This Insights article was contributed by Brendan Collins, Seahawk Innovation Partner and CEO of mimijumi
Friends and family. Angel investors. Incubators. Series A. Convertible preferred stock. Liquidation preference.
The world of startup financing is filled with buzzwords and murky concepts that can be overwhelming and confusing for entrepreneurs. The mainstream business media, with its focus on fundraising, doesn’t help, and entrepreneurs could be forgiven for thinking entrepreneurship is all about raising capital and that successful fundraising equates to a pure victory.
But the reality is not so simple.
Successful traded sector startups need the three Ts of “time, talent and treasure.” In our experience at Seahawk Innovation, “treasure” is the least important of the three Ts. We advise entrepreneurs to follow a milestone-based fundraising model in which they raise only the capital required to achieve the next major milestone.
Entrepreneurs should invest their time and talents to identify a well-considered value proposition and develop a robust business model before thinking about raising money. The longer entrepreneurs can wait—and the more milestones they can achieve—before raising money, the better off they will be.
There are a few reasons why:
- More milestones achieved = less investor risk = higher valuation. Investors are rightly obsessed with risk and its mitigation. Each achieved milestone (for example, a working prototype or the first paying customer) increases a company’s likelihood of success and lowers the perceived risk for investors. Investors are willing to pay higher prices for investments with lower risk. This means entrepreneurs can raise money at a higher valuation – and retain more of the company equity – if they raise money only after they have achieved major milestones.
- Using time and talent first almost always lowers the amount of treasure required. Starting a company has been likened to scaling Mount Everest. To help guide climbers up the mountain and avoid costly mistakes, Everest expeditions always employ Sherpas with local knowledge. Similarly, by seeking the assistance of experienced partners, entrepreneurs can avoid mistakes like automating before finding product-market fit or hiring the right person at the wrong time. Avoiding errors and following a more direct path will significantly lower the amount of capital required and allow entrepreneurs to retain more of the upside for themselves.
- Less capital required = improved definition of success and increased likelihood of exit. For a traded sector startup in which exit value drives investor returns, the math is easy – the more money an entrepreneur raises, the higher the exit value required to generate an acceptable return for investors. Turning $500,000 of investment into a $5 million exit will generate an outstanding return for the investor and life-changing wealth for the entrepreneur. Furthermore, the universe of companies that can afford to make a $5 million acquisition is relatively broad.
Alternatively, when a company raises $5 million, the entrepreneur would need a minimum of a $5 million exit just to return the investors’ capital! Not only must the entrepreneur now target a $20-25 million exit to satisfy investors, but the universe of companies that can afford to make a $20-25 million acquisition is much smaller.
Further complicating the picture, the entrepreneur most likely sold a significant stake in the company to raise $5 million and as a result may not share much of the exit proceeds.
By following a milestone-based fundraising model, entrepreneurs can lower the amount of capital they need, retain control of their company, maintain their definition of success, and increase their likelihood of successful exit.
Seahawk Innovation launches, funds and grows innovative, traded-sector businesses solving large, intractable problems like concussion (SportGait), personal safety (Safur), and breastfeeding while returning to work (mimijumi).
Diane Durance, MPA, is director of UNC Wilmington's Center for Innovation and Entrepreneurship (CIE). The CIE is a resource for the start-up and early-stage business community to help diversify the local economy with innovative solutions. For more information, visit www.uncw.edu/cie.