Just in the last three weeks, I had three different founders ask me “Should I raise and then build or build first and raise later?”. If you’re asking that question, you’re probably not ready to raise. Many technical founders fundamentally misunderstand the investment process. They think they can get funding because they have a great product or are sitting on a huge market opportunity.
They’ve got it wrong.
Investors don’t really care about your great product. They also don’t care about the market opportunity by itself. They care mostly about whether it will lead to great returns. But there’s a big problem: early on you’re all vision and no proof. They want the upside but they hate the risk.
So, rather than going all in and taking undue risk with your unproven idea, or walking away from the deal and losing out on the opportunity, investors take a middle path: they fund you in rounds. At each round, they assess what you’ve accomplished so far with the money you got. Then they assess the value they’ll get for the “price” of the new round, which is your raise amount. If they’re convinced that you’ll use their money to remove a significant layer of risks, you have a better shot at getting the check.
The Key to Progress: The Value Roadmap
When an investor looks at your pitch, they see all the things that could go wrong: your product may not work, customers may not want it, or have the means to pay for it, or distribution may prove too expensive. For your pitch to be credible, all the activities that you’re planning and budgeting should lead to one thing and only one thing: lower risk, which means higher certainty and greater startup value.
The Role of Risk
For most early stage startups, there are only two major risks: product risk and market risk.
Remember Theranos? The product was going to change the world until it was exposed as a fraud. That’s an extreme case of product risk that was covered by fraud, but it’s what investors watch for – that your product won’t work as advertised. Product risk is highest for deeply technical innovations, for example in life sciences, energy or advanced materials.
The textbook case for market risk gone wild is Webvan. In the heydays of the dot-com revolution, Webvan raised over $700 million in funding including from an IPO. Its grocery delivery model was two decades ahead of its time. It spent all of that to generate only $395,000 in revenue prior to shutdown. There is market risk for you!
Getting market adoption right is where most startups fail. Especially if you’re a technical founder, it’s easy to fall in love with your technology and assume that if you build it they will come.
Architecting Value
The smart way to get these risks under control is by creating a value roadmap that shows investors how and when you’ll prove a significant set of assumptions around a set of risks with real world data, or the receipts investors love.
You do this by setting up milestones in a logical order, telling investors exactly how each milestone will reduce risks, starting from the biggest. When they see this roadmap to value, investors trust that you know where you’re going, and won’t steer the startup right over a cliff.
If you’re a deep-tech startup, for example, and product risk is the biggest unknown, investors want to see milestones to prove:
- Technical specs and design
- Proof of concept
- Proof of technical performance
- Proof of scaling, e.g. lab scale to pilot scale to commercial application
For all products, investors want to see value events proving market demand:
- Validated customer need and problem urgency (e.g. customer discovery interviews)
- A well-defined beachhead market (e.g., letters of intent)
- Validated willingness and ability to pay (e.g., a paid pilot)
- Ideally, sales (e.g., a list of confirmed purchase orders)
The Real World Road Test
But product and market related milestones don’t tell the entire story. Here’s why.
WeWork was the startup that could do no wrong. It kept raising eye-watering amounts of capital, starting at $430 million in 2016 to over $10 billion by 2019. Even that wasn’t enough. The business model relied on continuous growth and funding to cover long term lease agreements. Funding dried up when its IPO plans collapsed in 2019. The company crumbled.
Even the best value roadmaps go awry if you don’t have the cash to execute on them. So investors are constantly assessing the risk that you’ll run out of cash before you can prove your value or generate a profitable exit. No exit means no returns to investors – a nonstarter.
To reduce funding risk, investors want to see:
- A well-supported view of your total capital needs until you’re self sustaining (or can exit)
- A funding plan with timing and money for planned raises
- Strong and credible financial projections to back up your story
Road Readiness Checks
With your value roadmap and financial story straight, you’re almost ready for takeoff. There are just a few tactical issues to check.
Get Stage Fit Right
The fundraising environment is constantly shifting in terms of expectations and availability. For example, what was normal to expect for a seed-raise a few years ago, like early paying customers for example, may now be the bare minimum for a pre-seed raise.
So step one is to figure out where you are in this ladder of funding levels, and how well you fit with the closest level for your stage in your industry.
Calibrate Milestones and Runway
Next, can you articulate your raise fluently in terms of your next milestones, runway and the specifics of how you’ll spend that money? A big mistake I see founders make is to pitch their ask in terms of expense line items like salaries or marketing expenses. Investors want to know that you know the details – but that’s not what they’re buying. They’re buying milestones.
Also test your ask in terms of the runway it buys you. Founders are notoriously optimistic in estimating costs and time to get things done. If your raise translates to a short runway, it’s likely you’ll run out of money before you achieve your milestones and raise your next round. That’s a big “no”.
Take the Long View on Capital
For many startups, one raise isn’t enough to get to exit or cash flow breakeven. Investors know that. To minimize your capital risk, investors want to see a clear picture of how much capital you will need in total to exit or cash breakeven.
They know the future isn’t guaranteed, but they want to see a thoughtful plan that shows them you know how much money you’ll need, when you’ll need it, and how you plan to raise it.
They’ll use the same yardsticks to judge your overall capital plan: that these raises are tied to clear and tangible milestones, the timing makes sense, and the raises are roughly in line with standard practice in startup investing.
There’s one more kicker: the biggest risk right now is that you won’t be able to close the current round. Even if you’ve checked all the other boxes, ensure you’ve thought through your backup plan in case you’re not able to raise the full round. For example:
- How will you stay afloat, and what will you keep doing if you can’t fill your round?
- How does that impact your ability to hit your milestones? Your revenue opportunity? Your exit options?
- What’s your worst case scenario and how well can you handle that?
So the next time you want to know “should I raise now?”, ask yourself:
- Have you identified the biggest risk for your startup, i.e., product risk or market risk?
- Have you correctly prioritized de-risking, starting from the biggest risk?
- Do you have a clear plan of activities and milestones you need to reach to de-risk?
- Do you know the resources, cost and timing needed to achieve each of these milestones?
- Do you have a backup plan in case things go south?
Check all these boxes, and you’ll know for yourself whether you’re ready to raise. How ready are you to raise?
