The Startup Financing Cycle
This article is a sort of an introduction to the startup financing problem. It originated from a question we received and is important to understand the very very basics of the financial needs of a startup. Probably (and hopefully) we will produce millions of articles to explore all the different corners that this interesting problem presents. But you cannot construct without the basics, so.. here we are, the first real article of FinancialKickOff.
The startup comes to life when an entrepreneur sees an opportunity and decides to exploit it. Usually the first step is a new idea, a new way to use existing ideas or simply an unexploited market. All these starts are important and can lead the way to greatness. However the idea counts for almost nothing if it is not backed up by a plan and if the plan is not carried through. Until the probation of success, the sale, and a good feedback from the market, the entrepreneur cannot be sure that a great idea is a great business.
To underline the fact that idea without execution is almost meaningless, we can just think about the royalties an inventor usually has on its product once it is produced, marketed and distributed by someone else. These royalties are about 4% of the final price, yes four percent.
What does it takes to transform a great idea into a great business? I tried “Great idea into great business” on Google and I just got 954,000,000 results. However I do not want to make cheap talk, if you are looking for answers like perseverance, gut feelings, support or motivation try my same research on Google. In this article I will try to address the financial part of the problem.
Exactly, taking an idea to market does not take only perseverance, luck, motivation etc… It takes also money! Usually a lot of money, depending on the industry and on the products. Do you want an example? A new drug sucks up on average (on average) $1.2 Billion! How can this huge amount be financed?
Well, the process starts from the entrepreneur’s pocket. At the beginning the money required is not so much and finding dreamers that have the guts to put money into the mere idea is pretty difficult. The first stage of “external” financing is named the 4Fs. The four guys that are willing to lend you or give you money in change of a stake in the non-existing companies are the Founder (obviously), Family, Friends and Fools, probably in this order. They finance the early development stage, the stage in which the idea is coming to life, the first drawings of the design.
As the idea grows and mature, strategic partners and angel investors come to the entrepreneur’s rescue. The strategic partner is someone that is really important to the realization of the idea in its early stages, he can be the computer geek if the business is a new website. He is probably putting a limited amount of money but will bring to the company skills that are complementary to the ones of the founder and that are absolutely necessary to the exploitation of the opportunity. Angel investors also like these newborn companies in their really embryonic stages. They usually put a limited amount of money as well and are quite demanding in terms of valuation, given the huge risk of the company in these early stages. You can read more about the division of equity between entrepreneurs and investors in our post on startup valuation.
The capital from angel investors and the expertise of strategic partners are probably spent on prototypes, packaging, business models and business plans. To the end of this phase the product should touch the market for the first time. Usually, the first contact with the market does not require a lot of money and is really useful to confirm the entrepreneurs idea.
After the development phase, we have the startup phase. We landed our first sales and we are planning to increase them. In this process venture capitalists may be really useful. They provide the money and the contacts to the distribution channels, but of course they demand high returns. It is always better to approach them with strong sales and with the first profits but it is not always possible. The risk at this stage is still high but is translated from an idea risk, the pure business risk that the product might not sell, to a broader business risk, to the risk that the company will not be able to profit from the product.
With VC money, a strong distribution channel and sales increasing strongly every month, the company is leading to success. VC money and strong earnings will guarantee future financing that will be mainly needed for inventory and to satisfy all those eager customers. The company is launched and, after a while, can consider itself out of the startup world.
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A lot of questions remain unresolved:
- What are the parameters that these people use in the valuation?
- What are the main uses of the cash?
- To what extent different companies have different needs?
- These and many more questions will be addressed in the forthcoming articles!