Financing your business, where to obtain funding to start up or further develop your business.
Question being asked by entrepreneurs at various stages of business development. Those who are just thinking about starting their business and those who have already achieved something, as well as companies that have been on the market for years and are thinking about business development, globalisation, entering new markets with new products.
Bolek Drapella presents overwiew of financing available on the market, worth considering.
Transcription of the episode
Hello. In today’s episode, I’d like us to think about ways of financing a startup – how to raise funds to kick off and then develop a business. These are common questions on Facebook groups as well as at meetings with entrepreneurs at various stages of business growth. They concern those who are just planning to start a business as well as those whose ideas and decisions have been verified by their first achievements. They also accompany the managements of well-established companies who are beginning to realize it’s time to consider new forms of financing to introduce new products to new markets or globalize their business.
My experience in financing startups or company growth comes from being a venture partner at venture capital fund Black Pearls VC. It is also my practical knowledge as an entrepreneur who did have to acquire financing from various sources. Each case described here has actually taken place in at least one of my companies that I have been developing over the last 20 years. This is my hands-on experience on what I’ve done both as an investor and an investment seeker.
Although it is impossible here to go through all cases, I am hoping to give you an overview of key aspects that are worth a thought. If any of you would like to discuss your personal case, you are welcome to join a mentoring session at saunagrow.com.
The general rule regarding financing and fund acquisition, almost regardless of the source, is: the later, the better. Why so? Because the more advanced your business is, the more funding you will be able to get at the lower expense (in the case of debt financing) or by having to give away a smaller share of your equity (in the case of share financing).
There are three sources of financing the development of a business. The one to be considered first, are the resources provided by the clients of the company who simply buy its product or service. If you can use this way to finance your growth, you don’t have to worry about loan interests, relationships with your investors or how hard it is to find them. You are also getting a bonus. It is a verification of your idea or product expressed in the number of its buyers who subsidize your development. As a result, you don’t need to sell a single share to anyone.
However, the recipe that customer sales boost your capital and fuel your growth, does not always work at the start. Very often, this organic, sales-driven development takes a long time. Some startups need a lot of it before they create something sellable and reach financial self-sufficiency. Still, they do need to begin somehow and so have to find some external financing.
Let’s now take a closer look at these external financing options. Whatever are its sources – banks or VC funds – they have one thing in common. It is hard to receive financing at the stage when we only have an idea with no proven sales of anything. Hardly anyone will be ready to put their trust in us and money on us. It’s not impossible, however, reserved only for cases when private equity or VC funds are approached by experienced teams of founders. If the founders’ track records already prove them as achievers in their field, just a Power Point idea presentation may win them the funding they need. The persuasive point here is their years of practice, and it’s actually the founders’ team that receives funding, not the business idea. Such things also happen in Europe or even in Poland, though are still rare. Wherever it happens, though, it does take a combination of the powerful idea and remarkable expertise to convince the investors and raise reasonable funds for the first months or years of growth.
If we cannot boast years of experience as founding fathers of thriving businesses, we are destined to the so-called “Triple F Round” – friends, fools and family. Whatever reason your friends and family may have, fools have no reason to invest in you, but they do. Only those in need find out how to get them to do it. Bear in mind, though, that even this small-scale Triple F Round financing is external. Realistically, a new-born project should take its first steps relying on the founders’ own resources. Use your greatest asset at this early stage – it’s the fact that you are not alone. Make sure that your founding team is a good blend of diverse competencies and experience. All of you should be capable of making some contribution at the start. Moneywise, it can add up to a few ten thousand euros. More importantly, however, the founders must be ready to contribute a year of unpaid work. The amount of money and time may vary case by case, but the founders should start from a sober evaluation of these resources. It seems advisable to have some savings to live off while developing a new project or a job to make a living, while working on it in leisure time.
Not until the new project is initially verified the business angels or angel investors come in. These individual investors often operate in the area related to your startup goal. Business angels are prepared to provide substantive support and invest their time and money. As it’s often the case with business angels, they usually have more money than time, but their help is essential because of their long experience & network connections. In the present market reality, the angels may want to acquire 5 to 20 percent of equity, depending on the investment amount and the contract conditions. If it turns out they expect more, be careful. At the stage of project verification, too much seed funding may spoil your book of shares. Too much equity may land with early partners who, after helping you out at the start, may become less committed. Also, along with the subsequent external money injections, the founders’ own commitment is bound to shrink, in proportion to their share. Worse still, the high non-founder participation seriously hinders future investments. If the external participation, after some seed-funding, leaves the founders with mere 20-30% of shares in hand before the A round (being first serious funding after product market-fit), this can scare away most venture capitals. They will not see enough participation of the original founders to trust them with their money.
Let’s have look now at another type of external funding – debt funding – a bank loan, for instance. We know that, at an early stage, when a business has a low value, low return and little assets, banks aren’t very eager to give loans. Usually, banks begin to find a prosperous business attractive when it no longer needs bank support. Recently, to meet the new demand on the market, a new form of bank loans has appeared, in Poland it’s coordinated by Bank Gospodarstwa Krajowego BGK. Most of these loans’ risk factor, interest and operating costs are covered by EU (the Jereme 2 project). This opens a new perspective of low-interest and low-cost loans to a number of business founding and development projects. Of course, the loan amount still has to be paid off, but I strongly encourage you to consider such loans as they enable you to avoid selling out your shares.
There are also separate public funds in forms of subsidies, grants, EU projects, including the much talked-about funds distributed by various national grant coordinators. As a rule, these funds have a precisely defined business destination, sector and way of spending. The amounts are often high, but hard to manage and use because of their very limited allocation purpose. It may turn out that your project does not ideally fit into EU scheme conditions and will be very difficult to settle financially. Also, it may take too much time and energy to obtain and use the funds. As a side effect, trying to fully benefit from the money while obeying its constraints, may lead to the loss of your natural business flexibility. So, having received these funds towards a given business project, you won’t be able to modify or abandon your project should the market conditions change. You will have to fulfil the funding agreement without altering a single detail. Given the amount of paperwork that goes with it, such as thousands signatures on your documents (I mean literally – thousands, been there done that), all this work calls for a separate full job. According to the regulations in some EU projects, such work can’t even be treated as a project cost or accounts settlement cost.
Apart from the public funding or, sometimes, in connection to it, there are acceleration programmes. As a matter of fact, these are practical post-graduate courses for entrepreneurs. They comprise seminars, mentoring programmes, support from companies and individual experts. They are often run by incubators of urban enterprise, venture capital funds and other business support organizations. There is a wide variety of them – they may focus on a certain type of business project, activity or enterprise. For instance, the Space3ac acceleration programme, organized by Blue Dot Solutions, in which our Black Pearls VC in closely involved, is a non-equity programme. It allows for a co-financing up to 45k EUR, without disposing a single percent of shares. However, the programme is targeted at B2B integration. The accelerator team links technology buyers (organizations that have a certain problem to solve) with potential solution providers. This accelerator, besides mentoring services, lectures and other general support, aims at implementations of necessary solutions in a given corporation. The acceleration amount is granted jointly by public institutions and the corporations which benefit from the solution. In this type of funding, the key benefits are that we receive the funding to verify our idea by getting our first corporate implementation contract, while our equity still remains in our hands. The information on the next application term can be found at the space3.ac website.
There are also foreign acceleration programmes. One of the best known is Y Combinator from The Silicon Valley. More than 190 companies, including AirHelp (which I used to co-manage) or AirBnB, have taken off, funded by this accelerator. It offers great mentoring, large network and post-graduate support. All that proves extremely useful in solving a lot of operational issues. So, please, do take acceleration programmes into your serious consideration.
Moreover, there are venture capital private equity funds of various sizes, project type preferences, geographical targeting and amounts available. Some might be interested in investing several ten thousand euros. Others won’t even look at anything worth less than several million euros, so it’s pointless to approach them at the early stage of growth. Simply, their scope of interest is the larger projects at more advanced stages of development. It’s good to be aware of the fact that, apart from their geographical, thematic and size targeting, also have preferences as to business type. That is, some of them focus on marketplace investments, others in artificial intelligence, advanced technologies or corporate software solutions. The specialization of their portfolio reflects the profiles of their member investors. Their know-how proves essential in making accurate investment decisions on the investors’ behalf as well as providing expert guidance on how to help projects work and generate income.
At some moment, after the A-round (often being ‘first serious round of external financing’ after seed money), owners consider initial public offering (the IPO) – entering the stock exchange. For Polish businesses it could be Warsaw Stock Exchange or others, such as NASDAQ in the USA or London Stock Exchange or any stock exchange in the world. When you consider going public, whatever the origin of your capital, wherever your investors come from, whichever markets you operate on and however big you are, please remember it is expensive to begin with and costly to maintain. In order to enter any domestic stock exchange or even an alternative market, such as NewConnect in Warsaw, we are talking of at least a tens of thousand euros spent on the preparation of the basic prospect elements.
Going public, expensive as it is, has its pros and cons. The good thing is that it opens you to investment from anyone, various corporate groups and individuals and makes it easy to trade shares. As both buying and selling is done at a click of a mouse, it allows for a flexible access to capital. That’s why lots of investors find it more attractive than becoming involved in a VC or business angel type of relationship.
So, the stock exchange, is one of the possible scenarios both for early investors and business founders. An alternative solution to entering the stock exchange is selling the company to a larger player in the same sector, the so-called M&A transaction (Mergers and Acquisitions). As in the previously mentioned cases, we have to bear in mind that receiving money from anyone outside your company – a business angel, a VC fund or any other financing that involves selling shares and inviting co-owners – will always be an additional commitment. Apart from simple stress, it will result in an obligation to report to outside people and a necessity to compromise while making key decisions. These are the consequences of sharing the capital.
With all funds and institutional investment forms, there is also a question of the investment horizon – the expected length of time an investor intends to keep their money in the company. If the time horizon is 5 years, that means that, after 5 years, the fund is planning to sell these shares, no matter if we want it or not. This approach might vary and be more or less flexible, depending on how rigid the investor’s procedures are, but entrepreneurs shouldn’t be surprised that money is invested to be withdrawn with a profit.
That concludes my short review of the forms of business funding.
Another point worth your thought is when is the best moment to acquire funding. As I’ve already told you – the later, the better. When the right time eventually comes, we should take into account that the fund-raising task calls for a few months long full-time job for a company president or any sufficiently experienced Board member. It is safe to assume that the process usually takes half a year and accept that this person will have to be practically counted out from company operations. On one hand, knowing this may take half a year, the company must be prepared to last without these extra funds until they arrive, if they arrive. On the other hand, our business must be sufficiently mature. Our investors must really see that their purchase decision is justified and that the price we want really corresponds to the company value.
Let’s see how this works in practice. Bearing in mind that only as much money is necessary as will take our company to a new stage of growth, let’s assume that, before the share sales money landed on our account (in the pre-money evaluation), our company was evaluated as worth one million euros. If we plan to sell 10% of its worth, we will receive 100,000 euros. When I was taking over the Morizon company, its initial stage of growth (quite a stormy one) had left it in a critical financial state – a quarter million euros spent on building its software, no customers or income. Its staff had been reduced to 3 people. That was when I had left Gratka and became CEO of Morizon. At that moment, the company owners managed to convince a friend to invest nearly 150 thousand euros for the 17% of its shares. After a few months of intense work of the whole team, we managed to get 750 thousand euros for 14% of total shares. That was when we entered the NewConnect – an alternative security stock exchange where, after another dozen months, the sale of 22% of our equity gave us over 1,5 million euros and enabled us to buy our larger competitor. This shows that in less than two and a half years, the value of a roughly equal chunk of shares can increase from 150 thousand up to 1,5 million euros. That was possible only because the company had grown, and so had its value, along with the investors’ faith in it. By the way, Morizon has been recently sold to RASP (Axel Springer Polska) at the value of 20 million euros – a well-deserved result of several years’ hard work. At each stage, only as many shares were sold as it was necessary to take the company to a new stage and make another equity sales round more profitable. Even though I wasn’t involved in the final sale, it was really nice to see that Gratka, which I have been managing prior to Morizon was sold to the same buyer at the same moment. It shows the power of an M&A as an exit strategy.
To finish this podcast, I’m going to tell you shortly about several key premises of your decision to plan a venture capital financing.
First of all, from the moment of receiving outside funding, the team should be entirely engaged in the project.
Secondly, it’s essential that the team members’ backgrounds, competencies and, particularly, their experience, are diversified. They get together to support the company with their know-how from various fields of business and their expertise in how to develop a company efficiently and wisely.
Thirdly, the target market must be wide and attractive enough, with an international potential. However, what always counts the most, is the experience of the team members. The problem that the company is addressing must be significant enough, so the buyers are willing to pay for fixing it. And the price they are prepared to accept for getting the new solution is lower than the way they’re solving it right now. Or it has be solved in a significantly better way that it has been done to date.
Also, the team must have a deep knowledge and analysis of their competition. If anyone claims there is no competition in a given market, is turns out in 95% that they haven’t done their homework. If a market exists, there must be competition in it. If there really happens to be no competition in a given market, it means that it hasn’t evolved yet and there are still no players there due to some reason. A discovery of a brand new market rarely happens. Probably, it just means that no one has seen any profit yet in paying for the problem solution that we can offer. If there is no money in the market to race for, there are no competitors.
Another thing important for VC funds is traction – that is to what degree we have managed to verify our business idea or project. Traction is best indicated by revenue, which reflects the customer response – the number of people who have already paid for an early version of our product or solution. Traction also indicates how fast we are gaining the momentum as our business grows – how rapid the growth rate of our customer base has been. These numbers really have to soar if we want to attract the investors’ attention. At Black Pearls, for example, we have a threshold of 10-15 thousand Euro monthly recurring revenue, to even potentially consider an investment.
It’s also worth knowing that, in addition to their geographical focus, VC funds have diverse policies, investment cycles when certain funds that are opened or closed as well as various development stages at which they invest at different times. Keep it in mind while approaching any of them. It is useful to ask when it is possible to apply for another round, if we manage to fulfil all their formal requirements.
That’s all for today. I hope I have outlined the basics of business financing. I’m sure there are well justified non-standard approaches that escape the rules I presented. However, if you expect that you can come up with a credible explanation for any non-standard approach, it may take a while before you get your next round of financing. Don’t give up, keep asking others for advice until you find out how to take your business to new heights. Remember, it’s your adventure. It wouldn’t be so thrilling if it was easy. If you have any questions, you know where to find me and other SaunaGrow mentors. Thank you & good luck!
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