Startup Financing Strategy

Our students in the Oxford Fintech Lab are all building new ventures, almost all of them independent startups that at one point or another will seek funding. What strategies should entrepreneurs use in financing their businesses? Here are some of the lessons I've learned from more than $330 million of early stage financings either as investor or entrepreneur.

I like to outline a selection of key components in startup financing strategy

1. Funding journey
2. Anthropology of investors
3. Creating a syndicate

Let's explore each of these elements in more detail:

1)   Funding Journey

It’s critical to remember that financing is not a point in time, or even a series of points in time. It is a continuous process and dialog with multiple parties that will take place as soon as you start thinking about taking external financing, and ending once you sell your company or shut it down.

You want to think about financing in the context of a journey, from seed funding through liquidity. Technically, once your venture investors have liquidity, the journey continues but now you’re working with new sponsors (such as public markets holders, institutions like big asset management firms, etc). For the purposes of this article we’ll focus on the venture and growth stages of the funding journey.

The key to this journey is thinking about inflection points. What are the milestones that you can achieve, and need to achieve, to get to that next funding point? Growing and financing your business then becomes a series of value inflection points. You want to time your financing around inflection points so that you get the increase in value to your business.

For example, a simple progression would be:

• Zero stage: Company formation & product development
• Seed Stage: Product launch
• Seed / A round: First paying customer(s)
• A/B round: Customer revenue expansion
• C+ round: Market share gains, product or geographic expansion, etc.

There are a host of milestones that accompany each of these stages (we hired a CTO! We launched our github! We had 3,000 people come to our developer event!) but it’s important to pick the key performance indicators that matter to investors at each stage. You also want to think about how much you need to raise at each step, and what milestones you can check off with that money to get to the next financing. CEOs of startups are always raising money; some times in an accelerated fashion, other times simply talking to the market and keeping ties and preparing for the next round.

These days, most of the venture community in the United Stages is looking at $5 million to $10 million average revenue run rate (ARR) to make a Series A investment of $10 million to $20 million. These numbers vary considerably by geography; in continental Europe you could see €1-2 million ARR and a €2 million Series A round. These numbers move considerably with the market and industry sector; it’s not unheard of for a biotech company to have an $80—100 million Series B round.

2)   Anthropology of investors

What kinds of investors are you approaching at what stages? The industry veteran “super angel” seed investor is going to look for a different kind of opportunity than the highly specialized, revenue-growth-stage venture capital fund. Professional investors will tell you on their website and at the first meeting what their “filters” or investment screens are – basically, what kinds of deals they look for. VCs will have very specific things they do or do not look at in part because it’s part of how they market themselves to their investors. 

So an EU focused fund gets put into the “Europe” allocation for a big investor, and they might be prohibited from investing in a business based in the MENA region. Or a software fund would be prohibited from investing in a hardware deal, perhaps, no matter how attractive. Or they don’t invest until you have revenue. Or they only invest in prerevenue companies. It’s critical as an entrepreneur to know what a particular investor will do, and what a particular investor won’t do.

When you think about designing your investor base, particularly at the seed stage, see what value they can bring to specific problems or issues you need to solve. For example, someone with customer relationships or technical knowledge or industry knowledge that you need to build your company.

In terms of your next round of financing, a great seed investor for your company brings “social proof” to the next venture capitalists. VCs tend to lean heavily on what they call “pattern recognition” for doing deals, including social signaling such as “has someone who is an expert, who I know, already put money in and is recommending I look at this deal?” That’s a high degree of social proof. Or "A CEO who I have backed, in this industry segment, perhaps even in my current portfolio, who is deeply versed in the technology and competitive landscape, is recommending that we do this deal." Next might be “someone who I have heard of, who is well known and well regarded in the specific industry, has invested”. Least relevant for signaling to your next financing round is “a bunch of professionals such as dentists and lawyers each put in ￡10,000.” 

Other pattern recognition around the company itself includes factors like the revenue run rate, the existence of patents, the academic and job pedigree of the key executives, etc. It may include historical experience of VCs – “We tried investing in a SaaS company in logistics and discovered that you can’t make money in Southern Europe.” That statement might not actually be true, but is followed as if it were holy scripture, because in my experience VCs operate on a large body of “received wisdom” that may not be rigorous; there’s such little scientific discipline or accountability across the industry that they hold to these ideas as obvious fact even if based on flawed assumptions. 

I saw this with one of my own companies. Large numbers of customers (relatively speaking) wanted to buy my product, I had verbal expressions of interest from more than 10% of the market, but I needed more funding to be able to offer it into that pipeline. The VC industry, however, was pumping money into a competing company with flawed technology that happened to capture a lot of headlines because it was attached to more buzzwords. That company had a single customer and less mature technology than I did, but the received wisdom believed that they were “hot.” It didn’t matter that it was a weaker team with weaker technology and less track record. Another company, the sector leader, had raised over $100 million for a product that didn’t work. And still on people’s lips. It’s not fair. It’s just venture capital. Oft-used is the expression "If you want a friend, buy a dog."

There’s a reason the venture capital asset class has average returns that are an order of magnitude lower than private equity, 5-8% versus 18-22% depending on time periods (although the very top funds generate better returns). And that's before you adjust for risk; PE deals are able to secure debt financing because they are broadly less risky than venture capital with many intermediate outcomes (we didn't grow it 10X but we got 1.5X) whereas early stage VC deals tend more to bimodal returns (it worked, or it didn't work). That said, top decile funds in VC drive almost all of the returns for the industry, whereas in PE the returns are more evenly distributed.

And not all investors are for all people. For example, Vinod Khosla has been one of the most successful venture capitalists in history. Getting money from him is a stamp of approval that you are on a winning trajectory. And he is known for frequent and detailed input that he provides to his CEOs. Some companies in his portfolio appoint a “SVP of Vinod” because he provides so much feedback and requires so much attention. Some CEOs might not want that managerial overhead.

There are hard-working, relevant, skilled professional investors in venture capital, who aren’t difficult to deal with. In my personal experience, they represent around 5% of the industry. You need to weed through a lot of other people to get to the ones you want. Talking to other CEOs who have gotten money from that investor you want is both a great way to figure out if you can work with them, and also how to get that investor to take you seriously as a prospect.

3)   Creating a Syndicate

At each stage of financing, you may be better served by having a syndicate of investors who each bring different value, rather than trying to find one single investor who fulfills all of your needs. Think through what value each investor brings, whether they are financial or corporate, at each stage. Balancing out your syndicate can bring more value to your business. I usually like to see 2 to 5 (institutional) investors in a round. Only one means you are beholden; more than five introduces complexity to manage the syndicate.

The hardest part of funding a startup is finding a “lead” investor who will price the round and set the terms. A good deal can find many “followers” who draft behind that lead investor and fill out the round. You definitely should ask, when qualifying an investor (in first email contact, even before a formal meeting) if they lead deals. Some lead all the time, some lead sometimes, some never lead, and a reputable investor will tell you right away if you ask. Professionals don’t take offense if you say “We’re seeking a lead” and refusing to meet until you have one (“wouldn’t be a good use of your time until we have a lead…”). Bear in mind investors also like to “window shop” and management can burn a lot of cycles meeting with follower investors who can’t lead. Or they might lead, but not in your geography, and want you to get a “local lead” investor.

I also like to see the lead investor hold 30% to 50% of the round…preferably closer to 50%…because then you have a “true lead” versus what’s called a “club round” where no one knows who speaks for the investors. This becomes important (1) when you try to raise your next round, because the B investors negotiate with the A, then the C round investors negotiate with the B and A, etc. and (2) if you get into trouble; a clear lead investor is more more likely to “step up” and help the company out if there is trouble versus in a club round. 

No matter who is your lead and who follows, on average you’re going to get one investor doing most of the work in the board room or in building the company, and they might not be your lead. Regular engagement with your investors will help get the most out of your syndicate.

Hopefully this has offered you some pointers as you start to think through your financing strategy. Taking professional investment requires professional skills and thinking, and you should also make sure you have good advisors (particularly a good, experienced startup lawyer) on this journey.

The next Oxford Fintech Lab begins December 7. Now accepting applications!

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Opinions represented herein are my own. My disclosures can be found at www.VisionaryFuture.com.