Startup 101 - Funding

Funding is where a business or enterprise raises money to fund operations, to expand, acquire other businesses, or for some other purposes. A funding round is where the investors make the investments at practically the same time, and on similar terms and valuation.

There are many types of funding and rounds, and we will cover them in this article.

There are, roughly, three types of rounds:

  • Seed - Money required to launch the business
  • Angel - Early investors who often takes an active role in helping the business launch and grow
  • Venture - Larger investments by Venture Capital (VC) firms. This can be further split into A, B, C... rounds.

Valuation

Pre-Money Valuation

Before you start asking investors for capital, you need to come up with a figure of what you believe your business is worth; this is termed the pre-money valuation.

Having this value at hand is important because:

  1. This will let investors know how much equity they can expect from their investments
  2. It will allow the investors to gauge your judgement - too low/high a valuation can signal to the investors that you do not really know the market well

Coming up with an accurate valuation is more a dark art than science, especially for startups; there are just too many variables in play. It is even more difficult for startups since, by definition, they have no financial track records to backup any claims.

So how do you come up with a reasonable valuation for a startup?

Market Size

The bigger the market size, the higher your valuation can be.

There are two areas you need to research - the location of your business and the type of industry. In the following section we will use Hong Kong as an example, but the same should apply for your location also.

The China market is much larger than the Hong Kong market, and thus investors are more willing to part with their cash. There are many places where you can get a rough idea of the size of the overall market. For Hong Kong, the Securities and Futures Commission (SFC) publishes data and research papers on the global and local market. The government also publishes economic reports and forecasts

The different departments of the government usually publish data on their particular industries too. For example, if you're interested in import/export, the Trade and Industry Department publishes these statistics.

For a more general overview of the industry as a whole, you may try . For reviews and updates, you can also try HKTDC Research

However, these statistics are given at a high level. If your sector is a developing or niche one, there's probably no statistics specific enough to be useful, at which point you need to base your valuation on other factors listed below. But you never know, there's even statistics published particularly for trade of wine in Hong Kong.

Availability of Funding

This is a very simple supply and demand relationship. If there are many startups battling for the same investment, there is a lot of demand for investment. The investors can thus give less capital for more equity than in an area where the demand is not so high.

Trend

Most of the most successful startups started with a niche market and made a fortune when that market grow. So your startup may have a small market size at the moment, but if it has shown it has potential to grow, then that'd warrant a higher valuation.

If you pitched your idea of a Bitcoin-based startup in early 2013, you'd probably get a higher valuation than if you pitched it today.

If, however, pitching for an Ethereum-based startup now would not be a bad idea.

If there's a trend, jumping on the bandwagon can often yield a bigger valuation.

In the same vein, if the market is predicted to plateau or deminish soon, then the valuation for your company will decrease, even if your startup already has a user base and gained some traction.

Comparibles

Comparibles means finding out what similar companies in your industry and location are valued at.

If a similar company was acquired for $1 million last month, then that's an indication of how much the market sees your company's potential market worth is also.

Likewise, if a similar startup was funded by an investor, their evaluation is also a good indication of how you should value yours.

Idea

The weight of this factor greatly depends on the locality. In some places, if you have a decent idea, a decent team, you can get good funding; while in other places, to get any funding, you're expected to have built a product and show some traction.

Back when Twitter had its IPO, it was valued at $24.9 billion; at the same time, Tesla, who only sold less than 50000 vehicles, was valued at $17. But because no one is making luxury electric vehicles at the time, the idea is good enough and investors saw enough potential to warrant it that valuation.

Similarly, Airbnb, Dropbox, Jawbone, Spotify, Pinterest, Uber, and Alibaba all had a massive valuation when it was still an early-stage startup with little or no profits. This was because the idea was innovative and had potential.

Originality

If your product proposes ways to resolve problems in an original way, you can push for a higher valuation because it tells investors that:

  • the founders are smart and innovative
  • original ideas usually goes along with an unsaturated market - think Uber, AirBnb - both original ideas and both have basically monopolized their respective markets
First-Mover Advantage & MVP

An idea is great, but many people have ideas - even good ideas. But it's not the idea that counts, it's the execution - is it executed well? Is it executed in good time?

Having an unsaturated market is great because you can eat up all the market share. Having a MVP in an unsaturated market means you can turn a bigger profit, faster.

Maturity of Startup

Early-stage startup's valuation is mostly based on speculation; as the startup matures, the valuation shifts towards actual results, such as revenue, profit and total capital.

Maturity is a very subjective metric. When Twitter went public with its well-publicized IPO on 7th November, 2013, they

  • Were 7 years old (Twitter was founded on March 21, 2006)
  • Had ?? users
  • Had $500 million in revenue but Were making a net loss

So while it was mature in terms of duration, the number of users and popularity, it was immature in terms of finance as it was not a profit-making business.

Twitter had an IPO price of US$26, which puts the valuation at US$ 24.9 billion.

which rose to US$44.94 at the end of the trading day.

Since (2)8th April, 2015, the

Financial Projections

In your business plan, you should include your predicted financial forecast - revenue (total income), net/profit loss - for each quarter/year. This allows the investors know how much money (and thus dividends) they can expect, and how soon after the investment was made.

An important aspect of this is your exit strategy. Yes it's kind of strange to think about how you're going to leave the business before you're really in it, but investors like to know who are the potential companies that may acquire you,

It'll also allow them to gauge the balance between profit and risk.

Obviously, ones which can arrive at the most profit, least risk and in the quickest time frame, will receive the highest valuation.

Quality of Team

If you team is strong, investors can expect a higher chance of the startup becoming a success. So what makes a team 'strong'?

  • Experience - Nothing beats experience. No matter how smart you are, there are many things you can't possible know how to deal with unless you've been through it.
  • Track Record -
  • Reputation - The higher the reputation, or the more influential a member is, the more business relationships and doors are open to the startup. This will be essential for product development and marketing. It also gives the startup more credibility.
  • *
Post-Money Valuation

Post-Money Valuation is what the business is worth after the investment is made.

If a company had a pre-money valuation of $10 million, and it received funding for $2.5 million, then its post-money valuation would be $12.5 million.

The investor had invested $2.5 million, and its equity share is calculated as the investment amount divided by the post-money valuation. And so the investor should receive 20% of the shares.

Subsequent Rounds

You also need to be mindful of subsequent rounds. It is not clear how much of a factor this plays practically, but investors expect their investment to grow. So if the seed round valuation is $250,000, then the next round should have a higher valuation, and the next one even higher.

If you

Share Dilution

If all the shares are already allocated, to accept more investment, more shares would have to be issued. This means existing shares will depreciate in value; this is termed share dilution.

Do you really need outside funding?

Getting outside funding provides you with extra capital which enables you to grow faster, but it is not free money. You'd have to give up equity, most probably some governing power - it won't be 'your' company now - other people will have a say. If you do not have a plurality of votes on the board of directors, you might even be removed as CEO of your own company.