Why you can’t raise $5 million for your startup.
When I’m working with the CEOs of startups, our conversations focus on what the business needs to achieve success. Specifically, how much money they think they need to move from an idea or concept to a sellable and scalable product or service. It’s interesting to hear the wide range of numbers these CEOs come up with. For some startups, especially those that run mean and lean, they might be looking for between $1 million and $2 million to move their business to the next level. Others tell me they need $5 million to $6 million to prove the viability of their business.
What’s interesting about these discussions is that they shed light on a gap–a no man’s land–that so many early-stage companies get trapped in. My advice for you: Don’t get stuck there, because you may never get out.
Raising Money 101
Let’s start by talking about where most startup founders raise money. The most common source is friends and family. You tap them for funds–and anyone in your social circle willing to participate. These are the folks who believe in you and are ready to risk some of their money on your venture. It’s typical to raise $2 million or less from your social connections, which makes sense. Unless you have some wealthy friends and family members, that’s about the most you could expect to raise. When you do the math, you can see that it equates to about 25 people investing $80,000 each.
The general rule of thumb is that no one will risk more than 5 percent of their liquid portfolio on a startup. And when you start asking for $100,000 or more, you’re likely running out of friends who have $2 million of investable cash.
The flip side of the money-raising equation is professional money: the venture capitalists (VCs) and private equity firms. These organizations have raised hundreds of millions of dollars with the mission of investing in companies capable of rapid growth. But if you want a professional firm like this to invest in your business, you need to understand the dynamics.
Each VC firm, for example, will make 10 to 20 investments per fund. That typically means they will invest 5 to 10 percent of their fund in any given firm. Why $10 million and not $5 million? Most VCs have a limited staff. They can’t advise and sit on the boards of 20 or more companies.
If you do the math, a fund that invests in 10 companies at the $10 million level is only a $100 million fund, which is small by fund standards. Most are larger and looking to write larger checks. That entrepreneur who wants $5 million needs to find a $50 million fund, and there are painfully few of those.
That’s why $10 million tends to be their magic number–and the basis for the funding gap between professional money and the friends and family limit of $2 million.
Understanding the Funding Gap
The trap that so many young companies fall into is when they need more money than they can raise from their friends and family–but they’re still too small to raise professional money. That’s no man’s land in a nutshell.
For example, I recently talked to a firm that put a plan together to raise $5 million. I did my best to explain to them the predicament they were in. They either needed to aim lower and raise $2 million–or higher by raising $10 million or more.
The CEO and executives weren’t happy with my advice. They told me that they had already raised more than $2 million from their social circle. But now, they needed the $5 million to spur their growth to the next level, and before they did an A round for $10 million.
This team didn’t understand that they had failed in an important way. They hadn’t leveraged their initial investment enough to build the value of their company where they could attract interest from the professional investors. They needed to use their initial $2 million stake to fuel the growth in the value of their business so that they were ready to absorb a $10 million investment–which might equate to a valuation of something like $30 million to $35 million. They hadn’t done enough with their money to cross the no man’s land gap. The kind of money they were trying to raise didn’t exist.
Crossing the Gap
The lesson that startup founders need to learn early on is that this funding gap, roughly between $2 million and $10 million, exists, and it should be something you plan for. To do that, you need to do everything possible to make the most of that initial investment and use it to catapult the gap Evel Knievel style–flying across on a rocket-cycle–so you’ll be ready to take the professional money and run with it to the big time.