Raise What You Need, and Then Some
Getting funded is one thing, but startup budgeting is a whole other matter. There are lots of sources one can go to about setting valuation and dilution such as Fred Wilson’s post the other day, but not a lot of people talk about the specifics of how to make that cash last, or even how to figure out how much you really need.
The rule of thumb is to raise what you need for 12 -18 months of operations. I alluded to this in a prior post about the dangers of not raising enough cash. But what does that really mean in practice? Continuing from that discussion, you need to consider five key factors; major expenditures, average monthly burn rate, breakeven point, contingency and funding capacity.
- Major expenditures – These are the items that you absolutely know you need to spend money on. Generally the largest costs will be for hiring, office space, customer acquisition and legal. As you probably will not have a complete team yet, you will need to outsource some work such as software / mobile development, design, HR and accounting. There may be other costs such as specialized equipment purchases, computing resources, warehousing, inventory, materials, shipping, regulatory fees, collateral generation, events, travel, etc. depending on your business model. Note that when you calculate labor, make sure you account for the fully loaded labor cost (salary, benefits and taxes).
- Average monthly burn rate – If you added up all of these expected costs, and then divided by 18 months, you would get your average burn rate (note that 12 months might be more appropriate based on the business, this is taking a more conservative approach). This number should be within a reasonable range, so if you are an early stage startup with two founders building a mobile application, a burn rate of $100K per month would be ridiculous. However if those same two founders said $40K per month with the expectation of hiring two more people and paying modest salaries, that would make more sense.
- Breakeven point – When do you think you will make enough money to cover your burn rate? To calculate this, you will need to estimate your revenues, which will depend heavily upon your business model. Even if you are going the freemium route, there should at least be a plan to either build in a revenue stream or gain significant user traction to drive towards the next level of funding. Note that revenues and breakeven point are extremely speculative early, but having a baseline that you are tracking can be helpful. Whatever your plan is, make sure you have an idea of what it will take to cover your costs so that you can have enough runway to keep going.
- Contingency – This is basically the cash buffer that you leave yourself to account for unforeseen events. Sometimes you run into budget busters where the costs hit you by surprise. This could be a larger than expected salary for a top hire, attending a key event, or some other budget busting expenditure. The other issue that arises is that by 18 months, you may still not have achieved product-market-customer fit, resulting in not getting enough customers and not reaching breakeven. Consider this bucket of cash your desperation reserve, the “do not break unless in an emergency” fund. The best ballpark figure to use is 10% to 20% of your total expenditures over 18 months. Do not break this down however per month thinking it is your monthly cushion. Keep to your budget projections and only access this cash when absolutely necessary. You might even consider dumping this cash into a high-yield CD account for safe keeping.
- Funding capacity – When you have a final number that is your total raise, are you in the range for your type of startup? A number of factors drive your ability to raise capital including your prior experience (serial versus first time entrepreneurs), whether you went through an incubator (Y-Combinator and TechStars companies for example tend to command a premium), the type of product and business model and region. You can look on websites such as AngelList and Crunchbase to assess what other similar companies or competitors raised to get a sense of your funding capacity. If you, as a first time entrepreneur, calculate that you need $1M for your seed round offering 20% of the company, but similar companies only raised $500K, you might be pricing yourself out of range. You may be better off setting your sights lower to ensure you are able to close out your round quickly.
- Resist spending – This is not really a point, but rather an urgent warning. It is tempting once you close a funding round to get a little loose with the bank, but resist the temptation! Do not buy more office space than you need, do not buy your team food, do not throw parties where you pick up the tab, do not sign long-term contracts for outsourced services, do not over hire, do not buy lots of equipment and assets and do not over spend on customer acquisition strategies before testing their efficacy (e.g. online and search advertising can bleed you dry if not careful). If your employees and co-founders and friends call you Scrooge, so be it, at least you are still going to be in business.
Once you have your numbers sorted out, you can feel confident in raising the right amount of funding for your startup that is reasonable, defensible and ensures you have enough time to get the product right and into the hands of eager customers.
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