Scope of Financing and the Company s Value

Scope of Financing and the Company's Value

Demand—The Company's Capital Needs

In the first stage which most startups undergo, namely, research and development, the company invests in developing the product and usually does not yet invest in the expensive infrastructure required to implement it. At this stage, companies usually generate no revenues (unless revenues are generated by granting licenses to use intellectual property or selling rights for future developments). These companies' operating cash flows are negative, because they incur only expenses.

At the next stage, the company may buy or lease additional equipment to start implementing the results of its R&D. Since the investments in this stage are larger than those made in the first stage, the company's operating cash flow is now even worse. The increasing pace of employee-recruitment is another great contributor to the cash burn rate.

Next, assuming that all proceeds according to the plan, the company starts generating revenues. However, these might be at first insufficient to pay for the marginal production and marketing costs and hence cannot cover the costs of development. The reason for this is that the company is struggling to introduce its product into the market, is spending considerable amounts of money on marketing and advertising, and is sometimes forced to sell its product at low introductory prices.

If the company's business involves substantial investments in infrastructure, the company's profit for accounting purposes will be lower than its current cash flow due to the substantial accounting depreciation components it must bear.

At this stage, the company's revenue is growing at a rapid pace. The more favorably the company's products are received on the market, the faster will its revenues increase, alongside the growth in the revenues themselves. A main reason for this is that satisfied customers are an excellent marketing instrument and they accelerate the company's sales. In addition, the more entities the company recruits to market its products, the faster does its marketing potential grow. However, the paradox is that, at this stage, the more successful the product launch is, the more the company suffers from negative cash flows.

In order to finance its current negative cash flows, the company needs to raise capital at an accelerated pace. Paradoxically, investors now have to invest more money for their first investments to bear fruit. However, since more information is available at every stage from the market with respect to the feasibility of the project, investors are prepared to increase their investments at ever-growing increments.

The more the project advances, the higher the revenues and the lower the risk to investors. Concurrently with this development, more sources of capital become available to the company, such as loans and, ultimately, public offerings.

Supply—The Company's Ability to Raise Capital

Any attempt to force the various stages of a startup's financing into one standard mold is doomed to fail. There are vast differences among startups in a wide variety of issues, which have an immediate effect on the amount of money they can raise and their value at any given stage. However, some factors are always important:

  • The entrepreneurs' past experience— The more experienced the startup's entrepreneurs and the more proven success in managing startups they can demonstrate, the easier they will find it to raise more money, according to a higher value.

  • The leading team— The earlier a company can present an experienced leading team with diverse capabilities in development, marketing, and business development, the easier it will be to raise more money, according to a higher value.

  • The field— There are significant differences in the type, scope, and structure of investments sought in fields such as advanced optical equipment or components to Internet companies (which are themselves divided into many subcategories) or to medical equipment or communications companies. Every field has different characteristics from the perspective of the main milestones which the company has to meet, the timetables for progress and success, the anticipated exit, and the investors' current sentiment toward the specific field (many investors act according to the "herd principle," investing in fields that are considered "hot" at that point in time). Accordingly, the value of the assessed company and the amount of capital it could fetch will also be affected.

  • The maturity and current status of the technology— Generally speaking, the more mature and less risky the technology, the easier it is to raise capital for it. However, some firms do enter highly attractive fields with experienced managers and investors and with a high value, although their technology has not yet been proven. This usually happens when the team and the management are outstanding and when success could revolutionize the field.

  • Understanding the market and the business planning— The better the company's understanding of its market and competition, and the higher the level of its business planning, the more money it will be able to raise more easily and at a higher valuation.

  • Market penetration— Usually, a company that has already established a presence in the market receives clear feedback from the market with respect to its products and has accumulated a visible mass of orders, is more attractive and entails a lower risk, and can therefore raise more money.

  • The situation in the capital markets— The condition of the public capital market, which is the main outlet of investors, as well as the amount of money available to private investors (the supply of money), which also depends on the public capital market, considerably affect the amount of capital raised and its cost. At times when IPOs rarely exist, it is also difficult to raise capital in the private market.