Kaushik Gala: How much money should you raise?

galatime.com - Kaushik Gala

Note: The views & opinions expressed in these essays are strictly my own, and not those of any entity I may be associated with as an employee, consultant, promoter, investor, etc.

How much money should you raise?

(Last revised Mar-2012, Send comments to galatime@gmail.com)

Amid their constant need for capital, entrepreneurs must strike a balance between:

Raising enough, to sustain operations and revenue generation for 15+ months
Not raising too much, to minimize equity dilution and fund utilization pressures
Chances of a recessionary fund-raising environment during the next round
Chances of a bubble-like fund-raising environment during the next round

Matters get complicated due to the uncertainties inherent in technology R&D and customer traction. Entrepreneurs - and investors - typically use milestones, burn-rate calculations, capex & HR needs, etc. to estimate capital requirements.

Capital Efficiency

One of the thumb-rules that entrepreneurs can use is capital efficiency; defined as the amount of capital typically required to grow a company to a certain level of sustainable annual revenue. Also, at that revenue level, the company should be profitable enough to (partly) reinvest its earnings.

Obviously, the typical (revenue : capital) ratio varies widely across industries (e.g. Web 2.0 versus drug discovery). Worse, 3-5 year financial projections are usually way off for startups - making it difficult to gauge total capital requirements.

Regardless, by keeping a reasonable range in mind, an entrepreneur can devise a multi-round fund-raising strategy. Such a strategy would include reasonable step-ups in valuation, tied to technology and market milestones.

To arrive at this range, the entrepreneur needs to clearly understand the target market segment, and the company's revenue potential when it turns profitable.

An Example

Consider a startup targets the orthopaedic surgical implants market in India - its relevant market is likely to be Rs 50 - 100 crore. Of this segment, the company aims to capture Rs 10 - 15 crore. Such a venture is likely to become profitable when it reaches Rs 3 - 5 crore in annual revenue. The typical capital efficiency ratio of such an enterprise is probably in the range of 2:1 to 3:1, based on similar companies created in the past. Thus, you can now estimate how much capital will be needed:

Total Capital Required ↘		Capital Efficiency ratio
Total Capital Required ↘		2:1	3:1
Stable, profitable revenue	3 cr	1.5 cr	1 cr
Stable, profitable revenue	5 cr	2.5 cr	1.7 cr

With a 2 cr target in mind, the entrepreneur can plan a 3-round fund-raising strategy: Round 1: Rs 20 lakh, Round 2: Rs 50 lakh, and Round 3: Rs 1.3cr.
The first round may come from founders, the second from a GoI seed fund, and the third from an angel network.

Clearly, the estimates for break-even/eventual revenue and capital efficiency ratio are different in each company's context. However, the model still applies.

Perspectives

VC Moneyball - using statistics and data to drive venture capital decisions.
Startups need a different set of (accounting) metrics than businesses.