Startup financing: The funding strategy that actually worksArticle added by Kenneth Marks on September 27, 2010
Ranked: #478 (176 pts)
You have an idea for a product or service and want to start a company, or maybe you already have a company and you are thinking about launching a new product line.
Either way, you need capital to make it happen. But how do you get the funding required? If you attend your typical MBA class on startup businesses or entrepreneurial starter program, you’ll likely be told to write a business plan and shop it to angel and venture investors.
Not in the real world!
Statistically, no one gets venture capital. Yes, we all read about the handful of companies that obtained venture funding, that are written about in the trade rags and that may have even gone public. But given the number of companies started each year vs. the number of companies receiving institutional (or venture) funding, the frequency of such cases is insignificant, and for most companies, just plain unrealistic. So, how do 99.9 percent of startup businesses get funded?
The financing strategy involves bootstrapping in stages based on iterative phases of success, working from the end backwards along a path of steps, and only doing what must be done to get to the next phase with minimal capital. This is a resourceful and practical approach:
Start with the end in mind; that is, the customer and the market need. Many businesses start with a solution and look for a problem to solve; this is natural when you have technical entrepreneurs and creative people.
- Start with the customer. Establish the critical path items for at least the first stage of the company or project.
- Define what it takes to validate the market and prove the company’s ability.
- Develop a list of where and from whom you can get the resources needed (i.e. who has a reason to care about my company’s success)?
- Assess — “Can we bridge the gap with friends and family and personal investment?”
However, capital is attracted to situations with proven market demand; a solution that is feasible at a validated price that allows the business to make a significant return based on the risk involved. The idea is to validate the market and price as soon as possible in the development of the company. Shape the product or service offering to assure profitable revenues, or at least those that can generate a reasonable gross profit (revenues minus direct costs). This means talking with potential customers as you craft the business plan and strategy — the same goes with likely sources of supply.
Next, leverage the knowledge gained to develop the critical path items required to launch the company, create a working prototype and confirm that the business model will work. One of the outputs of this process is a clearer understanding of the amount and timing of capital required.
Let’s look at an example. A small group of entrepreneurial-minded engineers see a market opportunity to develop firmware (software at the hardware level) for the next generation of integrated circuits. The team understands the technology and has insight into a new approach that will allow the firmware to be used for many different types of hardware. This is a unique solution and an opportunity.
To gain interest in their venture from outsiders , they need to prove that their concepts will work and that someone significant in the market will buy the product. Instead of trying to raise money to do this, one approach is to determine what portion of code they can have written with a team that will do the work for deferred compensation (future payments and stock), based on the success of the business. In addition, they need to get feedback and buy-in from a major customer in the form of a letter of intent or contract, or an agreement to conduct trials or tests.
Another dimension to developing the business at this stage is to understand industry players and leaders — both companies and individuals. From these players, you can recruit a board of advisors early-on to help guide the progress of the business, potentially open doors and relationships, enhance the credibility of the company, and to provide some seed capital.
Once the prototype and trial have proven successful, seek actual orders or licensing of the technology from the same customer, to include pre-payment. This pre-payment becomes part — if not all — of the next round of financing required to further develop the product and the business. The order or license agreement significantly validates the customer need and pricing, addressing two of our key risks and providing a potential referral to obtain more customers and other commitments.
Company valuation is almost always a point of contention. The entrepreneur values the business based on what it can be and the investors value the business based on what it is. These differing perceptions often result in a difference of opinion on the worth of the business.
One of the side benefits of obtaining resources and capital from those that have a reason to care about the success of the company (i.e. customers, suppliers, employees, friends and family) is less sensitivity to valuation because there is more to gain than just an economic return on the stock.
This funding approach forces management to get to the important and difficult issues quickly; engages those that will likely gain from the company’s success and leverages their resources; minimizes the required cash; minimizes the dilution of equity (i.e. keeps more of your stock for your team); and increases the likelihood of survival and growth.
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