How do I compute the optimal amount of capital to raise for my first round of funding?
Computing the optimal amount of capital to raise is both an art and a science. The goal is to raise enough money to get you to the next milestone, yet not so much that your incur unnecessary dilution.
There are two main approaches we use to get to a specific “ask”. The optimal method is to build a pro-forma financial forecast (as described in this post) that lays out your expectations for the business over the next 2-3 years. Typically, we map out the timing and potential of the business model, as well as what it will cost to get the company off the ground — salaries, marketing spend, IT expenses, etc. This takes the form of a P&L, and from there, we make a few accounting adjustments, such as stripping out depreciation and adding in CAPEX, to give us “free cash flow” which is the actual cash inflows and outflows of the firm.
For most startups, free cash flow will be negative for some period of time — say a year or two — until the company hits the break-even point and starts to turn a profit. The total sum of these negative cash flows — i.e., the cumulative losses incurred until the business starts to throw off cash — is the (minimum) amount you would need to raise for your first round. However, we usually pack on a “cushion” of 30-50%, as startup reality never goes quite according to plan (and indeed, most of the time it takes longer and costs more than we anticipate in the model).
The second approach is less accurate but much quicker and simpler — you simply make a list of all the expenses you expect to incur before hitting your next major funding milestone or inflection point — e.g. product/market fit, adoption ramp, etc.. In short, you use your budget to guide your funding needs.
Beyond the quantitative approaches described here, there are several other factors that come into play when determining the “optimal” amount of capital to raise. One is the macro climate — if there are storm clouds forming on the venture market horizon, then it may make sense to raise as much as you can, when you can — while things are still liquid. Think back to the “nuclear winter” starting in the summer of 2008 — well funded startups weathered the storm, whereas those that played it too lean ran out of capital.
Another factor to consider is the opportunity cost of raising capital. Fundraising sucks up a massive amount of precious startup founders’ time; in many cases it may be worth it to raise more than you need early — and bite the bullet on the added dilution hit — so that you can focus on product, sales or marketing.
Finally, look at what other firms are doing. If a particular marketspace is heating up, it may be time to raise more money in an accelerated manner to try and capture the market. The “social deals” space, with Groupon and Living Social, comes to mind as an example of this.