I get a combination of disbelief and befuddlement when I ask this question of founders. And I admit that I have stumbled on it multiple times in the past.
"What do you want capital for?" To put it a more specific way, I am asking, "what are you looking to spend on that you cannot otherwise?"
In investing parlance, this is the "use of funds" question. To what use will the startup apply the funds raised?
In his Entrepreneur's Office Hours newsletter Aaron Dinin has a great piece on how to think about this use-of-funds question:
While I understand the logic of including a "use of funds" slide, in practice, this type of slide is worthless. Simply put, nobody can successfully explain how they'll use millions of dollars worth of funding in a single slide. Or, more accurately, anything that gets shared in a single slide would be woefully unconvincing to any professional investor.
Step back for a second. A key reason to put money into any profit-seeking enterprise is to get a return. If that money is equity money, then the metric for success is the return on equity. That's an actual accounting term!
Return on equity answers the question, "if I put in a dollar of equity financing, how many dollars come out?" The classic story is growth. If I know that spending money on, say, paid advertising generates leads, and those leads will pay off as subscriptions on some reasonably predictable basis and at a decent LTV/CAC multiple, raising equity to juice that tactic makes money for everyone.
Put differently, the answer to "why are you raising money" is your whole business model viewed through the lens of return on equity. That requires an understanding of the business model based on self-knowledge. That self-knowledge is most solid as the experience of the individual business. Alternatively, the company's executives can put a playbook they have successfully used in front of the investors and some data that the playbook applies to this business.
Mid-to-late stage funding can operate at such high multiples. The cash machine is progressively more validated, which increases the confidence of investors. In turn, their perceived value of the company's equity goes up. The startup receives a decreased cost of capital, which is to say, a higher company valuation.
As one's business model becomes more distant, speculative, or unclear, the willingness to invest will decline. Fewer people will even consider buying stock because they need some other inside knowledge to manage the risk. That means being a mere money manager will not do. And since the people with that additional inside knowledge are few, there is a limited supply for that money.
The best trust comes from personal relationships. Barring that, I tend to think that confidence can come from three sources: a financial track record, market expertise, or product expertise. Put differently; you know how to take care of investors, customers, or the software.
The first is taking care of investors. I heard a story from a company I invested in discussing their fundraising woes. An institutional investor said to the founder, "We'd invest if you were Stewart Butterfield." In the case of the story, the proposal was not the founder's first startup - the previous one had sold for a modest exit. He was swinging for the fences. Why were these investors giving him a hard time about not being a famous founder?
But the investors were, reasonably, looking for ways to project from where he was to a cash machine. If he had a track record like Butterfield, they could take his previous liquidity event (Slack sale to Salesforce) and discount it heavily to see if there was a positive return on their money. For my friend, his modest previous outcome, while a triumph, was not as high an upside for them from which to start their discounted calculations.
Second, one can be a market expert. If one can educate the investor about the market from a well of profound knowledge, the risk can go down.
A younger entrepreneur can get a foothold by being part of an emerging market or demographic. "You old people don't get it because you're not like them, but I am" is a compelling story for an investor looking for markets!
Third, one can de-risk the product. For a few, this could be presenting oneself as a deep technological expert worth investing in for a hard tech problem. But for would-be software entrepreneurs, the most straightforward way to de-risk is to have the software in hand so they can get into the market to figure out their return-on-equity thesis.
Investors are reticent to fund technology development efforts. For what do you need that money? Initial product development is the most obvious place for a technical founder to put skin in the game. Of course, not all founding teams are technical, but an investor will look for this to have a high bar of execution proof if this is a technology business. If I want to invest in a Central American outsourced development team's efforts, I'll hire them myself.
No-code enters this conversation as it has so many others I have participated in over the last few months. The exceptional state of tooling in the world drives down the cost of prototyping both in staff time required and elapsed time before executing validated learning experiments to gain market knowledge. Many proud technical founders dismiss these tools as being insufficient - and many are! But others are pretty good for the job, and the job is generating market insight that turns into market data to validate a return-on-equity thesis.
Further, no-code can change the makeup of the founding team. Rather than requiring a technologist and a market expert, a market expert can lever the tooling to get much further into the market with a minimum of capital. So-called "non-technical" founders have an advantage here because they are usually more economically driven: they exploit a gap in the market rather than creating some new artifact in which they have intrinsic pride. The twin markets for investors and customers guide these non-technical founders, giving them a significant advantage in building a cash machine and raising that growth equity money.
The opportunity to use no-code to bridge that gap is enormous. Jason Fried of Basecamp believes that you can't tell what the customer wants before you put it in the market. His firm spent a lot of money on various products he would introduce into the market. One can test market-risk ("will they buy it?") with a product that contains crucial functionality at a tenth or less of the cost.
And there is no reason to think that after this prototyping, one has to go "pro-code" to move to a scaled model. Instead, one may be able to trade one kind of no-code for another, keeping technical costs down.
All of this means that the focus moves all the more quickly to return on equity. Figure out a cash register and then push with capital. Making a return on equity the whole of the model will drive equity wealth for the company's investors - starting with the founders.
I agree with Dinin that the use-of-funds slide is pointless. That's because the whole presentation - the entire business - should answer the question, "why are you raising money?" And often, when the pieces are in the correct position, you will get my favorite answer:
"We don't need to."
Photo by Evergreens and Dandelions on Unsplash