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5 legit reasons to raise funding for lean startups

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brainstorming strategies to raise money in the tech startup world

Concerned you might be not lean if you raise funding? That’s actually a pretty common myth related to the Lean Startup approach.

Let me ask you this.

Have you ever received a “recycled” present?

While it’s clearly new, it doesn’t actually match your interests. In fact, you know that the giver received that present from someone else a few months earlier. It’s likely, therefore, that they never opened it, and just gave it to you.

That’s similar to the day-to-day experience of a tech startup investor. I actually worked at a VC fund in the past. More on that in future emails. Download a free chapter of Launch Tomorrow to get in on the action.

Many times a day, VCs get pitched equity in a tech startup. The founders don’t want the equity. They prefer cash. This immediately reduces the equity’s perceived value, in the VC’s eyes. In some cases, screams desperation. If the founders, who have lots of equity they got somewhere else, are willing to give it away…what does it say about the company’s value? About its prospects? About what the founders believe about the company?

A common question that I get from people first looking at tech startups is why tech startups need so much money. After all, it shouldn’t cost that much to throw a product prototype together. Isn’t it all just self-serving hype?

Not always.

There are five strategic reasons to raise money in the tech startup world:

  1. Funding customer acquisition
  2. Hiring top talent
  3. The “land grab”
  4. The “pre-emptive strike”
  5. The cash flow shortfall

So, starting from the top.

In all but a handful of businesses, if you can’t buy customers, you don’t have a business. Sometimes an idea takes off and goes viral. For the mere mortals out there, though, you need to figure out how to acquire customers and serve them profitably. Paid advertising, in particular, has a bad name because it’s easy to misuse with other people’s money. It’s easy to fool yourself and others that something is happening, unless if you know what you’re doing.

Admittedly, most investors aren’t keen on providing money just to acquire customers, unless if you have already proven you can do this. Turn $1 into $4. Or $40. A marketing expense can reliably generate profit.

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Investors are keen to put money only if you prove them growth.

Recruiting talent to help you execute also costs money, particularly if you are breaking new ground technically. Figuring out how to scale certain technical problems (like search or constructing social graphs) requires serious technical chops. The number of software engineers capable of doing that is pretty small. And the first guys who scaled Google, for example, were self-taught.

Moreover, to be blunt, the guys in most cheapo emerging markets live in much smaller markets. They’ve never had to solve these problems in their home country. So you need to hire smart people and keep them happy.

Now–we get to the really good reasons why raising money is a good idea. The strategic ones. If you and your competitors are creating a completely new market, there is a land grab going on. Whoever can get the most market share–wins. There’s an old rule of thumb from Davidow who ran Intel’s marketing during their high growth phase. Having at least 30% of market share leads to consistent profitability in most niches. At that point, you can influence what happens.

Until you get to that point, you’re a commodity vendor. So while it can be a bit abstract, getting a strong footing in a niche will help establish you as a player. If you’re in a niche where this is happening, suddenly paying for growth has whole new meaning to investors. You only need to be a little bit better to beat out the competition, after all.

The pre-emptive strike is similar to the land grab, but more defensive. Let’s say you are a cheeky bootstrapper. You enter a market adjacent to niches already inhabited by companies with deep pockets. You’ll be at a loss when they decide to enter.

For example, Google entered the search market, knowing there were a lot of well-funded competitors at the time. Yahoo, Lycos, and Altavista to name a few. Moreover, there were big tech players like Microsoft who had kind of missed the boat, but still had a lot of money. They could catch up quickly if needed.

Think Bing. If Google had tried to bootstrap their way into the market, despite having better technology, they could have lost. Instead, they got funding. They built their technology to be completely scalable, while building up goodwill with users. Then, after 6 years of funded growth, they finally introduced advertising to monetize the growth. In 2004, they launched Adwords.

Last but not least, there’s the cash flow shortfall. This is more common in tech companies that combine hardware with rapid scaling. In essence, though the same financial problem happens across the sector. There’s a long list of well known companies which blew up, despite having a sales growth trend: Osbourne, Spectrum. That’s right. High growth, high sales, high profits, yet low cash inflows.

If there is a long time gap between a sale and getting cash, the company won’t have enough cash to fund operations. Scaling their operations becomes impossible without that. You may need an exponentially growing staff to service your exponentially growing revenues. You need inputs like parts for a hardware company–also at an exponentially growing pace.

Unlike in software, manufacturing at scale is complicated and costly. Should you think this is a throwback issue from the 1970s, what about the Internet of Things? What about hardware startups today?

So there you have it. Five legit reasons to raise money for your startup.

If you want to get on that path, you’re much better off using the Lean Startup approach. Don’t take external money, if you don’t need it. Stop selling yourself (and your business idea) short.

Validate your idea. With Launch Tomorrow, you can be certain that you’ve proven people want to buy what you’re selling. Or thinking of proposing. Or building.

Build the right product. Make sure you can acquire customers profitably.

Then get funding. And break out the bubbly.

Funding New Product Development

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Two Approaches to New Product Development Funding 

From a financial angle, there are two often encountered scenarios when funding the greenfield development of a new product:

  1. The founder /VC approach, where the founder serves as the first provider of funding
  2. The “new project within a large  company” approach

In a venture capital context, it is clear that a project is a calculated financial bet by the owners, whether the founders or the VC. An investor (such as the entrepreneur) puts some money into a company. The investor thinks the project will be wildly successful, even though at the moment, the company has no profits, revenue, or possibly even product.

From a pure net present value (NPV) point of view, it looks like the VC in particular has lost a few marbles. They’re handing over a large sum of money to a group of people who might earn an unknown sum of money a few years in the future, at an unknowable discount rate. They might change the world, or be bankrupt within a few months.

As a result, in pro-forma financial forecasts of expected returns, VCs use their estimated discount rate is as a “fudge factor”. This fudge factor gives them an additional margin of safety, if they believe the revenue forecasts are unrealistic. Specifically, if they don’t trust the entrepreneur selling them a part of his company, a new financial investor (VCs) increases the discount rate to reflect the higher level of perceived risk. This approach is, however, a bit heavy-handed. Moreover, it is imprecise, because it doesn’t really reflect risks in the venture. It also allows anyone to “game” a valuation, based on their intuitive gut feel about a company. Despite these issues with NPV in the context of startups, it has traditionally been the most widely used.

Funding a new product within a larger company is also a bet, but with a different source of capital. Let’s say you are such a product owner or sponsor. You have a pool of money, either as part of an annual budget process, or obtained via an external loan.

Your goal is to earn an excess return over the cost of having that capital. Traditionally, the most cutting-edge tool for detailed analysis like this would have been Microsoft Project. Not only do you draw out your Gantt Charts about the various stages of the project, and base your estimates on what you expect will happen, you can even use Project to calculate project level rates of return using NPV, internal rate of return (IRR), and possibly scenario analysis.

Your cost of capital, typically the weighted average cost of capital (WACC) serves as the benchmark for deciding whether to invest in a project. The WACC is a simple accounting concept, where you take the average interest rate paid on all debt, and estimate the expected return on the equity based on observable comparable companies, and take a weighted average.

The WACC is analogous to the “fudge factor” assigned arbitrarily by an external financial investor in the VC case. Both of them serve a few purposes:

  • They are a “hurdle rate” above which the investment needs to perform
  • They summarize the opportunity cost of investing in that particular project/new product, as the investor or company sponsor could be invested in any other product/project/investment
  • They quantify the “cost of time” which everyone faces, when working on the project.

Unlike the fudge factor, a WACC is based on actual funding the company already has. It’s very real, not an estimate. Arguably, the VC “fudge factor” is just an estimate of an actual mature company WACC, particularly since most of the funding will come from equity investors expecting a high return, so the actual WACC in a VC venture is high. WACC is also based on financial characteristics specific to that company, such as creditworthiness, risk profile, etc. Most importantly, both are fed into an NPV model, which subsequently gives you an invest/no invest criterion.

What are the effects of using this denominator in NPV?

Both of these scenarios focus you on one objective: controlling or minimizing your immediate costs (negative cash flows) until your product launches in the (usually distant) future, according to John Judd, a serial CEO and CFO. This helps to offset the venture liabilities to investors and banks. It also causes more problems than it solves.

In most industries, product lifecycles have shortened dramatically. There is much less certainty than there was in the 1960s and 1970s, when NPV-based waterfall project management styles were the norm, and rightly so. Nowadays, your industry can change completely over the space of a few years. Just ask any music industry executive.

Moreover, this pace of change is accelerating still. Moore’s Law dictates that the number of transistors which can fit on chip doubles roughly every 18 months. This doubles the processing speed available. It does not even take into account improvements in the available software, which obviously affects you if you are competing in the software industry.

Make the Most of Now

Instead of controlling costs, it makes much more sense in a volatile environment to focus on revenue, and how quickly you can generate it. This is because the software industry is still rather young. After spending much of his career promoting project metrics within software engineering, Tom Demarco came to a rather odd conclusion about the role of cost control in IT projects. Demarco notes:

To understand control’s real role, you need to distinguish between two drastically different projects. Project A will cost around $1 mln, and earn $1.1 mln. Project B will cost around $1 mln, and earn around $60 mln. What’s immediately apparent is that while control matters a lot on Project A, but almost not at all for Project B. This leads us to the odd conclusion that control matters a lot on relatively useless projects, and much less on useful projects.

Great software projects generate massive payoffs. You are better off looking at how your project will generate incremental revenue, than pinching pennies, because the software industry is still very young.

Projects like Demarco’s Project A are sometimes necessary, particularly when looking within existing companies. They do work- if you are sure the project will be steady enough to generate stable cash flows. In this case, you are taking a “value investing” Warren Buffet approach, where you want to pay as little as possible for a very stable, slowly increasing, stream of cash flows. Buffet supposedly doesn’t even look at companies that don’t have a 10 year track record of stable and increasing cash flows, and where the current price of the business implies a certain “margin of safety” (hint: it’s really cheap).

SOMETIMES this is relevant for new products in software businesses, or mature businesses using a lot of software. Nonetheless, you are making a rather dangerous set of assumptions about your environment, your competition, and typically a product that doesn’t even exist yet, much less have a track record. Often these assumptions go many years into the future.

What works for investing in Coca-Cola or Heinz (both owned by Buffet’s Berkshire Hathaway), may not apply to an IT initiative. If you are so risk averse, that you only look at actual cash flows from the last ten years, you don’t take into account that most of the big players change every 10 years in IT. You also need to have a really clear business rationale for sticking to 10 year old technology, if you compete with other software companies.