Getting Finance - Part 1

So far in the series I have looked at some of the different types of assistance that is available to a startup and also about what benefits working with a Mentor can bring and how you should be trying to maximise those benefits. 

But this time I wanted to start to look at the subject that many consider to be potentially the most difficult – finance. The March edition of Startups Magazine is focused on all aspects of finance and I have written a complete article there, but I still wanted to cover the basics here.

When anybody starts to run their own business the vast majority are guilty of making the same two fundamental mistakes in their calculations: how long things will take and how much money it will take. Put simply, everything typically takes longer than expected and costs more, and this then has the very real impact of how long it is before the company starts to turn the corner from loss making to breakeven to being profitable. By far the biggest reason that startups and early stage companies fail is simply that they run out of money. My own rule of thumb would be to estimate the time and cost and then double both!

All this means that at some stage the majority of businesses seek outside funding, either by way of a loan or by way of investment into the company. Many companies see external finance as some form of prop and often could survive without it as the companies own cash flow and profits can be recycled to help the business grow. It is true, however, that external finance is often needed or can help the company to grow much more rapidly and that may be critical in some markets. The only real way a normal early stage business has of raising debt is to do so on the basis of it being secured by a personal guarantee from the owner/directors and the amount is often not very much. Many lenders also look for three years’ worth of trading accounts which obviously is not possible with a startup. This type of debt is often expensive and interest would normally need to be paid on a monthly basis so worsening yet further the company’s cash flow. For these reasons the majority of startups in need of external finance decide to go down the route of sourcing investment into the company by way of selling equity.

The very first question of course you should be asking is do I really need external finance? This will depend upon your own resources as well as how capital intensive your business is in the early days, how long it is until it breaks even (remember to double the time and costs!), what is the burn rate (that is, how quickly does it consume cash), will your business generate lump sum payments or monthly fees, and so many more such questions. As part of your business planning you should already have developed a detailed business plan as this is the only real way to ensure that you have looked at all the issues that will affect your chances of success. As part of the Business Plan you should have produced financial forecasts and the assumptions behind them (remember to double time and costs!) and this will enable you and others to assess how much funding you need and be able to value your business.

At this stage I need to point out that startups always over value their own businesses – this is natural given that it is their baby and they believe wholeheartedly in it - and seem to expect investors to take on high risk for unrealistically low rewards. No matter how optimistic you are of your product / service / market until you make real sales or sign contracts then your business is an unrealised dream. The more sales. clients, contracts, letters of intent, negotiations etc that you can prove, the more real your business is to an outsider and the easier it will be to raise finance and the greater the value of the company.

Any external investor will be very keen to know how much actual cash has been invested by the founders and any other previous investors. All founders are keen to state how much time they have spent working on the startup and even how long they have gone without being paid but to an outside investor nothing speaks as loudly as the level of hard cash actually invested. 

After injecting your own savings (or indeed borrowed funds) it is typical to go to family and friends as they will typically decide to back your venture based as much on you as on the venture itself. For this reason they would not normally to any real due diligence or necessarily have any business or investing knowledge. In the trade this type of funding is often referred to as ‘Friends, Family and Fools’ and is of course the highest risk capital.

Next time in the second part on Getting Finance I will look at the different types of equity funding with a brief summary of the benefits and drawbacks for each.