When should your company raise outside capital and how much should you raise?

There seems to be an underlying assumption amongst many entrepreneurs that when you start a company you need to raise $500,000 to $1 million in seed funding pretty soon after the formation of your company to solidify your idea and test your product concept.

Frequently, the thought process is something like this: "I need to pay myself and my team for the first year to 18 months while we prove out our idea." This is a catastrophically bad idea and is likely to lead to a lot of frustration--or even worse--for you and your investors.

Here's why.

Small to mid-size businesses can be tough investments.

There are two main types of startup companies. The first are small to mid-size businesses, sometimes called "lifestyle" businesses by the professional investor community.

These businesses are the backbone of the U.S. economy and they drive a substantial amount of job growth. These businesses are typically "bootstrapped" by the founder with his or her own money without ever raising outside capital.

In some cases, these businesses may take a small business loan, raise some money from friends and family, or maybe even get an outside investment from an angel investor or strategic partner in exchange for an equity stake.

These businesses may remain relatively small enterprises of five to ten employees, or they could even grow to 100 to 500 employees over a period of years. They can generate from hundreds of thousands of dollars in annual revenue to tens of millions.

These companies can be very profitable, employ quite a few people, and create a reasonable amount of wealth for the business owner. However, they typically lack the market size and growth for adequate venture capital returns.

Companies that have potential for a billion-dollar market cap.

The second type of company is one that has the potential to be a large and explosively growing company. You need to be addressing a potentially large and rapidly growing market with a highly differentiated solution that solves a significant problem for customers in a unique way.

Venture capitalists are looking for companies that can have at least a $1 billion valuation at exit, which is either a mergers and acquisitions transaction or an IPO. Interestingly, according to a Kauffman Institute study, "the pace at which the United States produces $100-million companies has been stable over the last 20 years despite changes in the economy."

The study also states: "Anywhere from 125 to 250 companies per year (out of roughly 552,000 new employer firms) are founded in the United States that reach $100 million in revenues." Multiply $100 million in revenue by ten and you get $1 billion. So, billion dollar companies are really rare.

The vast majority of companies don't even make it. Although about 70 percent of all businesses that are started in the U.S. fail in the first ten years of business, closer to 90 percent of venture backed companies ultimately fail.

Key considerations when raising outside capital.

Before you embark on the process of raising outside capital for your startup, make sure that you honestly answer these seven questions:

  • What type of company do I have?
  • Do I need to raise money?
  • If so, how much money do I really need to achieve my next set of key milestones over the next 12 to 18 months?
  • What would I do if I didn't raise that amount of money?
  • Do I need a minimum amount of money to win?
  • What am I willing to give-up in terms of control, equity in the company, and other corporate governance to get the needed capital?
  • How much money will I need to raise in total capital before my company can sustain consistent profitability?

If you really don't need to raise outside capital, don't do it. If you want to be successful, treat these decisions around selling equity in your company very seriously and thoughtfully. The vast majority of companies should bootstrap their way to success and selectively get money from friends and family or small business loans.

Some companies should partner their way to success. A very select few should raise outside capital from angel investors and venture capitalists, and in those cases look downstream and don't raise too much money too soon or all at once.

There are exceptions to this rule, but they're rare. It's almost certain that your company is no exception.