A startup financing strategy that works

September 20, 2010

— Kenneth H. Marks is the founder and managing partner of Raleigh, North Carolina-based High Rock Partners. He is also the lead author of the “Handbook of Financing Growth”. The views expressed are his own. —

Statistically no one gets venture capital. The ratio of the number of companies started each year vs. the number of companies funded is minuscule. For most companies it’s just plain unrealistic. So, how do the 99.9 percent of startup businesses get funded?

The financing strategy is bootstrapping in stages based on iterative phases of success and only doing what must be done to get to the next phase with minimal capital. This is a resourceful and practical approach:

  • Start with the customer
  • Establish the critical path items for at least the first stage of the company or project
  • Define what it takes to validate the market and prove the company’s ability
  • Develop a list of where and from whom you can get the resources needed (i.e. who has a reason to care about my company’s success)?
  • Assess – “Can we bridge the gap with friends and family and personal investment?”

Start with the end in mind – that is, the customer and the market need. Many businesses start with a solution and look for a problem to solve; this is natural when you have technical entrepreneurs and creative people. However, capital is attracted to situations that have proven market demand with a solution that is feasible at a validated price that allows the business to make a significant return based on the risk involved. The idea is to validate the market and price as soon as possible in the development of the company and shape the product or service offering to assure profitable revenues, or at least those that can generate a reasonable gross profit (revenues minus direct costs). This means talking with potential customers as you are crafting the business plan and strategy.

Next, leveraging the knowledge gained to develop the critical path items required to launch the company, create a working prototype and confirm the business model works. One of the outputs of this train of thinking and process is a clearer understanding of the amount and timing of capital required.

Let’s take an example:

A small group of entrepreneurial-minded engineers see a market opportunity to develop firmware (software at the hardware level) for the next generation of integrated circuits. The team understands the technology and has insight into a new approach that will allow the firmware to be used for many different types of hardware – this is a unique solutions and an opportunity. To really gain interest from outsiders in their venture, they need to prove their concepts will work and that someone significant in the market will buy it. Instead of trying to raise money to do this, one approach is to determine what portion of code they can have written with a team that will do the work for deferred compensation (future payments and stock based on the success of the business). In addition, they need to get feedback and buy-in from a major customer in the form of a letter of intent or contract or an agreement to conduct trials or tests. Another dimension to developing the business at this stage is to understand industry players and leaders (both companies and individuals). From these players, you can recruit a board of advisors early on to help guide the progress of the business, potentially open doors and relationships, enhance the credibility of the company, and to provide some seed capital. A follow-on financing step is to seek actual orders or licensing of the technology from the same customer, to include pre-payment. This pre-payment becomes part (if not all) of the next round of financing required to further develop the product and the business.

Company valuation is almost always a point of contention. The entrepreneur values the business on what it can be and the investors value the business on what it is, which usually results in a difference or gap. One of the side benefits of obtaining resources and capital from those that have a reason to care about the success of the company (i.e. customers, suppliers, employees, friends and family) is less sensitivity to valuation because they have more to gain than just an economic return on the stock.

This funding approach forces management to get to the important and difficult issues quickly and increases the likelihood of survival and growth.

One comment

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Well-reasoned approach. One company with which I’m familiar taking just such an approach is BizGreet (I’m not affiliated with them). www.bizgreet.com The founder understands all too well that a product without customers generates no cash (for future operations) and no funding (for future growth).

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