How do early-stage entrepreneurs raise money?

Early-stage entrepreneurs need three things to succeed: adequate funding, a strong team, and a high-quality product. The timing of funding can give a business a competitive edge or help it overcome a critical moment. A good product must impress users, but seeking funding is about impressing investors. To raise funding, entrepreneurs must convince investors that they have a solid team that is solving a problem or capturing a large market opportunity with a leading technology or idea.

Here are some tips for entrepreneurs to raise funding in the early stages.

01 Product is Key to Success

As a founder, it's crucial to prioritize raising the necessary funds quickly so that you can focus on building a top-notch product. Spending too much time and energy on funding can hinder progress in product development. Some founders may become fixated on finding the perfect institution or achieving a certain valuation, but this can lead to missing out on the best financing opportunities and ultimately harm their product's development.

Successful founders and investors have emphasized the importance of having a great product and promising growth. If you have these things, good institutions will come to you naturally.

02 When to Raise Funding?

Founders can get the right money at the right time by understanding their company's development and future plans, as well as the broader capital environment and market trends. The right financing can help a company secure enough capital early on to build their product for future growth. It can also help gain more control of the company with less dilution of equity, as well as better quality investors.

When Can You Defer Funding?

If your product is already breaking even in the early stages and is still working towards achieving product-market fit (PMF), like Microsoft, Bloomberg, or 1Password, then you may choose to postpone funding. The less you rely on external capital, the stronger your incentive to innovate and grow, and the greater your future returns will be. This can also attract more investors.

When Do You Need Accelerated Financing?

If you are in a competitive market where you need to quickly gain market share, you will need to build up sufficient capital. For example, Zynga raised a lot of money early on and then increased its market share through advertising, mergers, and acquisitions. Similarly, the sharing economy, group buying, and takeaway markets all fall into this category. However, in most early-stage startups, only a few have a very good growth situation. Most companies need financial support to build their teams and products. It's best to prepare a strong demo or beta test version before launching your product to avoid the dilemma of not having significant growth after launch and making investors question your worthiness for investment.

Macro market economies go through boom and bust cycles, and the frequency and scale of investors' interest in projects will change with the cycle. For example, in 2015 and 2021 when there is a lot of money in the market, teams with strong backgrounds can easily over-finance in the seed stage, which means they will have more than enough money and time to do a good job on their product and reach the next growth inflection point. However, it's important to avoid getting "too much" funding in a good market and high valuation. High valuations come with high return expectations from investors, and startups can inadvertently increase their costs. For example, because they are well-funded, they may hire too many people and lose their alertness to the market and startup sensitivity.

In a poor market environment, the first priority is survival, with enough funds to last through the 6-12 month venture capital (VC) investment freeze. In a downward market cycle, speed is more important than valuation. Valuations fall faster than you can hesitate. In hindsight, there is usually a 6-12 month VC freeze period during economic downturns where investor activity drops to a freezing level, and the few funding cases that do occur are mostly less than ideal. After the freeze period, the market will gradually pick up. So, entrepreneurs need to check if they have 2-3 years of the runway on their books to support them through the entire down cycle at the beginning of the downturn. If not, they need to raise capital as soon as possible and reduce their costs."

03 How Much Should You Raise?

This can be determined based on the stage of your company's development and the macro market environment. You can calculate the amount of funding you need by determining how many operating costs are required to reach the next funding round. For seed-stage companies, this is primarily the operating costs between achieving product-market fit (PMF) and reaching the next product stage. This is largely dominated by the cost of manpower. For example:

18 months (the usual time to reach the next product stage) x $150k (the usual median annual salary for an engineer in a startup) x 6 (the number of engineers in a team) = $1.35m.

Looking at the macro environment, company valuations tend to fall in a down market, but the size of funding tends to increase, and more companies choose to raise funds on a 2-3 year runway to ensure they have enough money to survive a market downturn.

Entrepreneurs should also be aware that financing is full of unknowns and should prepare several financing options for bad market conditions. They should also plan how to use funds wisely to grow the company at different levels of financing.

It's also advisable to reduce the amount of funding when making public announcements to send a positive message that the funding is going well. This also allows you to continue raising funds if you still have investors interested in you without publicly limiting your goals. In practice, many deals that go well are often overfunded, and overfunded funds typically have better terms."

04 Tips for Effective Pitching to Investors

Finding an investor through networking links or attending conferences and demo days is just the first step. The first 30 seconds of contact will determine the possibilities for follow-up.

How to Make a Good Impression？

First, research investor preferences.

Investigate their investment style and history in the industry, their investment preferences, and whether they have already invested in a competitor. This information will help you tailor your pitch and materials to their interests.

Next, clearly and directly demonstrate your potential.

Rehearse your pitch in advance and think about how you would explain the value of your project in two or three sentences at a conference or in an elevator in 30 seconds to grab their attention.

"Who are you, what are you doing, what is the market potential in your industry, and what have you achieved to reach the market goals you just stated?"

This narrative should be concise, clear, and strong, backed up by concrete data and aiming to convey the essential value of your business to the investor. Also, prepare a simple, straightforward, complete, and specific pitch deck that can be sent to investors to help them understand your business in more detail and serve as the basis for a full demo of your project later on. It should be interesting and engaging to keep their attention."

05 The Psychology of Venture Capitalists

What is the investor across the table thinking when you present a demo of your product and the business value logic of your company? What are venture capitalists (VCs) thinking when faced with an early-stage project?

VCs tend to have a fear of missing out (FOMO) mentality, fearing that they will miss out on high-return projects and that other VCs will succeed while they do not. They also have a fear of looking stupid (FOLS) mentality. Most investors seek consensus investments and are worried about looking foolish by investing in projects that other investors would obviously pass on. Out of this mentality, many investors instinctively struggle to make up their minds to invest in tracks that lack consensus or are not hot.

The lack of information that can be provided about early-stage projects makes it difficult for investors to get a grip on the project. So, they delay in order to gather more information. However, they understand that good projects do not wait for investors nor do they delay for long. They need an exciting investment signal, such as a good lead investor coming through or getting their first term sheet (TS), which will push those indecisive investors to make a quick decision.

It's best to get a term sheet within 3-4 weeks after a pitch. For example, one project incubated by Y Combinator, the corporate welfare platform Cherry, had its Series A funding in 2020 coinciding with the outbreak of the COVID-19 pandemic in the US. The four investment intentions that took two months to get all went up in smoke before reaching the TS stage. So, it's best to finalize institutions that already have investment interests as soon as possible. A day's delay may be detrimental and lead to investor reversals.

Generally speaking, it takes about 3-4 weeks from the last meeting to a term sheet. Too much time will leave the VC with hesitation and redundant judgement, while too little time may not be enough to think and make a decision.

You can take advantage of investors' FOMO mentality by doing unified fundraising at the same time and then suggesting to some institutions that you are in high demand and that the funding line is filling up quickly. If they don't invest, they will miss out.

Before signing the investment documents and making the payment, founders can consider locking in investors through a handshake deal, a concept developed by Y Combinator, which simply means confirming the investor's intention to invest via email.

In fact, both entrepreneurs and investors are in a mutual screening and nurturing relationship. Even if they don't reach an agreement this time, they can keep in touch and create opportunities for collaboration as the business progresses.

You Can Put Your Investors to Work for You

As an entrepreneur, you should not only work with your investors on a financial level but also consider what your investors can do for you beyond funding and seek help with your business as appropriate. You need to understand in which direction your investor can provide help. Each investor will be good at different things; some are good at product building, some have senior networking resources, and some can help at the business development (BD) level.

If you have a lot of investors, you can also set up a simplified version of an investor board that can meet regularly to discuss major events regarding the company's business development. Entrepreneurs can also send regular business progress emails to keep investors informed of the company's development and improve efficiency during meetings.

Entrepreneurship is not a journey of burying your head in the sand and charging alone. Founders must understand human nature and the market, and use their wisdom and determination to find like-minded investors to help them move forward. This guide aims to provide early-stage entrepreneurs with a roadmap to help them understand the basics of entrepreneurship and make informed decisions based on their unique situations.