I meet with new startups everyday, it’s what I do. Every week I hear at least one pitch where the founder is trying to raise a large sum of money in the early stages of the startup process. The conversation usually sounds something like “we are skipping over the angel and seed round and raising a Series A of $3mm.” The amount of the raise is heavily correlated with the pre-money value of the company, which is correlated with the amount of risk in the business model. Early stage companies a have higher risk profile and a lower pre-money. A company in the early stages should seek to raise an amount that minimizes the dilution but allows the company to achieve the milestones necessary to raise a follow on round. A startup is a process and has a method that should be followed, skipping steps today will only increase the likelihood of future problems.
The purpose of this post is to go through run through lifecycle of a startup and correlate the capital raise with the stage of development. The secondary goal of this post is to use the Cynefin Framework to model each stage and illustrate the operations needed to achieve a scalable business.
The are are 4 quadrants/ontologies in the framework, Chaotic, Complex, Complicated and Simple. To get up to speed on Cynefin watch this video or go to the Cognitive Edge. The framework has traditionally been used for Agile software development but over the past few months I’ve been using it to think about scalability.
This is purely the ideation stage. It’s where you and your 2 to 3 founders identify a problem or market opportunity. The problem begins in the Chaotic section of the Cynefin Framework. Your team will spend most of its time white-boarding a hypothetical solution to the problem. The first cut at solving the problem is usually pretty rough, (turbulent and unconnected) but you hack away, iterating on the approach, until some form of the product is manifested. This is a paper version which is articulated in wire frames mission statements, or a business model canvas. Since your entire team is working on the same project scalability isn’t an issue.
Friends, Family and Fools
The product and the business model have been mapped out and you can articulate the vision. You start getting out there to see if your value proposition connects with customers. It does, and while your mom is not a valid test market, she still decides to invest. She gives you $20k to get you through the next couple of months. The majority of the problem is still in the Complex Quadrant with many unknowns and variables, but your team is able to distil the big idea into a minimum viable product (MVP). The MVP prototype allows you to test some assumptions with your target market, think clickable wireframes. This effort aims to reduce the number of variables by probing the market, sensing for input and responding with a different test. This phase is also known as the customer development cycle.
Your team has done several iterations and has nailed the prototype. It’s been a long haul but it’s now finally time to start laying the first lines of code. You and your co-founders spend the next month or more building out the MVP prototype. You finish and launch in private alpha and start collecting user data.
Your initial code has served you well. Customers like aspects of your product but have uncovered some significant issues with the user interface. Thankfully the basic value proposition is solid. A few tweaks here and there and you think you can get the core product to market. You are ready for some Angel money and you raise $300k on a convertible note that converts into the Series Seed round. You work with an entrepreneurial law firm to roll the Friends and Family money into the note, which brings the total value to $320k. You and your team are still working out of the same room, but you find that using tools like Pivotal Tracker or Agile Zen are helpful to get everyone on the same page. Much of the problem is still complex but parts of it are moving to the complicated region.
Congratulations, the hard work you’ve done to date has paid off and you’ve launched your core product publicly. It’s officially for sale, you begin to test a small vertical in the market. Of course this product is only the tip of the iceberg, the grandiose vision isn’t built yet, but the data points you are receiving from the market are positive and you feel like you are on to something big. An early stage institutional investor also believes in what your company is doing and you raise $1mm. The $320k note converts into the round at a 20% discount. With interest the total dilutive capital is $1.39mm. You use the $1mm of new money to hire a couple of developers, a sales/marketing guy and an undergrad to help with admin. The team of three has now doubled in size and you start relying on documentation to keep the internal team aligned and the investors informed.
While there are still chaotic, complex and complicated parts of your business, documentation allows you to simplify some of the basic tasks. This frees up your time to make the most important business decisions while keeping tabs on the operations. This is the first step in building a scalable machine. You begin the process by expanding the business model canvas into a List of Objectives. These are your value drivers, imperatives, branding etc. The Objectives guide the Product Roadmap which conveys the value proposition to the end user and differentiates your product from the List of Competitors. The Key Performance Indicators tell you about your customer’s perceptions and allow you to adjust the Product Roadmap. The Financial Reports allow you to understand the economics of the business model and your capital requirements which ultimately affects your Organizational Structure.
You’ve moved your core product offering forward and your solution is compelling. Although you still have some additional features you want to add to the core product, it is pretty solid (the majority of the product risk has been mitigated). On the other hand your “real” product just launched and you still haven’t fully tested the market. The customers in your small vertical love the product but you haven’t marketed it to the full set of potential customers. Your Series Seed investors love the progress you’ve made and think the company is in a good position, and decide to follow pro rata in the Series A round of $3mm. You spend the bulk of it on user acquisition and marketing, hiring a full sales team. The team creates a Sales Funnel Model which reports deals closed, deals in the pipeline and the ROI on your marketing spend. You gain a few customers, do some analysis and realize that your initial distribution strategy was wrong and your pricing model was a little off. You go through a few iterations and end up figuring out something that resonates with the large market you are trying to capture.
Series B and Beyond
You’ve got the product’s functionality down, the market is starting to pull and you simply need to add fuel to the fire. In order to keep up with the market demand and scale the larger team you’ve used structured documents to move your Chaotic, Complex and Complicated problems into the Simple Quadrant. You’ve succeeded in creating an organized scalable company. But this is only the beginning, you will require some growth capital to put your stake in the ground and own the market. Time for a bigger round of $5 to $20mm to improve the product and win the space.
- During each stage of development you reduce then amount of risk in the business and thereby increase its value. As a founder you want to minimize the cost of money by raising an amount that is correlated to your risk profile. Raising a Series A round when your business has a Friends and Family type risk will alter the financing lifecycle and has the potential to complicate financing the business in the future.
- Operating an early stage business is much different than operating a mid or later stage business. As you grow leverage the use of documentation to move problems from the Chaotic/Complex Quadrant to the Simple Quadrant.