One of the big questions that every entrepreneur struggles with is how much funding they should request from investors in the first round. They know from forums such as Shark Tank on TV that asking for either too much or too little will derail credibility in the eyes of the investor, and leave the entrepreneur with no money and a struggling startup.
Strategies that I do not recommend include opening the discussion with a big number, hoping to make a more reasonable value feel like a good deal, or starting with a tiny number, hoping to entice interest from everyone. Both of these will brand you as an amateur to avoid, rather than a savvy business person with an exciting new opportunity.
The right answer is to ask for an amount that is just right, based on your real needs, and consistent with the capabilities and interests of the investors you are addressing. Here are eight key questions that will you get in the right ballpark with the right investors:
- Who is your investor audience? Every type of investor has comfortable ranges and limits. Angels usually won’t consider requests above $1 million. On the other hand, venture capital organizations typically look for needs that exceed $2 million. If you are talking to your rich uncle, do your homework to find his limits before you meet.
- What business milestones have you met? If you have a good idea but haven’t started yet, only friends, family and fools will likely be interested. Angel investors will perk up if you have a prototype or a few real customers, while venture capitalists will likely choose to wait until you have achieved several million in revenue or customer count.
- How much do you really need for the next 12 to 18 months? Here is where projections of cost, pricing, volumes, and cash flow are critical. If your financial model projects a negative cash flow in this period of $400,000, you should buffer this amount by 25 percent, and ask for $500,000. Be prepared to explain your business model.
- Can you justify your use of funds to this investor? Professional investors expect to see your top three use of funds categories, and how these relate to scaling the business, rather than initial development. Ancillary objectives, like retiring existing debt, buying a building or paying salaries to people with equity ownership will not get traction.
- How much equity ownership are you willing to offer? This is all about setting a credible current value on your startup — not future value. If you ask for more money than your company is now worth, no investor will bite. The average valuation for angel investments is $2 million, which will get you $500,000 for 20 percent of your startup.
- Are you flexible on the terms of the investment? Most professional investors will expect preferred stock, a board seat, rights to later rounds and perhaps anti-dilution protection. If you refuse to offer these, or balk at negotiating even more restrictive terms, the amount of a viable investment will be compromised.
- Are you willing to offer milestones for staged investment delivery? Many investors like to reduce their risk by delivering their investment in stages or tranches, based on your successful achievement of specific milestones during the period covered. However, this reduces your ability to plan or pivot quickly based on unforeseen events.
- Can you project a compelling rate of investor return? Equity investors typically look for 10 times return projections, since they expect many of their investments to fail totally. The best way to show return on investment is to declare an exit strategy, such as being acquired or going public in the next five years, which allows the investor to cash out.
In fact, the most successful entrepreneur strategy is to bootstrap or fund your own startup, such that you don’t need to expect or require any external investor involvement. Despite all the hype you hear on attracting investors, more than 75 percent of startups are still self-funded and avoid the hassle of dealing with partners and giving up a portion of the company.
The best and happiest entrepreneurs build a successful startup that attracts investors, rather than waiting for an investor to find them and kick-start their success.