is to get centered. And the best way to do that is by developing different scenarios (options) for funding your company. Below is a tool that compares equity awards through a progression of early stage valuations and milestones. I call it the Funding Path Scenario model. It is represented in an excel spreadsheet.
The first questions founders ask are:
How much money should be raised?
In what form?
At what valuation?
From who?
At what level of control or percentage ownership?; and,
When?
This easy to build (somewhat) spreadsheet gives founder(s) a way to make comparative calculations that toggle these variables to milestone accomplishments and events. It also helps founders to understand how much equity can be budgeted to different classes of equity in the early stage of your Company’s development life-cycle. And importantly it provides founders with an understanding of what valuations have to be achieved at given milestones to support the financial objectives of the founder(s).
To get the most out of a scenario analysis model, the underlying foundational work has to be solid. In other words – an accurate prognostication of budgets, early stage revenue if any, and the organizational cost required to deliver product and revenue are all variables that must be understood to make the equity path meet founder expectations. Hit your targets and the model works. Miss them and the equity equation may end up unbalanced.
Prognosticated revenue and other performance metrics (product development) have to support the milestone valuation objectives as well. The obvious mistake most often made in budgeting is that everything always takes longer than founders expect. This means that going forward, fixed costs (hosting, staff, product) will start taking up more of your budget and less of your funds will go to essential business development and marketing as well as founders’ draws. Sound familiar?
In this case, the seed stage is heavily weighted (30%) and the starting valuation artificially low (1.7MM post). This scenario illustrates that building value early, before too much seed investment is taken, greatly improves the equity position of the founders. In other words “social proof” in the form of – team, revenue, and achieved product development – partially de-risks early stage investment.
Tool 2: Exit Analysis
Your first reaction to using the Exit Analysis tool in planning, might be: “What? – I just got started”. True. But if you understand how your funding path relates to possible exits, then, you can better strategize the funding path. The Exit Analysis Tool is fully integrated with the Scenario Analysis Tool. This means that if you change a variable in one – it automatically changes a variable in the other. This is a simplistic tool – it for instance does not calculate internal rates of return (IRR’s) which require an estimation of time to exit at each stage. What it does provide is an estimation of the gross funds available to each class of equity as you build your funding path options.
One of the important questions that the Exit Analysis tool answers is how to reverse engineer the amount and structure of early stage participation by an early stage or angel fund. In other words, if you know that a fund targets a 10X return to their investment, and if you know that their investment profile in an A round is to own 25% of your company, then you can determine both what your company’s exit outcome would have to be to satisfy them and at what stage, and also, looking backwards, how much equity participation you can allocate to the Seed Stage investors to leave necessary room for the A round. (If you fail to get this right, it is very possible that a fund investor will require a reallocation (recapitalization) of the equity structure as a condition of its participation.) In my experience it is never too early to model exits so that you can ensure that the capital formation path that you choose supports your business model – and your desired outcomes.
Tool 3: Shareholder Participation
Shareholders always want to know where they stand. Often founders have a general understanding of what each class owns as percentage of a Company. (“the Cap Table”).But that is as far as it goes. They make the shareholders do the math to get to individual outcomes.
Do you know how much of your Company each of your individual shareholders owns? Across multiple rounds? The Shareholder Participation Table provides a more specialized view than standard capitalization tables to show each shareholder’s level of participation in both each class of equity and in the aggregate – across rounds. In other words, you don’t want to make shareholders do the math. Nor do you want to be guessing either – especially when you spontaneously run into shareholders locally!
Tool 4: Transaction Expenses
As a pre-cursor to modeling individual financial outcomes, it pays for founders to roughly estimate expenses that they will incur to achieve a transaction. Transaction expenses come “off of the top” and have a net effect of reducing what is returned to your shareholders (including yourself). The most impactful of these is often investment banking fees and/or attorney or other professional fees. Guaranteed returns in layered rounds can also be considered as an expense in the event that an exit breaks the “floor” that triggers the guarantee. If you keep this tool in mind it will help to negotiate obligations that the Company incurs along the way to an exit. A five percent (5%) obligation to an investment banking firm incurred early in the Company’s development is just as, if not more dilutive than a 5% ownership by a Seed Stage or A shareholder. Though contractual, that type of obligation is like having an early shareholder with super-priority. That is why fixed expenses that are incurred along the way but paid at a transaction or exit should be carefully considered.
Tool 5: Individual Shareholder Return Matrix – Getting to the Bottom Line
The Individual Shareholder Return Matrix is the last piece of the model. By stepping through funding scenarios, exit scenarios, participation levels and transactional expenses you can get to the bottom line – what is each shareholder likely to receive at different levels of exit – including you as a founder. This is a tool that you should rarely share with anyone outside of the Company – it is best used internally. But it is helpful to know the bottom line – what comes out in relationship to what is contributed?
The point is: for founders – look ahead. The models rarely come true. Your business, after all, is not simply a math problem. But at each decision point in the business path it is helpful to have an understanding of inputs and outputs. You don’t want to be caught in an outcome where you invest all of your blood, sweat and tears to find out that you receive little of the fruits of the start-up that you have carefully built. If that is what happens – it should be a conscious choice – not a surprise. Having command of these basic principles will also help you to project confidence to your friends, family, and early stage investors. And hopefully you will have the capital that you need, when you need it.
(Obviously – Use your own professional advisors – your CFO or financial professional, attorney, investment banker – whoever you rely upon. This is just one perspective on tools that have helped me. Your experience could be very different. This isn’t advice!!! I am not a spreadsheet master. Nor am I a CFO. I am just a founder who thinks about these things in a way that I understand them. I share these tools in the hope that they might be helpful to you. Maybe they will simply help you to ask the right questions!).
