To read part one of this series, please click here.
LONDON, United Kingdom — Founders seeking outside investment are volunteering for round after brutal round of tough questions about their creativity, competency and ambition.
And yet few start-ups ask one very basic question up front. Why?
“Why are we raising capital?”
Neil Blumenthal, co-founder and co-chief executive of Warby Parker, believes that question “is the most overlooked aspect of fundraising." He emphasises the need for clarity on why outside money is being sought, what it will be spent on, and where it will take the business.
“The moment you raise outside money, you’re making an implicit declaration that you’re going to sell that company at some point in the future,” he said. “You will have to get a return for the investors.”
Founders and investors alike stress the importance of first appraising whether fundraising is the right move. Here are some good and bad reasons for raising investment:
The Right Reasons
1. Building a team
2. Developing the brand
3. Scaling production
4. Growing the product mix
5. Building out sales channels
The Wrong Reasons
1. Providing an income for the founders
2. Creating prototype designs
3. Assessing whether demand exists
4. The company can’t pay its bills
5. Validation for the founders
Swapping cash for a slice of a start-up means the company will almost always be pushed to grow — sometimes past the breaking point. Companies not conducive to scaling will struggle with this mandate, and in the long run will fail to provide a meaningful return for investors. Anu Duggal of Female Founders Fund says: “You need to convince why this will scale to a $100 million company.”
The No-Investment Path
Some founders opt out of the process before it begins. They try to grow purely off the cash generated by their businesses, accepting slower expansion in exchange for having complete control of their businesses.
“We didn’t want external investment,” said Quang Dinh, founder and chief executive of Girlfriend, an ethical direct-to-consumer activewear start-up. “They want 10x growth and speed. We want to nurture our business, tell our story properly, not get pushed into stuff we don’t want to.”
He adds: “A lot of fashion and apparel is about brand and physical product. That takes time to grow. The mistake is people look at the time-frames of Facebook rather than Nike.”
The downside is that organic growth is slow and precarious. Although it’s cheap to launch a brand, scaling is expensive, leaving little room for mistakes. The company is more vulnerable to outside forces such as better-funded competitors, a change in fashion trends, a misjudged collection, a downturn in the economy or the collapse of a key retailer. They have to hope for a combination of good luck and faultless execution.
“Own the Process”
For those who need outside investment, seasoned founders talk of the need to “own the process” — defining in advance what a successful deal looks like: the terms, the profile of investors, the date it’s concluded and the impact on the business. Hard dates should be put in front of investors. The deadlines will push prospective investors to act quickly and show the start-up is serious.
Maintaining that focus isn’t always easy. Those who have gone through the experience describe a treadmill of meeting people, pitching, refining the pitch documents and meeting more people.
Will Green from L’Estrange, a menswear start-up focussed on staples, describes raising investment as “a numbers game,” adding, “you have to think about the psychology of it. The energy around the fundraise has to be positive while making sure you come across well.”
Green and his business partner Tom Horne found themselves poised to agree to unfavourable terms from an investor and only aborted the deal at the last minute in early 2017.
“We had to take a step back and ask whether we wanted this route at such an early stage of the brand,” Green said. “It was a baptism of fire but this process did give us a quick-fire education in the investment process.”
Raising investment in five not-so-easy steps:
1. Develop a Minimum Viable Product
The first step toward securing investment is to build a business without outside funding.
Cuyana founders Karla Gallardo and Shilpa Shah each put $20,000 of their own savings into their leather-goods business.
Before their first round of fundraising in June 2013, they were able to demonstrate to investors their competency in running a business, their creativity and a real demand for their products. That made it easier to sell the potential for Cuyana to scale.
“Make the vision of what the business will become as big as possible and the leap of imagination that it will achieve this as small as possible,” said Duggal of Female Founders Fund.
2. Put Friends and Family First
The first bit of money to get a business off the ground is either the savings of the founders or those closest to them. It means scouring their contacts for friends and families willing to take a bet. This cushion allows the founders to experiment, test ideas, make mistakes and learn.
Even though the sums at this level are small — around $50,000 or even less in many cases — many observers say this is why start-up founders often come from wealthy backgrounds.
While this might be true, what matters most is how hard a person scours the limits of their network.
“Leverage everything. Your early fans, college peers, places you’ve worked. Literally everyone,” Duggal said. “How well you do this is also an indicator down the line for future investors of how well you can sell and how entrepreneurial you are.”
At Warby Parker, the four co-founders agreed each would put in $25,000 up front, and, if required, they would each put forward an additional $5,000. They agreed that the $120,000 was a cap, and they wouldn’t throw good money after bad if the business wasn’t going anywhere.
3. Hone the pitch
The amount being raised needs to be specific. It should be based on what the start-up needs to propel it for its next phase of growth and get to its next big milestone. This is typically composed of new staff salaries, making products, upgrading the website and assets needed to accelerate the business, like hiring a PR agency.
Investors will want to dig into where the money will be spent over a period when either the company becomes sustainable on cashflow, or until its next round of funding. This is often known as a company’s “burn rate” — how much the business is likely to lose month to month.
The next big question is how much equity the founders will give away, which is determined by calculating a realistic valuation at the time of the raise. Valuation at seed stage is far from a precise science. It’s a guess largely based on investor appetite and valuations of companies at a similar stage that recently raised funding.
4. Identify Investors
Before embarking on the search, there is an ideological question that needs answering: is it “smart money” or “dumb money” that’s coveted? The latter targets investors willing to take a backseat, and puts the most favourable deal as the main concern. The former is about taking cash that also comes with expertise, connections and know-how.
Investors should also be aligned with the founders on the direction and values of the company.
Gallardo and Shah say were frustrated by the male-dominated investor scene in San Francisco. They found a Pinterest post which had a directory of female investors — a path ultimately led them to Maha Ibrihim and Canaan Partners who backed Cuyana with a $1.7 million round in 2013.
Finding the right backers can start with tracing individuals who backed similar companies. Investors respond favourably to recommendations from other founders.
Investor-specific sites like AngelList can be effective, and social platforms LinkedIn and Twitter can sometimes open doors.
5. Tailor the Pitch to the Investor
Investors appreciate a pitch deck that tells a tale simply and without hyperbole. The deck should cover the origins of the business, the vision, the opportunity, the founders and some key financial information.
“With all of the information and advice in the market around how to develop a pitch, we’re definitely seeing the average story told by a founder to be much more succinct and grounded,” said Eurie Kim, general partner at venture capital firm Forerunner Ventures.
The particular needs of a fashion start-up are the mix of creativity and commercialism. A creative drive is at the core of the business. So is the founders’ savviness around building a fashion brand that will give the start-up distinctiveness and desirability in a competitive space. That requires a combination of commercial, product and branding smarts, and a sense of unity among a start-up’s core team.
The calibre of the founding team can be decisive. Are they exceptionally talented in their fields? How well have they been able to make a product and sell it so far? Have they problem-solved and hustled their way through the early problems? Investors will be looking for signs of ingenuity, tenacity, chemistry and operational competence.
Every investor has their own approach. Some are more founder driven, others act more on a market opportunity. But the basic questions are consistent.
According to Blumenthal, “Investors ask ‘Is this a good idea? Is the market big enough? Is the team any good? Can they acquire customers affordably and scale fast?’”
Although financial performance at this stage isn’t game-changing, investors want evidence the founders have rigorously thought through a business model. Even if not present today, they will explore metrics such as revenue growth, cost of acquiring customers, the margin on each customer, how many customers buy again and more.
Finally, there is the magic element that investors crave: a unique angle that gives what is often referred to as “an unfair advantage.” The London-based VC Venrex has termed this “a trick.”
Sasha Roupell of Venrex says: “It’s some kind of supersonic advantage that’s impossible to replicate. It could be a patent, but it could be the founder is uniquely placed like Samantha Cameron [wife of former British prime minister David] did with her start-up.” Cameron set up Cefinn, a womenswear brand, in 2017. Her trick was her fame and connections.
If an investor is warm to the pitch, he or she will then take it to their team and appraise its suitability to their fund’s portfolio. They will then formulate a “diligence plan” to learn more about the company, the founders and the sector. A second meeting will follow.
The founders will then be asked to provide a variety of information. The investor may call people who know the team to get more background. And, of course, will arrange more meetings.
Kim, with Forerunner Ventures, says: “If it looks like the stars align and we want to make an investment, we work with the founder/team to align on terms for the deal, and what amount of capital we will be investing.”
The investors may offer to be a “lead investor" and form a syndicate with other backers.
Legal documents are then finalised between a lawyer acting on behalf of the start-up and the lead investor.
According to Kim, a deal can take as little as a week or drag out over several months. Kim adds: “I’d recommend teams allocate three [or] four months from when they kick off their raise to when they expect to have money in the bank.”
And from that point, the founders can take a deep breath, reflect on their success and then get on with the serious business of scaling a business which now has a responsibility to outside shareholders.