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This is a guest post by serial entrepreneurship expert Steve Blank.
One of my ex-students recently gave me an update on his startup. When I asked, “What are you working on?” the first words out of his mouth was his fundraising progress.
Sigh. What I should have been hearing is the search for the business model, specifically the progress on product/market fit, but I hear the fundraising story first at least 90 percent of the time. It never makes me happy.
Entrepreneurs need to think about 1) when to raise money, 2) why to raise money, 3) who to take money from, and 4) the consequences of raising money.
It all starts with understanding what a startup is.
What’s a startup?
As a reminder, a startup is a temporary organization designed to search for a repeatable and scalable business model.
It’s worth parsing this sentence.
• Temporary Organization: The goal of a startup is not to remain a startup. The goal is to scale. (If you don’t have scale as a goal then you shouldn’t be raising money from angel or venture investors, you should be getting a commercial or government small business loan.)
• Search: Although you believe your idea is the most brilliant innovation ever thought of, the odds are that you are wrong. If you raise millions of dollars on day one, simply executing the idea means you’re going to waste all those dollars attempting to scale a bad idea.
• Repeatable: Startups may get orders that come from board members’ customer relationships or heroic, single-shot efforts of the CEO. These are great, but they are not repeatable by a sales organization. What you are searching for is not one-off revenue hits but rather a repeatable pattern that can be replicated by a sales organization selling off a price list or by customers coming to your website.
• Scalable: The goal is not to get one customer but many — and to get those customers so each additional customer adds incremental revenue and profit. The test is: If you add one more sales person or spend more marketing dollars, does your sales revenue go up by more than your expenses?
• Business model: A business model answers the basic questions about your entire business: Who are the customers? What problems do they want solved? Does our product or service solve a customer problem (product-market fit)? How do we attract, keep, and grow customers? What are revenue strategy and pricing tactics? Who are the partners? What are the resources and activities needed to make this business happen? And what are its costs?
Who to take money from
First, decide what type of startup you are. If you’re a lifestyle entrepreneur or a small business, odds are the return you can provide is not what traditional angel or venture investors are looking for. These types of startups are better suited to raising money from friends, family, commercial and government small business loans, etc.
If you’re a scalable startup, you want to spend small amounts of money (seed capital) as you run experiments testing your hypotheses. Why small amounts? No startup ever spends less then it raises. And at this early stage you’ll be giving up a larger percentage of your firm to investors. A seed round can come from friends, family, Kickstarter, angels — and most importantly, early customers.
These sources are a lot more forgiving of iterations and pivots than later-stage venture-capital funds.
When to raise money
In a “lean startup,” the goal is to preserve your cash until you find a repeatable and scalable business model. In times of unlimited cash (internet bubbles, frothy venture climates) you can fix your mistakes by burning more dollars. In normal times, when there aren’t dollars to undo mistakes, you use Customer Development to find product-market fit. It’s only after you have found product-market fit (“value proposition – customer segment” in the language of the business model canvas) that you spend like there is no tomorrow.
Don’t confuse “raising money” with “building a sustainable business.” In a perfect world, you would never need investors and would fund the company from customer revenue. But to achieve scale, startups need risk capital.
Raise as much money as you can after you have tangible evidence you have product/market fit, not before.
The consequences of raising venture money
The day you raise money from a venture investor, you’ve also just agreed to their business model.
Here’s a simple test: If you’re the founder of a startup, go to a whiteboard and diagram how a VC fund works. How do the fund and the partners make money? What is an IRR? How long is a fund’s life? How much will they invest in the life of your company? How much do they need to own at a liquidity event? What’s a win for them? Why?
There are two reasons to take venture money. The first is to scale like there is no tomorrow. You invest the dollars to create end-user demand and drive those customers into your sales channel.
The second is the experience, pattern recognition and contacts that great investors bring to the table.
Just make sure it’s the right time.
• Fundraising is a means not an end
• Preserve your cash until you find a repeatable and scalable business model
• Focus on product-market fit
• Run small experiments testing your hypotheses
• Raise as much money as you can after you have tangible evidence you have product/market fit
Serial entrepreneur Steve Blank is the author of Four Steps to the Epiphany. This story originally appeared on his blog.
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