How much money do you actually need to raise?

 
I am writing this blog post to address a problem I am encountering time and time again – many entrepreneurs lack a solid grasp of basic financial knowledge; this is an even bigger problem when they are seeking investments. My aim here is not to criticize but to empower, as it is crucial for every founder out there to understand their numbers thoroughly, especially when trying to convince potential investors to give you money.

When meeting with founders in the process of raising capital for their startups, one of the questions I always ask is: How much capital are you looking to raise, and for what purpose? The responses I receive vary from the amusing to the disheartening.

Often, the founders provide vague answers such as “this is what our competitors raised 3 years ago”, or “we are still figuring that out”, or the classic “this is for 18 months of runway”. Unfortunately, it's rare to encounter an entrepreneur with a compelling answer that resonates with investors, who seek a clear understanding of your goals, timeline, and the resources required to achieve them.

Here are three key points that will serve as the foundation for crafting a compelling and convincing narrative when talking about your round size with investors.

Setting Clear Goals

It is imperative to articulate specific, objective goals or metrics you intend to achieve. Generally, your trajectory involves either reaching breakeven and reinvesting your profits for sustained growth or reaching milestones that will significantly enhance your company's perceived value for future funding rounds.

Having a Realistic Timeline

The usual timeline to achieve these goals falls within the 12 to 18-month range. It is important to consider that, if you are planning on raising another round, you should expect to spend raising capital between 6-8 months. Because of this, demonstrating progress by months 10-12 is crucial for engaging future investors effectively.

Calculating how much you need to raise

This is where things become tricky, given the widely acknowledged reality that your financial model is bound to have (multiple) mistakes. Numerous assumptions must undergo validation, a task particularly challenging for pre-revenue companies. Nonetheless, it is crucial to possess a model founded on assumptions derived from industry standards, insights gleaned from competitors, and information gathered through interviews with your target customers.

A critical point to delve into is the understanding of the disparity between accrual and cash-based accounting. To keep everything homogeneous with the financials you will be reviewing with your team at the end of each month, we will approach this exercise using accrual accounting and accrual financial projections. Equally noteworthy is the fact that many founders tend to concentrate solely on forecasting their Income Statement (also known as Profit and Loss or P&L). Let me tell you, this is a terrible mistake for most companies.

The rationale behind this assertion lies in the fact that that the revenue, expenses, and profit (or loss) outlined in your Income Statement constitute just a fraction of the puzzle in determining your financial requirements. Considering this, my personal recommendation for determining your cash needs is as follows:

1. Generate a pro-forma Income Statement. In this step, employ preferably validated assumptions relevant to your business model (i.e., Customer Acquisition Cost (CAC), Churn Rate, Pricing, # of employees, etc.) to create a forecast for expected revenue and expenses. The model can forecast all the way to seven years. However, if you are a pre-revenue company without validated assumptions, a prudent choice would be to project for only the next three years.
   
   Additionally, it would be a good idea to incorporate a cushion when estimating your expenses. My recommendation would be to add approximately 30% to your estimate. Believe me, there are so many overlooked expenses that should be taken into account (did anyone say Delaware Franchise Tax Fee?). It's worth noting that some investors may interpret this cushion as a lack of scrutiny on the model. To mitigate any concerns, you can categorize this additional amount as "Other Operational Expenses" in your model to avoid raising eyebrows.
   
   
2. Create a pro-forma Balance Sheet. Develop a Balance Sheet that aligns with your Income Statement. Focus on elements influencing your Capital Expenditure (CAPEX) and Working Capital, both critical for forecasting cash needs. It is also important to consider any long-term debt in your plans, although this is an uncommon scenario for most early-stage startups. On this statement, leave the Cash on Hand as your plug. This will be calculated with the next model: the cash flow forecast.
   
   
3. Generate a cash flow forecast. This involves creating a Pro-forma Statement of Cash Flows to ascertain your cash flows from Operating, Financing, and Investing activities. Make sure to include your current and future fundraising rounds. Subsequently, add or subtract these cash flows to the Cash on Hand from the previous month in your Pro-forma Balance Sheet.
   
   

After completing this exercise, it is time to analyze the results. The most relevant element that you need to assess is your month-over-month Cash on Hand in your pro-forma Balance Sheet. Here is how to determine if you model makes sense and will clear the first hurdle when being reviewed by an investor: if the number is <0 or if it exceeds to the amount being raised during more than a couple of months, you are doing something wrong.

The rationale behind this lies in the fact that if your Cash on Hand is 0 (or less than 0) in your model, it means that, if everything goes as planned in your model, your company will become illiquid at that time. This implies that you are no longer able to pay your suppliers, creditors, and employees, requiring to stop operations. On the other hand, if your Cash on Hand is projected to be higher than the amount you are currently raising or plan to raise in the future, it raises the question: Why raise funds in excess? This discrepancy is observed frequently in the models I review, where a founder is seeking $1.5M but plans to accumulate $1.5M+ in their bank account for the next 18 months until the next funding round. It defies logic.

Figure 1: Cash-on-Hand (End of Month) for a company reaching its breakeven point in the 13th month.

Figure 2. Cash-on-Hand (End of Month) for a company raising an $1.5M in the 13th month and then reaching its breakeven point in the 32th month.

While not every founder is required to possess an in-depth understanding of financial modeling or accounting, a grasp of the basics is essential. Founders should have a good understanding of their true financial needs and should be able to communicate this effectively to their potential investors.

If you find yourself struggling with the intricacies of financial modeling, don't hesitate to reach out at [email protected]. We are here to help!

Fernando Moreno
Growth Partner