Finance

What to consider when raising investment capital

Two people shaking hands after a business transaction

You don’t have to raise money to build a successful business. There are plenty of examples of big companies who haven’t, Hotjar being one of my favourites.

But capital does help. So does having the backing of intelligent people who can give you good advice when it’s needed, and keep you accountable to achieve what you’ve set out to accomplish.

The problem is, however, raising money from good investors is hard, particularly in New Zealand it seems. And bad investors can be more of a liability to your company than an asset.

If you want to raise ‘smart money’, you need to put work into building something that will allow you to get in front of good investors and present an evidence-based story that’s compelling enough for them to invest.

But maybe you don’t need to raise money at all.

Here are our answers to some of the burning questions surrounding raising investment capital.

Do you need or want to raise money?

There are two primary points in the early life-cycle of a startup where business funding might be required: (a) to build the product, and; (b) to fund growth.

Some companies need extensive capital to fund product development, for example, hardware companies, biotech and medtech startups. These companies have high equipment and intellectual property costs, and often require long periods of development before a product is ready to take to market. There is a large window that needs to be funded before any money can be made from sales. In this case, raising capital may be necessary.

However, if the founders of a company have the technical capabilities to develop a product relatively quickly and cheaply, which is often the case with software, funding may not be needed to cover the product development gap. The company may be able to get to a point where it can make enough money through sales to sustain itself.

This is a desirable position to be in because the company does not need to raise capital at a time when the company has such a low valuation.

Once a company has a product in the market, proven sales channels and validated margins (how much the company makes from a sale), funds can be raised to “pour fuel on the fire”.

The intention here is that the money raised is used to repeat a model that the company has validated on a small scale. This enables a company to grow at a much faster rate than they would be able to if they were dependant on sales revenue to fund growth.

The benefit of this is that the team can potentially build a more valuable company quicker, and potentially gain market share faster than the competition. As a founder, it often also means that you can start to pay yourself a salary too.

The downside is that when you raise money, you give away a share of your company; you bring people into your company who will likely have a significant impact on the direction you move in and the decisions you make. How much of an impact depends on what you agree to when you raise money, and who you raise money from.

When's the right time to raise money?

The simple answer is when you need it.

The factors that you need to weigh up when making the decision about when to raise capital are:

(a) how long can you last without raising money?

(b) what are the significant risks to the business and will having more money injected into the company mitigate them?

(c) who do you want to take money from, what percentage are you prepared to give away, and what position do you need to get your company into in order to achieve this? By going through the process of answering these questions, you will start to get a better idea of when the right time to raise money is for your company.

How much money should you raise?

It depends on the trajectory of your company and who you are raising money from. Often founder will raise a small amount of money through what is called a Convertible Note. This might be from family, friends, or an investor that the founder wants to lead the next round of investment.

Convertible Notes don’t require a valuation to be placed on the company, which means the terms can be agreed upon faster. It is becoming common for founders to raise a smaller round of investment using a convertible note to fund the period over which they build the first version of the product and to start acquiring customers.

Companies will later raise a larger amount to fund the next year or two of company growth. In NZ this is usually through Angel investment groups. At this point, a value is assigned to the company, and in theory, it is easier to raise money at a higher valuation because the company has demonstrable traction.

It can take 3-6 months to complete this type of funding round. Because raising money is so time intensive, it’s best to not have to do it often. This is the trade-off when considering how much money your company should raise. The value of a company should increase with time if the founders are focusing on the right things, which means you don’t want to raise too much too early at a low valuation. But you also don’t want to have to go through the process of raising capital again within less than 1 year. Nor do you want to risk running out of funding if you’ve built a business that is dependent on it.

If you can raise enough money to fund yourself until you become cash flow positive (you are making enough gross margin to cover operating costs), without giving away too much equity, it’s probably a good outcome.

Who should I raise money from?

Raise money from investors who aren’t going to force the people in charge of your company to make bad decisions. These are decisions that negatively affect the ability of your team to execute on the fundamental purpose of the company.

To avoid this, you must first know the purpose of your company and the values that best serve these intentions. Then you must work hard to be able to build something that will attract smart people who will give good advice, support the vision of the company and the wellbeing of the team. You must also work hard to think at a level of sophistication so you can spot who these people are, and prune out the people who are not.

Looking at the track record of investors and get feedback from the founders they have invested in, whose opinions you trust to be well considered.

It can take a lot of time and experience to be able to manage the process described above.

So, as a rule of thumb, try to raise money from people who:

  • have built their own businesses from the ground up before as they will have more reference experience.
  • have invested in startups before, as they will be better informed on the process and what’s required of them, and
  • ask good questions about your business, have a good understanding of your industry and what you’re trying to achieve, and give you good insights and advice that demonstrates that they understand the specifics when it comes to building a startup.
  • or, people who are going to leave you alone if they can't add value.

How do I raise money?

Start by reaching out to organisations in your area that facilitate investment in startups. You can find a list of the ones that exist in New Zealand in our NZ Startup Ecosystem Map.

These organisations will likely have a screening process, which will comprise of a number of questions to gauge whether it’s worth inviting you in for an initial conversation.

Some of these organisations might also have drop-in clinics or events that give you an opportunity to connect with them and their investors.

You will need to have a pitch deck and accompanying pitch that tells a compelling story about your startup and it’s potential. There are many examples of pitch decks available on the internet. We’ve put together our version here. We've also put together some examples of startup pitch decks that we admire. You should be prepared to pitch (with your pitch deck) for all face-to-face meetings with potential investors.

Following your pitch, you will likely need to provide interested investors with an Investment Memorandum ("IM") which details the important components of the business, and the investment terms (although sometimes these are left out of the IM). The best example of a startup IM that is publically available is Sequoia Capital's one for YouTube, which includes recommendations from the lead investor.

It is also important to have the key documents supporting your claims in the Investment memorandum stored in what is sometimes called a Due Diligence Vault. This is a folder that you will give investors access to in order to complete due diligence before the investment terms are finalised.

A process of negotiation and discussions will take place to agree on the terms. These terms are set out in a Term Sheet, which is an important legal document that records the valuation, investment amount, investment structure and investor rights. Simmond Stewart has shared an excellent article covering investment mechanisms and terms for raising money in New Zealand. We highly recommend hiring a startup lawyer to draft the term sheet to ensure there is nothing in there that might trip you up further down the track.

When you are having discussions with a number of investors, we recommend using what is called an ‘Investor Funnel’ to manage the process of reaching out to investors and ensuring your following up with investor leads.

Conclusion

You don’t necessarily need to raise money to build a successful business.

The amount of money a company raises does not have a direct correlation with its success.

There are alternative methods of business funding.

But if you decide that raising investment is the path you want to take, consider the risks and work hard to mitigate them by doing the work to get as far as you can without investment, and being selective about who you raise money from. Connect in with people who have raised money before, so you have the support to know what is fair and reasonable.

All the best!

If you would like guidance through the process of raising money, please contact [email protected]

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