Questions to be answered:

1.    How much money should I raise?

2.    How long does it take to raise money?

3.    How do I value my company?

4.    What’s dilution?

5.    Should I raise money through a loan, equity offering or convertible loan note?

1.    How much money should I raise?

This is a very important question; and one many entrepreneurs don’t really know the answer to even though they know they need to raise money.

The short answer is ‘as much as you need’.

The first mistake to avoid here is raising too much money. To some it may seem self-evident that raising as much money as possible is the best option, because more money raised, equals more money to spend on your product, marketing etc.

But this is a dangerous way of thinking. The problems with overfunding are set out below:

• More investors usually results in more terms and more due diligence. This is not only tedious but also time consuming and takes the focus away from actually growing the company.
• If you raise too much money this will result in your having an artificially high post-money valuation. This is a problem if things don’t go well with your use of these funds and you need to raise money again. You’ll have to raise funds at a higher valuation and if you’ve not made much progress to prove your value at that higher valuation you are going to struggle to raise money.
• Psychologically, having surplus cash lends towards being more frivolous and spendthrift with it; when rational and deliberate spending is what makes startups grow successfully.

The second mistake to avoid is the flipside of this: raising too little. If you run out of money before you reach breakeven, then you're in a world of trouble.

In conclusion, raise as much as you need...

But how much is ‘as much as you need’?

Good question. You need to work this one out for yourself as it is specific to your business. But there is a general formula to help you…

Generally fundraising is done to help startups grow to reach their targeted milestones (whatever they may be). 
For instance, if your goal is to grow your startup from early product to profitability, you need to work out the key milestones that you need to achieve along the way (e.g. build out core product, create app version, hire developer, launch marketing plan). You also need to work out how much each milestone will cost and how long the process will take (in months).

From this you’ll know the cost of achieving your milestones and your monthly burn rate (i.e. how much you will be spending each month on costs). This figure will be close to the figure you should target.

Example:

If in a 12 month period, Startup ABC wants to achieve 5 key milestones that should result in its profitability.

To build and execute each milestone the estimated total cost is £150,000.

Paying staff and renting a serviced office costs Startup ABC£10,000 per month (burn rate).

So to operate their company over 12 months and improve it according to their plan, it will cost £150,000 + £120,000 (12 times the monthly burn rate) = £270,000.

Obviously, it would be sensible for Startup ABC to give themselves a little bit of leeway/security in case things go wrong or they need to deviate from the initial plan. The general rule for this is to ask for at least six months extra runway (worked out from your monthly burn rate). So in the case of Startup ABC, this would mean asking for another £60,000.

So the total for their raise would be £330,000. This total would constitute ‘as much as they need’ plus a bit more as an insurance policy.

The model set out here is a good basic starting point, but it is by no means mandatory. Funding requirements will vary dramatically from business to business and founder to founder.

A variety of well-informed opinions on the subject can be viewed and digested on Quora

2.    How long does it take to raise money?

The hypothetical example above assumes that the money required is raised instantly. As you might expect, this is rarely the case.

So how long does it take?

Unfortunately, this is a question without an accurate answer, other than ‘probably longer than you think’.

American Super Angel and serial entrepreneur, David Rose, who has been on both sides of the pitching table has the following to say;

“At the very, very fastest (assuming that the first person you pitch falls in love with you, offers to lead the round for you, accepts your Series Seed docs without hassle, is connected/interested enough to bring in enough other investors to fill the round (or can write the whole check him/herself), and that the deal happens at a time when neither your attorney nor the investors' is overloaded or on vacation), it is conceivable that you could get from pitch to close in 30 days.”

So many factors both expected and unforeseen will affect the duration of your raise that it is almost impossible to predict a closing date.

The key is to keep building momentum and to never cease cultivating interest from investors. The more conversations you are having the more confident you will feel and the more feedback you will have. Investors want to see confidence as it helps them believe that they are making the right decision.

A ballpark average is probably 3-6 months, but again it depends on where you are, how strong your network is, how good your business is, how strong your pitch is etc etc etc…

3.    Startup Valuation:

Please note: for startup first-timers valuation can seem tricky. Because of this, we normally advise those looking to raise money through our website and who don’t know what valuation to give, to just ask for the amount they need. Investors will then offer the amount in exchange for a portion of equity they suggest and you can negotiate from there.

However, it is not that tricky and the summary below should be helpful in getting your head around it so you can calculate a reasonable valuation for your startup.

What is it?

“Valuation is an art, not a science.”

Mohandas Pai (at TechSparks 2014)

Valuation, put simply, is the estimated value of a company. It is something of an art form and cannot be calculated entirely quantitatively. With our focus on early-stage startup companies, valuation requires a reliance on factors that demonstrate a company’s potential for success.

Startup investment is a game of risk and reward; and obviously, potential is not always fulfilled. That is the risk investors must take. And that is why a reasonable valuation is an essential part of the process of raising funds.

As Anna Vital from FundersandFounders.com puts it;

“At the early stages valuation does not show the true value of a company. It shows how much of a company an investor gets for his investment.”

Your startup business is not really worth anything until it is profitable because only then can you exit and sell the company. Therefore, startup valuation is inevitably predicated upon a focus on the future. How quickly can you achieve profitability/significant market share?

Why is it important?

It is important to investors because it dictates how much value they get for their money. To reduce their risk, they want as large an equity share as possible for the least amount of their cash.

(This will be within reason because if you have said that £100k is the minimum amount you need to grow in the next 18 months, there is no incentive for the investor(s) to go lower as they obviously want you to grow and succeed if they invest!)

The valuation can also give investors insight into the competence and realism of the entrepreneur. So, if done well, giving a suitable valuation can make investing in you and your company doubly attractive.

It is important to you, the entrepreneur, because it determines the stake of your company that will be given away in exchange for a decent amount of investment. At a very early stage your company will be worth very little, at least objectively speaking, in assets; and yet you will need to decide upon a reasonable valuation so that you can ask for the £250k you need in exchange for 25% of your company, for example.

This example would give your company a pre-money valuation of £750k and a post money valuation of £1 million; even though the chances are you have nowhere near £750k worth of assets, at this point. Your pre-money valuation therefore has to be justified by more subjective factors.

N.B. Pre-money valuation is the process discussed in this article and, as is probably clear, it can be a qualitative and quantitative process. Post money valuation is a more objective calculation as it is simply the agreed upon pre-money valuation plus the sum invested.

E.g. Pre-money valuation (£1 million) + sum invested (£100k)= Post money valuation (£1.1 million).

How can it be estimated and justified?

1. Determine how much money you need to grow to the next stage over an 18 month period. Let’s say you need £150k.

2. Work out how much of your company to offer for the desired £150k. You don’t want it to be 50% or more as this would leave you, the founder, without incentive and not in control. You don’t want it to be 40% as that leaves you with little to offer investors in your next funding round. 30% is okay but is still a fairly substantial chunk for the relatively small sum of £150k.

Realistically, you ought to be offering between 5-25% equity for £150k (depending on what stage your company is at). Where in that range you decide will depend on your valuation and could have significant repercussions on the ultimate success of your business.

3. These figures of £150k and 5-25% are now fixed which gives a pre-money valuation between £450k and £2.85 million and a post money valuation between £600k and £3 million. Now to work out the valuation between these two figures.

4. This will depend on three principal factors: how investors value other similar companies, how well you can indicate your chances of good growth and the value of your assets.

5. Key Performance Indicators (KPIs) is the term often attributed to factors pointing towards good future growth. Here is an almost comprehensive list of possible KPI's (though it will vary from company to company):

-    Financial Forecasts/Revenues: Revenues can be a useful means of estimating a valuation as they can be interpreted as indicators of success and potential for growth. They are usually more useful indicators for B2B startups because high revenues for a consumer startup can cause slower growth; although you may be making money right now, charging users can make it more difficult to attract lots of users. Early stage startups have to be about growth not making money straight away! Forecasts are a good way of articulating the future value of your company but only if backed up with sufficient evidence, otherwise you are merely plucking numbers out of the air. If your forecasts look like pure fiction, you will be doing yourself a severe disservice.

-    Team/Reputation: A strong and capable team is an important performance indicator. Your product will iterate and change, but, all things being well, your team will not and it will be the decisive factor in the success of your iterations. Ideally, you want team members who, have previous startup experience, have experience in their roles and/or within the industry, have degrees from respected Universities, and have anything else that lends your team credibility as people who will make your business a success. When analysing this you are not trying to put a figure above the head of each member but rather to assess the value of the team as a unit that will bring about the success of your enterprise. Previous experience is by no means a pre-requisite for startup success; names like Systrom (Instagram) and Zuckerberg (Facebook) are testimony to this. However, purely in terms of valuation, your team will inevitably be considered as a key potential performance indicator.

-    Traction: This is arguably the most important thing investors will look for; it is the proof that your business model works and is attractive to your target market. Sales are the best example of traction, but the chances are that at an early stage, high sales is not a realistic aim. As such, user signup growth, cost per acquisition, social media followers, celebrity endorsement, high margins etc can all constitute valid proof of your concept that will make you attractive to investors.

-    Timing: Investors follow trends; they also follow each other. If you are creating the right product/service at the right time, you can reflect this with a higher valuation as investors scramble to get involved.

-    Readiness to operate: Your product might be very early doors but if you have a channel already established for distribution to your target market, you have a clear means of launching, executing and growing. This too can be reflected in the valuation.

6. Comparative Valuation: you should compare your estimate valuation with other similar startup companies and use this information to help you settle on a valuation. You can’t get away with not doing this as interested investors will most certainly be doing it; and if they find a large discrepancy, they may be put off.

7.    Assets: although it may be impossible to calculate the true market value of most of your assets, it can be calculated again by comparison to other similar companies. Examples of assets could include but are not limited to:
-    Proprietary Software/Design
-    Product/Prototype
-    Cash Flow
-    Patents
-    Customers/Users
-    Partnerships
-    Equipment
-    Previous funds invested

Ultimately, irrespective of what you think your company should be valued at, you have to bow before the inexorable force of what your market says you are worth.

If your investors or brokers tell you that your company should be valued at £1.5 million not £3 million, they are more right than you are by virtue of being the funders. This can even be the case if you have more than £1.5 million in tangible assets. Market is king.

On the flip side, your justifications founded upon your key performance indicators can mitigate against this to some extent by telling the market what you are worth.

Hence, valuation is a negotiation between you and your market, but the more justifiably you can support your proposed valuation the more competent you will seem and the more chance you will have of leveraging it in your favour.

Although it is generally accepted that early stage valuation is not an exact science, a number of attempts have been made to help make the process more empirical. I have linked these in below. It is worth trying out all of them and cross-comparing results as his will give you a good idea of what a reasonable valuation of your business might be.
-    The Berkus Method

-    Risk Factor Summation Method

-    The Scorecard Method

-    The Cayenne Consulting Method

4.    What is Dilution?

Dilution is the term given when the value of an equity share is reduced by the issuance of more shares. When the number of shares is increased naturally the value per share decreases so each shareholder will own a smaller (diluted) percentage of the company.

e.g. If a company has 100 shares valued at £1 each divided equally between 100 individual shareholders, then each shareholder owns 1% of the company valued at £100.

But if the company then issues 100 more shares, each shareholder now owns 1 share out of 200 so 0.5% of the company.

Why might a company issue more shares and so cause dilution?

If a company needs to raise more money, more shares are required to be offered to the new investors.

So in our example, the 100 new shares are offered for the new investors to ‘buy’. When the new shares have been acquired for investment the value of the company should go up, and so, in our example, the existing investors may own 0.5% of the company now, but hopefully that 0.5% has more financial value than the 1% they previously owned.

Here’s a great video from the extremely well-reputed Khan Academy which covers the basics of everything mentioned above.

It’s very clear and easy to understand. Well worth a watch!

5.    Should I raise funds through debt or equity?

Most Angel investors, incubators and crowdfunding sites usually operate on an equity share basis. This is not always the case; and it is useful to be aware of alternative avenues.

Should I ask for a loan or give away an equity stake? How much should ask for? How much should I give away? These are some of the key questions that will keep you awake at night when it comes to raising funds.

This sections aims to give a concise explanation of the difference between debt and equity.

Equity:

In terms of startup companies, equity investment refers to the acquisition of a percentage ownership in the startup. It is a high risk investment for the investor (though in the UK it can often be mitigated by the SEIS & EIS tax break schemes), but if the company goes on to be successful, a large equity share can prove extremely lucrative.

For you, giving away an equity share in your company can not only secure risk-free funding but also a wealthy and competent investor (or several) who will be actively interested in seeing your company succeed and will want to leverage all his expertise to help it to do so.

Debt:

Generally speaking, most startup companies do not take this option as having to regularly pay back loans can severely disrupt the cash flow that is often so crucial during the early stages.

Additionally, unlike an equity offering, you will often be required to put up assets as security against failure to repay the loan. Accordingly, you are at much greater personal risk.

The fact that you maintain full ownership of your company, provided you keep up your repayments, can be viewed as an advantage.

Convertible Loan Notes:

The Convertible Loan note gets a lot of attention on the internet as a ‘best of both worlds’ alternative to conventional equity funding. The attention is very mixed with some investors liking; others loathing them.

As its name suggests the note is a form a loan. This means that the investor has more protection if things go downhill for the business and it has to dissolve for whatever reason. On the other hand, the way the note works is that if the company raises funds in a later round and takes on more investors, the loan note holder can convert the cash they are owed into shares (usually at a discounted valuation to the more recent investors).

So a loan note holder has the greater security of a loan but also has the potential to enjoy the rewards of holding equity if the business goes well.

Pros:

• Less paperwork and documentation so can save time and legal fees
• Investors have the security of a loan
• The startup can delay deciding on a valuation until a later round (this is especially useful for early stage companies)
• Investors can receive discount upon conversion

Cons:

• A note that is too large could have a negative impact on your next round by crowding out the amount of equity new investors can receive
• Can cause extra dilution
• Notes can be made with specifics terms in favour of the note holder – the entrepreneur risks handing too much power to the investor
• Too much convertible debt can be dangerous when it converts
• In the UK, notes are not eligible for SEIS tax breaks.