The True Cost of Raising Funds
A startup is considered to be successful when it is able to raise money. The fact that a startup was able to convince potential investors to open their wallets is considered to be proof that the business model is stable. The fundraising aspect can be considered to be quite thrilling and even glamorous.
However, it is important to note that fundraising is not free. While many people are fixated on the fact that capital starts flowing into the company’s coffers, they tend to ignore the exorbitant costs which are associated with such transactions.
In this article, we will try to provide details about the various costs which are commonly associated with such transactions.
- Opportunity Costs: Now, anyone who has raised money knows that the process can be quite lengthy and time-consuming. The management of startup companies needs to put in an inordinate amount of effort in order to be successful in raising funds. There are endless meetings and presentations where investors constantly ask for more data about the firm. Also, companies are not able to raise funds from the first investor that they pitch to. This means that they have to constantly connect with newer investors and start the process all over again.
It has been estimated that when any company is trying to raise funds, almost 50% of the time is spent on activities related to this fund-raising. The management is only able to devote half of its time to strategic and operational purposes. This can have a significant impact on the performance of the firm. In the best-case scenario, companies may have to hire people to perform the day-to-day operations when the management is busy raising funds.
In the worst-case scenario, the revenues and operations of the firm will end up taking a hit while the managers are busy raising funds. In both cases, it can be said that the firm has to bear significant opportunity costs related to fundraising.
- Out of Pocket Costs: The process of raising funds requires the firms to interact with a lot of intermediaries. Each of these intermediaries provides services to the firm and hence the firm has to bear its costs.
For instance, firms have to hire lawyers, auditors, and investment bankers to be able to approach the correct investors with the correct documentation in place. Each of these intermediaries takes a huge fee. These costs can significantly add up to become a big percentage of the funds being raised. The out-of-pocket costs can make it unviable to raise money, particularly if a relatively small amount of money is being raised. In the absence of fund-raising, the firm does not have to spend this money and it can all be redirected towards improving the performance of the business.
- Compliance Costs: Even after the firm is successful in raising funds, the costs do not end. Investors often provide funds with the caveat that they want to monitor the use of these funds. Hence, companies have to appoint auditors and accountants who routinely inspect their books. Also, the firm may have to comply with other points mandated by the investor in the underlying agreement.
Compliance requires skilled personnel to spend their time. Hence, the process often turns out to be quite expensive for the company raising funds.
- Information Costs: Startup companies want to maintain secrecy at an early stage of their business. This is because they generally have some sort of intellectual property that they believe will help them in beating the market. Also, startup companies do not have very strong legal defenses for their intellectual properties. Hence, it is common for such companies to restrict the outflow of information. However, when it comes to raising funds, companies feel a significant loss in their ability to maintain secrecy.
- Firstly, companies have to disclose a lot of this confidential data to investors when they discuss business plans.
- Secondly, companies also have to provide investors with periodic access to this information.
Even though startups get investors to sign non-disclosure agreements, there is always a risk that the information could be leaked to competitors causing potential harm to the startup firm.
- Limitations on Freedom: Lastly, when a company raises funds, they lose a certain part of their freedom. Unless they have raised funds from the market, the company can take risks in order to grow its business. However, after they have raised funds, there are limitations on their freedom. They need to convince the investors before they implement an aggressive marketing or operational strategy. This adds a layer of complexity and the go-to market time for the firm increases. This increase in the time required to implement the strategy can also hinder the success of the same strategy.
The bottom line is that fundraising is not only about glamour. There are some very real costs associated with raising funds. Hence, if a company is able to avoid funding and continue with its own money, it would be better to do so.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Seed Funding - Introduction
- Why is it Difficult to Raise Seed Funding?
- Documents Required for Startup Financing
- How Co-Founders Split Their Equity?
- Proof of Concept
- Minimum Viable Product
- What is Prototyping?
- Asset Light Business Model
- Advantages of Asset Light Business Model
- Disadvantages of Asset Light Business Models
- Cash Burn Rate: The Basics
- Managing the Cash Burn Rate
- Startup Financing and Term Sheets
- Key Terms and Conditions in a Term Sheet of Startup Funding
- Red Flags that Investors Need to Look out for in Term Sheet
- The True Cost of Owning a Property
- Valuation of Early-Stage Startups: The Mindset of Investors
- Pre Money and Post Money Valuation
- Start-Up Valuation: Advanced Concepts
- How Pre-Revenue Companies are Valued?
- Valuation Divergence - Meaning and its Importance
- How Do Option Pools Work?
- What are Capitalization Tables?
- Asset Sale vs. Stock Sale
- Financial Models for Startups
- Key Performance Indicators for Startups
- Restricted Stock Options (RSU’s)
- Veto Rights - Meaning and its Importance
- Financial Benefits of Incubators
- What are Unicorns?
- Why Startup Companies are Staying Private?
- Why Unicorn Companies Fail?
- Building a Startup Team
- Bootstrapping: Meaning and its Advantages
- Disadvantages of Bootstrapping
- Revenue Based Financing
- Convertible Notes and Startup Funding
- Pros and Cons of Convertible Notes
- Simple Agreement for Future Equity (SAFE)
- Keep It Simple Securities (KISS)
- Series A Funding
- Series B Funding
- Series C Financing
- Venture Debt in Startup Funding
- Pros and Cons of Venture Debt
- What is Venture Leasing?
- The Freemium Model - Different Types of Freemium Models
- Pros and Cons of Freemium Model
- Scalability and Startups
- Pros and Cons of Scalable Business Models
- Why Do Start-ups Fail After Receiving Funding?
- Start-ups and Arbitration
- What is a Revenue Model?
- Understanding Investor Focus on Burn Rate
- How Investors Evaluate Start-up Ideas?
- Government Regulations Which Impact Start-Ups
- What is a Start-up Accelerator?
- Managing the Operational Metrics of a Startup
- Different Types of Investors
- The Founder’s Dilemma
- Role of Social Media In Start-Up Funding
- Start-Ups and Public Relations
- Red Flags for Start-Up Investors
- IPO: An Exit Route for Start-Ups
- What is Acqui-Hire?
- How to Build a Start-Up that gets Acquired?
- Legal Issues Faced by Start-up Companies
- Corporate Venturing
- How Reverse Pitching Works?
- Aggregator Business Model
- Marketplace Business Model
- Difference between Aggregator and Marketplace Business Models
- Product as a Service (PaaS)
- Benefits of Product as a Service (PaaS) Model
- Disadvantages of Product as a Service (PaaS) Model
- The Co-Working Business Model
- How Co-Working Spaces Make Money?
- Peer to Peer (P2P) Business Model
- The Instacart Business Model
- The Goodleap Business Model
- The Twitter Story
- How Tesla Reinvented the Automobile Industry?
- How Epic Games Changed the Gaming Industry?
- The SpaceX Success Story
- The Stripe Business Model
- The TikTok Business Model
- Zillow Story - The Real Estate Marketplace
- How Business Cycles Affect Start-Up Companies
- Managing Start-ups During an Economic Downturn