You have decided that you need to raise money for your business. We have already discussed the difference between debt and equity money (see my September 2006 column). But how much money should you raise? And when is the best time to raise it?
The amount of money that you seek to raise is affected by a number of factors:
Perhaps most significantly, the amount of "equity money" that you raise can affect your ownership and control of the business.
In determining how much money to raise, there are competing concerns: adequacy of the amount raised to meet your needs and the cost of the money raised. There should be a reason for raising money -- an immediate goal. For a start-up business, the goal may to bring the business to “self- sufficiency," or to a point where it is feasible to raise additional funds at a lower cost. The amount must be adequate to accomplish your goal, and, preferably, to deal with unforeseen contingencies and take advantage of opportunities that might arise. But you don't want to pay too steep a price for something that you don't need. The cost factor is particularly important if the price for OPM is paid with equity interests in your business. You need to plan in order to avoid a cash shortage, but if you raise too much “equity money” too early, you may unnecessarily dilute the ownership of your business.
The cost (in terms of percentage ownership per dollar) is primarily a function of the valuation of your business at the time you seek "equity money." For that reason, you should correlate your fundraising with critical growth stages and milestones in the development of your business. Try to identify specific milestones or events that would cause a significant increase (appreciation) in the valuation of your business. (Typically, you raise only enough money to get you to the next milestone that significantly increases the value of your business.)
In other words, you build up the value of your business as much as you can before each successive round of financing and do not raise money until you actually need it. With a "parsing" strategy -- identifying a series of specific milestones or events that significantly increase business valuation, and raising only the amount necessary to reach the next milestone (taking into account the lead time necessary to raise funds) -- you can bring in equity investors without giving away the store.
Here's a quick scenario that helps put into perspective the decision to take on equity investors for particular milestones versus a heftier, less directed investment that serves the general growth of your business.
First, let's assume that the present value of your company is $100,000, and you need $400,000 to bring the company to the point where it is cash flow positive. If you bring in $400,000 of equity investment at this point, you would be left with only a 20% equity interest in the company (Your contribution to the venture would be $100,000 -- the pre-investment value of the company -- against the investors $400,000). In other words, the cost of the equity money would be 80% of your company.
Now let's assume that you identify a specific milestone that would cause significant appreciation in the valuation of your business -- e.g., completing a prototype. At a cost of $20,000, this prototype has the potential to increase the value of your company from $100,000 to $300,000. If you "parse" your financing, and raise only the $20,000 necessary to complete the prototype, you can significantly reduce the cost of raising the remainder with equity money after the prototype is completed.
With respect to the $20,000 funding, your contribution to the "co-venture" is $100,000, against the investor's $20,000, leaving you with an 80% equity interest. When you raise the remainder of the $400,000 after completing the prototype, the value of the company is $300,000 (80% of which is attributable to you), against the new investor's $380,000 (leaving you with approximately 35% of the equity).
If you could self-fund or obtain a loan for the $20,000 necessary to get to the point of obtaining the contract, so much the better. (You would retain approximately 44% of the company). Of course, if you identify other milestones or events that would cause a significant appreciation in the valuation of your business, and correlate your financing activities to those events, you will do better still.