A successful startup begins with a good idea. It is also supported by a business model that is desirable, feasible and viable. Specifically, ‘viability’ refers to the ability of your business model to generate enough revenue to cover fixed and operational costs from the sale of your product or service. Many startups fail because the products or services cost more than what people are willing to pay for them. This article sets out the elements to consider to ensure you have a viable startup.
Before pitching to investors, it is essential you have a good grip on the financials of your startup. Ensure you know the cost of delivering your value proposition (the innovation or feature that makes your product stand out in the market) and how much revenue you can gain from it. When assessing your cost structure and revenue stream, consider the following:
- how will you pay fixed operational costs and variable expenses until you generate cash flow from sales?
- how much working capital do you need?
- what is your customer acquisition cost?
- how many sales do you need to make to break even?
- when will you break even?
- what is the cost of goods or services sold, per item?
- what is the lifetime value of a customer?
- when will an investor get a return on their investment?
- what is your contribution margin?
- what is your exit strategy?
Most startups do not make a profit in the initial stages of operation, as there are considerable start-up and operational costs. It is therefore essential you have a plan to cover your fixed operating expenses and variable operating expenses until you generate enough cash flow through your business to cover them.
One option to do this is by raising capital. Only raise capital if you need to. While raising capital will help your company grow, it will also dilute the shareholding ownership of the founders.
Often, raising capital will occur across several rounds. To ensure you retain as much control of your startup as possible, only raise as much capital as you need to get to your next milestone. For example, if your startup revolves around an online platform, conduct a financial projection estimating how much it will cost you to develop the first version of the platform and reach a given amount of users.
There are three structures for an equity capital raise:
- equity round;
- convertible notes; and
- simple agreement for future equity (SAFE).
An equity round involves issuing shares to investors in exchange for cash. It is essential to know how much your company is worth so you can give an appropriate percentage of ownership in exchange for a given amount of money.
Investors will also want you to have a clear plan of what you will do with the money and how much return you expect from their investment.
Convertible notes are a mixture of debt and equity. The investor provides you with a loan that allows you to reach your next milestone. Instead of being repaid, the loan converts to equity when an agreed trigger event happens. That trigger event is usually the closing of a future equity round for a certain amount.
If the trigger event does not occur, convertible notes will need to be repaid or they will automatically convert to equity at a given date.
SAFEs are similar to convertible notes. However, instead of being debt instruments, they are equity instruments. The investor gives you an amount of cash that allows you to reach your next milestone and, in exchange, you promise them equity when a trigger event occurs. Usually, that trigger event is the raising of future capital.
Unlike a convertible note, a SAFE is not a loan and does not accrue interest. A SAFE does not have a fixed term, so if the trigger event does not happen, the investor never receives equity.
Alternatives to Equity Capital Raising
Although many startups go through the equity capital raising process, it is not always necessary. If your startup has little upfront costs and you can grow it through bootstrapping, you do not need to raise capital. Bootstrapping involves using your personal savings and revenue from the startup alone to build your business. Bootstrapping is advantageous because you do not need to give out shares or dilute the ownership of the company.
Another alternative to capital raising is government grants. The government is looking to encourage innovation and new businesses, so there are many grants available for startups. For example, Jobs for NSW offers a Minimum Viable Product grant for startups that are not yet generating revenue. Government grants are a relatively risk-free investment, so it is a good idea to explore this avenue when looking for capital.
If you require capital to grow your startup, you may also consider venture debt. Venture debt is a type of loan available to startups. Unlike regular loans, venture debt does not require positive cash flow or significant collateral. It has the advantage of allowing you to keep full ownership of your company. However, it does require you to repay it with interest.
To turn a good idea into a successful business, you need a business model that is desirable, feasible and viable. A viable startup can generate enough revenue to cover its costs. When looking at the viability of your startup, consider how you will cover your expenses until you create enough cash flow from your value proposition.
If you need assistance determining whether you have a viable startup, get in touch with LegalVision’s startup lawyers on 1300 544 755 or fill out the form on this page.
For more information on your options when raising capital, download LegalVision’s free 60-page manual featuring 10 case studies from Australia’s leading VCs and startups.
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