Opinions expressed by Entrepreneur contributors are their own.
The primary objective for any entrepreneur is to ensure that their company has sufficient capital. For many businesses, this can be achieved through revenues, but for others seeking high growth, this requires raising venture capital.
The amount of capital that you seek to raise is a key part of the deal when raising venture capital. Investors need to know that you are raising the right amount of capital for the business. This is often determined based on a milestone you promise to hit using the newly invested funds. Investors want to clearly understand that when they invest in your company, they will hit a specific key performance indicator such as a revenue target, user target, intellectual property development goal or other tangible milestone.
There are specific best practices for determining how much money to raise. First, investors will want to see how achieving your milestone will increase your company’s value. Second, estimate the cost of achieving that milestone. Lastly, determine if you can raise enough money to cover costs at a valuation that doesn’t overdilute you or make it hard to raise again. While no one knows precisely how much money they need to build their company, these practices can help establish a realistic target for raising funds.
Related: 99% of Investor Pitches End in Failure. Here’s How to Make Sure You’re Part of the 1% That Succeed.
Step 1: Select milestones achievable with the funding round
To secure investment from VCs, creating a convincing story of how their money will be used to increase your company’s value is important. These goals, referred to as “accretive milestones,” will differ between businesses, with examples including reaching product-market fit or achieving cash-flow break-even. When setting these goals, it’s essential to consider whether they will enable you to raise your next round on a valuation twice as high as the current round or to become profitable enough to avoid the need for further VC funding and limit dilution of ownership.
Step 2: Determine your burn rate
Once you know the milestone you aim to hit, you need to focus on your burn rate (the amount of money you will spend) to achieve it.
Burn rate is the amount of money a company loses monthly after accounting for revenue. For startups without income, the burn rate is simply the money spent each month. The burn rate can help determine the amount of money needed to raise, referred to as the operating runway. The runway is calculated by dividing the bank balance by the monthly burn rate and multiplying by the number of months being calculated.
It would be best if you aimed to have enough money so your company can continue operating for at least 12 months, ideally 18-24 months after raising a funding round.
Entrepreneurs need to set realistic goals for their company and not overestimate what they can accomplish in a certain period. To do this, they should consider what meaningful progress they could realistically achieve within the next 12-24 months and create a list of the people they would need to hire to accomplish those goals. By doing this, entrepreneurs can ensure that they have a clear plan for using the funding they raise from investors and can avoid setting unrealistic expectations.
Related: 4 Signs That Your Small Business Needs Funding
Step 3: How much to raise
As a general rule, you should likely raise at least 20% more than you estimate you will need but less than 2x what you estimate.
While the downsides of running out of money are significantly worse than the downsides of having too much, it remains true that there are negative consequences of overraising. Taking too much money can set unrealistic expectations for your team, putting you under more pressure to perform. It can also lead to wasteful spending, creating a culture and habits that eventually lead to the business’s downfall.
Step 4: Determining your valuation
Generally, once you’ve decided how much to raise, your valuation will end up being 4-5x the amount you are raising, as most companies are requested to give up 20-25% of their shares in any investment round. The truth is that there is no clear guide we can give on deciding your valuation as there are too many factors, including your market, the economic conditions, etc. The best advice is to focus on two things when determining the valuation.
First, in the current market, look at other companies with similar deals and see what their valuations are; remember that venture capitalists are looking to make the best bet possible, so you don’t want to price yourself so highly that the risk/reward doesn’t make sense.
Second, set a target number of shares you are willing to sell. Make sure to chart out your dilution over the next few rounds. Determine whether you are willing to give away 15% or 25% of your business at this stage and base your valuation on that figure.
