In my last two blogs (Part 1 and Part 2) I raised questions about when to ask for external finance and the critical factors that an investor might look for, before deciding to make an investment offer. I provided some answers to each of these questions, based on considerable research in this area. However, I left questions about how much cash to ask for, how much should you offer in return and how do you identify an exit strategy to subsequent blogs. So, today I will address how much cash should you ask for?
The answer to this question requires that you first calculate the cumulative negative cash flow the company expects (plus some contingency), before the cash flow becomes positive. You must then identify every possible way of reducing this cash flow to minimize the amount you have to raise as equity.
Typical ways to reduce these costs may include sharing resources, leasing instead of purchasing and finding partners who will wait to get paid. In some cases, government funding can also reduce the negative cash flows. In addition, debt financing can sometimes be used to fund the negative cash flow, for example to buy fixed assets, or inventory. While this debt has to be serviced it can also reduce the total negative amount of cash the venture requires, before cash flows become positive. The answer to the question of how much to ask for is then the total cumulative amount calculated by your negative cash flow forecast (including some contingency for unexpected delays or expenses).
Now you have decided how much you need, you need to decide whether you wish to raise it all in a single round, or over several rounds. To decide this you need to consider that the costs of raising money are often fixed, making it more efficient to raise money in a single round than over stages, however this can mean that you raise all the money at a relatively low valuation.
If your negative cash flow extends beyond six months, it may be worthwhile raising the money over several rounds, each round corresponding to the achievement of a milestone that significantly increases the company valuation. The benefit of this approach is that the achievement of milestones allows you to justify an increased valuation for the company, and you will have to give up less equity for the same amount of cash.
Once the forecast of negative cash flow has been defined, next you have to identify points in the company’s progress when the company valuations will increase. Contrary to the normal view of how company valuations change, at this early stage the company increases in value are not linear but step-wise. Each step increase in value corresponds to the achievement of specific milestones, and is a function of both time and the magnitude of the impact that achieving that milestone has on the value of the business. Examples of such important milestones can be completion of a prototype, signing of a first contract or obtaining a patent. Each of these has a significant impact on the value of the company. Armed with this information, it is possible to identify how much you should ask for.
While this leads to the conclusion that you should raise money every few months, you must also bear in mind that the process of raising is money is costly, time consuming and a big distraction for the entrepreneur. Consequently, the number of occasions when you choose to raise money should be minimized. This creates a challenging balance, because raising too much money early can lead to you having to surrender too much equity in the company, while raising it too frequently can cost too much, be a distraction and increase the likelihood that you will run out of money before reaching the next milestone (which is often fatal).
To answer the question about how much and when, you need to work out on a monthly basis the negative cash flows identified, and any steps you can take to minimize them. You then need to indicate on the same chart, the milestones that you think will have a significant (greater than 10%) impact on the value of the business. Armed with these two pieces of information, and cognisant of the cost of raising capital, you should be able to develop a cohesive strategy that you can validate with your first investor.
Specifically, you will learn that experienced investors contemplating several rounds of financing, will already plan where to source the next round of finance when making the initial investment offer (even if it is themselves).
We will leave the questions about structuring different rounds of financing, developing a viable exit strategy, and showing the investor you can develop a relationship with them to subsequent blogs.
Andy is currently working at the Canadian Innovation Centre and pursuing a Ph.D. in the area of new venture creation at the University of Waterloo. In his spare time, he enjoys teaching technology entrepreneurship at UTM and the University of Waterloo.
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