Going back to the well too soon
Bloggers Name Dr Laura Faulconer
Founders are typically in a careful balancing act between operating lean and being undercapitalised. Investors don’t want to see bloat and want to know that their money is being spent toward maximal impact in growing the business – however, an undercapitalised startup is not an efficient startup.
What is undercapitalisation
Undercapitalisation occurs when a startup does not have enough cash runway to reach milestones, generate sufficient cashflows or scale the business and is unable to secure additional funding.
Why is undercapitalisation bad?
Undercapitalisation can put the company at risk of insolvency or force them to accept less favourable terms from investors or creditors.
Startup fundraising is physically and mentally taxing. It takes at least one founder’s full attention for an extended period of time. Undercapitalisation will require additional fundraising effort from founders and may drive founders to seek investment at a less than ideal time. The ideal time to kick off fundraising is either just before, or just after, you’ve successfully completed a key value inflection milestone.
The worst time to fundraise is in between major milestones when past achievements are viewed as prior value creation, not current de-risking, and too far away from a big value uptick to be an incentive, leaving open the potential for loss of momentum.
Going back to the well too soon can leave a startup unable to secure desirable investment terms, or even potentially unable to raise additional funding. Every time you have to go through the fundraising process, you will inevitably lose momentum in your commercialisation efforts.
Logic that leads to undercapitalisation
Some startups intentionally undercapitalise. Admittedly, it is a fine line between operating lean (big plus to investors) and being undercapitalised (big red flag to investors).
Here are some of the reasons that some startups have used to justify undercapitalisation:
“We want just enough money to prove out this milestone as we’ll be worth a lot more afterward and if we delay taking more money we’ll be less diluted.” You may find you need wiggle room for pivots or incorrect cost assumptions.
“I can easily raise the next round in a year’s time.” Market conditions can change that negatively impact availability of investment.
“Our funding ask gets us to a major milestone.” Investors like to put their capital to work and accelerate the pathway to market – would more money get you there faster or get you to a significantly greater value uplift?
How much should you raise?
How much to raise in a round is a common angst-inducing question that founders wrestle with. The key factors to consider when determining how much to raise are:
18 months’ runway: In an ideal world, your round should give you 18 months’ runway, including a buffer for cost overruns and potential pivots. To get to that number, you need robust financial projections that:
Are tightly tied with your strategic plan
Clearly indicate your value inflection milestones
Comprehensively identify your cash needs
Achieve significant value inflection milestone: If you can’t hit a major milestone in 18 months, adjust by the extra few months as appropriate.
Add lead time for fundraising: It will take a few months to raise the current and the next round. Add 6 month’s burn to your number to give yourself enough breathing room.
You definitely want to limit capital raising in the beginning. However, there is a big difference between being capital efficient and being undercapitalised. Just as a good founder spends a significant amount of time and energy crafting a go to market strategy, they should also give considered thought to creating and executing an effective capital strategy.