This post is Part III in a series of articles about incubating a company. See Part II on how to spot trends and capitalize on them.
After concluding there was a very real market for Shake, my team needed to figure out how much money to put in the company. As a co-founder, RRE was committed to putting in the money at a relatively attractive price instead of receiving any founders' equity. The question then became, “How much?”
The amount of money required to start a company has declined dramatically since I began in venture capital. Companies once had to buy servers and software licenses, and hire many programmers just to get a product up and running. Thankfully, computing in the cloud and open source software have changed the paradigm: $750,000 to $1,500,000 is now enough to get a product to market, particularly in the consumer space. The lean start-up was born.
But when raising money, there are two conflicting forces at work. The first is dilution. Obviously, the more money that a company raises at low Series A valuations, the more dilution founders must accept. The basic rule is to raise enough money to enable the company to hit a set of milestones that puts it in good shape to raise money at a higher valuation during subsequent rounds of financing and stages of growth.
The other force at work is the unpredictability inherent to start-up life: Everything costs more and takes longer than you think. The business you start with is often not what you end up launching. And even after launch, many start-ups pivot, changing focus to better meet the demands and needs of their customers. How do you deal with this? You plan and plan and plan, and when you are fully confident in the amount of money you’ll need to get to the next level, you add approximately 25 percent. Why? Pattern recognition. Companies historically always need about 25 percent more capital than they initially estimated.
The lean start-up world has made this calculus even more precarious, since after a single round of financing a company is either working well and is highly sought after by venture capitalists or it is not taking off and has a hard time raising more money. The success of an early-stage start-up is very often binary. So the first round of capital better be enough to get the company to a point where it shows very promising metrics, whether those be user growth, revenues, or other quantifiable goals.
Shake started with a ground-up analysis: How many people to hire? How much to pay them? What to outsource? How to get state of the art design and UI? How many months to get the product to market?
Abe’s analysis showed 18 months of runway and promising metrics for $750,000. We pushed him on it. He truly believed $750,000. So we agreed on $1,000,000. There’s no rocket science here. Scrub and scrub and scrub the numbers until you are sure you can get the company to the next level of funding at a higher priced round, then add a buffer for all the things that can and will go wrong. This sounds like hyperbole, but it can mean the difference between success and failure for a start-up, regardless of the idea and how good it is.
The idea proved viable, and the financing was complete. But despite how much effort has already gone into the process, the real work has yet to begin. A good idea is necessary but without execution, it's nothing.