Funding: How Startups Use Investors’ Money
September 22, 2022
Where does investors’ funding go? 5 key ways startups use and allocate investors’ funds
A standard inquiry posed to entrepreneurs looking for investors is: what will you use the money for? In other words, where will the funding go? Startups should focus on the importance of sufficient capital upon the launch and development of the business.
Being aware of what the startup uses funds for is essential information for investors. This is because it provides them with key insights into the business’ plans for growth, and strategies to achieve this. Using this information, investors can ensure they are making a more informed decision. Then, they can accordingly decide whether or not they should invest in a company.
This article explores the 5 key factors investors want to explore to understand how their funds will be used and allocated. In general, funds can be used to overcome barriers to entry, gaining traction in the market, business or product development, scaling the business, and for cash management purposes.
1 – Overcoming Barriers to Entry
For most startups, a number of different obstacles exist when trying to enter a market. This can range from government regulations, manufacturing equipment, patents, etc.
The American economist George J. Stigler defines a barrier to entry as, “a cost of production that must be borne by a firm which seeks to enter an industry but is not borne by firms already in the industry.” For example, a new company willing to enter a market must incur research and development costs that match that of existing competitors. Another example is startups that require funding for raw materials or licensing, which is why they turn to investors for funding.
However, keep in mind that investors are often deterred when a startup asks for funds that are just enough to cover barriers to entry. They prefer to know that a company plans on putting their funds to good use for manufacturing, product development, etc. to generate incomes.
2 – Gaining Traction in the Market
To gain traction in the market usually requires funds. From investors’ perspective, they check that the marketing strategy is feasible. It must be attractive enough for a company to gain traction in the market. They then look at the required expenses and the bottom line.
Initially, a company will have to undergo the process of customer acquisition.
This means that market research is an essential step for startups. It includes activities such as gathering information about the target market, customers’ preferences, pricing strategies, and ways to make your business stand out.
The purpose of all this research is to know which customers to target. It also explores how to convince them to buy your products or services.
One of the questions investors always ask companies is: what is your Customer Acquisition Cost (CAC)? This is important because investors can get an idea of the company’s scalability and profitability by comparing the amount of money earned by acquiring new customers with the costs of extracting it.
If a company is able to discover whether or not there is a market for their products or services – and can back this information up with data and statistics – it will encourage investors to pour funds into the startup.
3 – Business/Product Development
Business development is a broad term, but generally encompasses initiatives by companies to help improve the business. This may include adapting the product to better satisfy customer needs, or building strategic partnerships. Once a company initially launches its product or service in the market, the next step is to industrialize and improve the solution. The main objective of a company should revolve around capitalizing and enhancing its unique features to stand out from competitors.
As a result, investors are interested in uncovering the roadmap of the product and its evolution as it enters the market. This gives them an idea of where their funding is flowing. The process of business development is essential for companies and tends to continue till the end of the product or service’s lifecycle.
4 – Scaling the Business
Traditionally, there does exist a negative connotation around asking for funding. Namely, that a business is not doing so well because of a lack of capital. But, investors shouldn’t view it as a bad signal by default. According to a post-mortem analysis for 101 startups by CB insights, for example, a surprising 29% of small businesses fail due to lack of capital.
Contrary to popular belief, the most precarious period for a startup is not the initial launch. In fact, it is the process of scaling up for growth around the second round of funding. When a startup is starting from scratch, there is somewhat of a margin of safety. There isn’t too much to lose, errors are easily amended, and a dedicated team can solve any difficulties that may arise. However, when business growth accelerates, the necessity for funding grows almost exponentially to finance future growth.
Scaling the business involves moving from the current situation to the next step in order to grow the business. A company requires funding and resources in order to gain faster traction. Funding will flow into the support functions, operation and sales departments of the company. This may include recruitment costs, marketing expenses, investment in IT facilities and infrastructure, to name just a few examples.
This is because a startup is constantly reaching milestones, and requires financing for future growth.
It is therefore crucial for companies to clearly highlight their priorities for scaling the business, so that investors are aware of where their funds will go.
On the contrary, investors are not funding founders’ salaries. They invest to fund resources that will contribute to grow the income.
5 – Cash Management for Businesses: Working Capital Requirements
When a company is in its early stages, cash management is a key component in ensuring financial stability.
Investors are keen to analyze a startup’s business plan. In particular, they analyze financial forecasting and projected cash flow to ensure there will be a Return on Investment (ROI).
Some companies facing an inconsistent cash flow may look to finance their working capital requirement (WCR). Required working capital is necessary to cover their day-to-day, short-term operations expenses before having the collected cash available in the bank account.
At the same time, it can be useful even if a business isn’t facing a cash flow issue. It ensures a reserve of cash is available for unexpected circumstances, like delayed receivable payments.
From an investor’s perspective, their funding will offer the business quick financing to sustain operations.
In conclusion, it comes as no surprise that funds are essential for small businesses. This is not just for initial development stages, but also for further growth and expansion. It is thus necessary for a startup searching for investment to have a clear vision of where the invested money will go. This information is also key for investors, as it allows them to determine whether or not they should provide funds. With good business planning and careful cash flow management, investors view startups as more promising. As a result, it will encourage them to invest in the business.
That’s why with IdeasFundX, we are helping companies to formalize their funding needs and how they plan to use the investors’ money.
Visit IdeasFundX, a new tool to help both companies and investors in the fundraising process.