Rule of Thumb No. 1 For Fundraising: Create Value First Before Finding New Funds

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May 31, 2012

Rule of Thumb No. 1 For Fundraising: Create Value First Before Finding New Funds

Entrepreneurs have to create value for their company before going to the next stage of funding. A startup is worth nothing, if it is just an idea alone. Entrepreneurs have to prove that the idea is feasible as a business and that there is a market for it. To do this testing or to launch, you will require some sort of funding to get it going.

There are many ways entrepreneurs can begin their start-up. Some put in their own money, some take on credit card debts, and then some borrow from their family and friends. It is quite typical to start with the “3Fs” when starting up, and these 3Fs are family, friends and fools. (Some people call the third “F” fools because it is always highly risky when investing in start-up companies, and the chance of losing all the money invested is very high, so it is like fools parting with their money, but I am sure it is meant as a joke, because people part with their money in anticipation to make money and not to just fool around). Mr Inderjit Singh – The Art and Science of Entrepreneurship.

To be frank, these days, unless a start-up starts with one of the F’s, others outside this circle will rarely give you money. Of course, if the money needed is too much, beyond what the 3Fs can support, then you will have to look beyond this group. The next group of people the entrepreneur will find easier to convince are angel investors, who are typically willing to take on much higher risks than the VCs, and who can make the investment decision much faster than any institutional investors can.

This being said, if you can manage with money from the 3F’s, it would be advisable not to jump ahead to the next stage too fast. The reason is simply what this rule of thumb says: you should create more value first before raising new money.

The structure of your 3F’s funds can vary. Depending on your own internal understanding, it could be taken as a loan or as an investment in your company. Often 3F investments go on to have high valuations later on, many of the early investors of companies like Paypal or Facebook were very well rewarded. This was because they invested at such an early stage, where there was a huge risk and uncertainty if the idea would work at all.

So, once the money from the 3F’s is in, the focus should be to do the initial work that results in a company being set up, with a few key people coming on board, preferably on a fulltime basis, and with some initial work done to design and produce the product or service – the prototype to prove that the idea works.

Once a working prototype can be produced, or you have a minimum viable product, which has some proven result in the market, you can then move to the next group of investors, who are the Angel Investors. By creating a product and proving it in the market, you have created some value for the company, showing that the idea is tangible and that there are people who are interested.

Angel investors will typically invest smaller amounts than VCs would invest but they take on tremendous risks at this stage of funding, typically called the seed stage. Only after the project gains momentum and the start-up has gained more traction, achieving more results and value in the new company, may it be the right time to go for bigger institutional investors like VCs.

The key objective for the entrepreneur is to enhance the company’s value before embarking on any new rounds of financing. In this way, the company’s valuations will increase, and therefore the original founders and investors will get less diluted as a result of the new investors paying a higher price for each share in the company issued at the later stage.

There is of course a balance and a judgment that has to be made as to how much money should be raised at each stage. Too much money at an early stage may get you diluted, resulting in the team owning less of the company at an early a stage. On the other hand, too little money and you risk having insufficient money to bring the company to the next stage of development, and perhaps in the worst-case scenario, lead to a premature collapse of the company due to a lack of funds.

We will look into the idea of planning for your fundraising in next weeks lecture –
Rule of Thumb for Fund Raising No.2: Bring in Just Enough Funds Plus a Small Buffer Each Time.

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