The Science of Financing a Software Startup (Part 2 of 2)

“Action expresses priorities” ― Mahatma Gandhi

Last week, I shared operational tips on How to Prepare Your B2B Software Startup for a Bumpy Ride. As the world settles into ‘a new normal’ of uncertainty and active planning, I have come across two well-written articles of venture market sentiment and funding predictions. In times of uncertainty, sentiment is often what drives private and public market behaviour and activity.

This week’s article is a continuation of The Science of Financing a Software Startup which offers a practical frameworks for software entrepreneurs who may look to raise (additional) venture funding, perhaps sooner than planned. Previously I addressed the same topic from the perspective of VCs and LPs (a.k.a “Limited Partners” who are investors in venture funds) in How to Due Diligence VCs.

The purpose of this content series is to reduce the information asymmetry that persists in the startup and scaleup ecosystem, so that founders, operators, investors, advisers, and LPs can invest time on strategy and execution (rather than knowledge collection).

As previously mentioned, the supply of capital to young and ambitious technology companies is no longer a constraint in Europe in the way it was 6 years ago. There are over 440 European VCs — more than 2x the number a few years ago. In addition, debt is now acknowledged as a a complementary source of funding alongside equity for venture-backed businesses. (Over 1.5 years ago, I started a series of content on venture debt which will be completed in the coming months.)

Given the immense pressure that startups and scaleups face after raising venture funding, it is critical to ensure that a business is well-designed for high sustainable growth in advance of raising external capital. This begins by understanding the purpose behind what the money is used for and what expectations startups have from their funding partners.

The first article of this mini two-part piece addressed the question “How much money should a startup raise?”. This one discusses “Who should a startup raise from?”.

To address both topics, founders should evaluate their high growth business and prospective funding partners in terms of:

  1. Business maturity: Scale vs. Predictability

  2. Purpose of money: Cash Flow vs. Growth

  3. Business objective: Flexibility vs. Cost

  4. Fund strategy: Fund Size vs. Growth Acceleration

Let’s dive into topics #3 and #4 in more detail. (First two are discussed here.)

Who should a startup raise from?

A few months ago, a founder told me: “Money is currently a commodity. Aside from the US funds, Accel, and Index, the rest are pretty similar. So we will optimize based on which investors have ‘light touch’ due diligence and provide the highest valuation.” This is simply not true. Money is terms, terms is money. Actions and expertise are also money.

In venture, it is critical to understand the business model and strategy of funding partners in order to be aligned on expectations — what happens in great, good, and bad times for a startup after it raises capital. Because let’s face it — most startups don’t survive, and (almost) all scale ups go on a bumpy ride.

Flexibility vs. Cost

Formula 1 line up for 2019. Each year, Formula 1 fans judge a team based on their budget, experience, strategy, team principal, drivers, and car. Mercedes is the best all-around for 6 years running. Ferrari has lasting brand value. Red Bull is ruthless with driver performance. Renault is trying to make a comeback. Haas is the ‘scrappy new kid’ taking big risks. Williams has its family legacy at stake. Which team is your favourite?

While venture investors and lenders are minority shareholders of software startups, they still have significant influence over the future growth of the business. It is therefore important to consider:

How does the company value flexibility vs. cost over the next 1–2 years?
What is the right composition of funding partners for the business?

In the early days, a young and ambitious startup should prioritize flexibility and relevancy above all else. As the business matures and becomes a predictable growth engine — with clear revenue & cost attribution and predictable forecasting behind marketing & sales — then optimizing the cost of capital is more valuable than flexibility.

Flexibility is more valuable than cost for startups and scale ups.

The below chart shows an overview of the type of venture funding available to software startups and evaluated in terms of flexibility, cost, and governance (also mentioned in prior article).

In the world of high growth venture-backed businesses, flexibility provides startups and scale ups the ability to deviate from the financial and strategic plan promised to investors. Below is a framework that can be used to evaluate the flexibility of a prospective funding partner.

On the other hand, cost is the price tag associated with the expectations of a funding partner. This is generally a byproduct of the fund strategy and business model, which can be broken down and analyzed using the framework below.

As you can see, there are many variables to consider. Therefore the best way to get a quick answer is to speak with the customers — founders, investors, advisors, and LPs — to understand historical behaviour and actions taken.

Fund Size vs. Growth Acceleration

Boards should provide tangible support to accelerate the growth of startups and scale ups.

Last month, I sat in on a discussion where a successful entrepreneur and Board executive had mentioned that his prior Board members had ‘opened the doors’ and introduced two-thirds of the company’s customer base. Impressive value add.

In the early days, a young and ambitious startup should utilize the Board as a sparring partner and leverage the experience & network of seasoned operators and industry strategists in order to fuel growth. As the business matures and becomes a predictable growth engine, the Board functions more as a governance mechanism to optimize the business and support change management.

Before raising institutional capital, a startup should closely evaluate its organization and identify experience & skill set gaps needed that can be filled by the Board. Only after that can the business identify the right funding partners and what tangible support you can expect them to provide — aside from money — following a successful fundraise.

Below is a framework that can be used to support this discovery process.

How should a startup apply these frameworks?

It is important to clearly understand business expectations and how those aligns with the strategy & business model of prospective funding partners before embarking on a fundraise.

During the research process, consider doing the following:

Closely evaluate the first 20 employees and customers for your startup. Identify experience & skill set gaps to be filled.
Have candid and transparent conversations with funding partners who are owners or key decision-makers within their fund (i.e. have equity stake or ‘carry’ or some type of medium-long term performance-based compensation). Ask about fund strategy, execution, and support (not just decision-making).
Conduct references with prior and existing founders, operators, investors, advisers and LPs the funding partner has worked with.

In practise, venture is equal parts art and science. As we have recently seen and will continue to experience, changes in the industry can happen quite quickly based on market conditions (i.e. access, competition, sentiment). Therefore invest the time upfront to do research and build trust so that you have high conviction of what happens in great, good, and bad times for a startup after raising capital.

Two Michelin-star restaurant Noma closed down for a year in order to prepare for Noma 2.0 — the big risk has resulted in significant success since its re-opening in 2018.

Milton Friedman coined the statement ‘there is no such thing as a free lunch’. Always the case when money is involved. There are, however, certain restaurants and lunch menus more suited for a particular palate, appetite, budget, ambience, service, and overall dining expectations. Which ones satisfy your craving?

*Note: The classification of startups and scale ups as ‘Unicorns (or Rockstars), Dark Horses, and Walking Zombies’ have been previously discussed in The Business Model of VCs vs. Venture Debt Funds and What I Learned as an European Software VC.