Should You Raise Money for Your Startup? If So, When?

Published on by John Teel

Should you raise money for your startup, and if so when?

The short answer is yes, you probably will need to raise money for your hardware startup. It’s very difficult to completely scale a hardware startup without, at some point, raising money.

However, the key is to wait as long as possible to raise that money.

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The more progress and traction that you make, the more value your company will have. The more value in your company, the less equity you need to give away when raising money.

Also, it will be easier to raise money because you will be a less risky investment. More people will be interested because of your initial progress and traction.

By focusing on what you have already accomplished with your startup you will move the focus away from your skills and background.

For instance, if you are new to product development you’re going to need to make more upfront progress than someone who has already built and sold a hardware startup.

The longer you wait to seek outside funding, the more upfront progress you can make. More progress makes it easier to raise outside funding, and allows you to give away less of your company.

Raising outside funding is hard. It’s really hard work, and it takes a ton of time. In fact, one of the biggest risks when focusing on raising outside funding is that you don’t have any time left to actually work on your startup.

Fundraising can easily absorb all of your time. I know this personally, having gone through the process of trying to raise outside funding. I was a solo founder, so trying to get funding basically sucked up all my time.

While trying to raise money I ended up neglecting my business itself which created various problems. This then makes it harder to find investors, so you are forced to focus on both raising money and running your startup. That is exceptionally difficult especially for solo founders.

This is one reason why you may want to have multiple founders on your team. That way one of you can stay focused on the startup while the other founder is out pitching the product and trying to raise funding.

The question you should really be asking is when should you raise money? If you can grow your startup without raising outside funding, obviously, that’s great. But that’s very challenging to do.

Outside money is usually required if you want to grow your startup more quickly. If your growth is too slow that allows competitors to move in and take away your market share.

So let’s look at the different stages of a startup, and when you should raise money.

Stage #1: Pre-Seed Money

The first stage we’re going to look at is loosely defined as “pre-seed.” Think of this as the “you’re-at-the-idea stage.” In this stage you need money to take your product idea and turn it into a working prototype.

At this stage, you would only have your product idea and maybe a proof of concept prototype that uses development kits like an Arduino or Raspberry Pi.

The other term you’ll hear at this stage is “angel investors.” An angel investor is a wealthy individual that’s not necessarily an established venture investment firm.

Angel investors are wealthy individuals that have money to spend and to lose, because investing in startups is very risky, especially at the pre-seed stage.

Your other funding option at this stage is self-financing, and getting investments from friends and family.

At the pre-seed stage typically you’re talking about tens of thousands of dollars depending on the complexity of the product. For really complex products this may exceed $100k.

The amount of money that you need to get from an idea to a prototype is also heavily dependent on your skills.

For example, if you, or your co-founder happen to be an engineer, it should cost you less to develop your prototype.

For many products a great team would be a hardware designer and software developer.

With a skilled founder team, it’s going to obviously cost you a lot less money to get to the prototype stage because the founders have the technical skills to do most of the development on their own.

Image result for prototype electronic

It’s going to cost you your time, but you can basically eliminate most of the engineering fees associated with development. Instead most of your cost will go towards actually producing the prototypes.

The cheapest option is almost always to do as many things as possible yourself. The more skills you have then the less money you will typically need to raise to get to a prototype.

Raising outside funding at the pre-seed stage is very difficult, because it’s such a high-risk stage. You haven’t proven yet that you and your team can actually execute.

Professional investors are always more interested in your ability to execute than your ability to come up with great ideas. As I always say, the value isn’t in the idea, it’s in the execution.

Investors are not going to place a whole lot of value on your idea alone. Not only does this mean it’s harder to get people interested in investing, but those that do invest will want a lot of equity in your company in exchange for taking a bigger risk.

Remember, if you seek outside funding at the pre-seed stage, you’re going to have to give away a lot more of your company than you would if you raise money at a later stage.

Most of the emphasis when raising money at the pre-seed stage is going to be on you and any co-founders. It’s going to be really difficult to raise money if you don’t have a track record in product development or startup success.

However, there are still investors willing to fund risky startups, because the flip side is the higher the risk, the higher the potential gains.

But if you’re new to product development, it’s going to be challenging to raise outside funding. You’re going to need an impressive résumé and an impressive set of skills to show people to prove that you’re capable of executing.

To find an angel investor, you will also probably need to have some type of personal connection with them. That’s connection is going to be critical, because at this stage it’s really all about you.

Any investors are going to be investing mostly in you and your team, and not necessarily in your product idea. Of course, investors have to like the product idea and think it has some chance of success.

But ultimately, anyone that knows anything about startups knows that the founders are the most critical piece, especially at the beginning before the product has any proven sales.

Because of this fact you are most likely going to need a well-rounded founder team. It becomes exceptionally difficult to raise pre-seed funding if you don’t have a founder team, especially if you lack any directly relatable skills like engineering, software design, sales or marketing.

Have you run a startup before? Have you done product development and management previously? Or have you worked in a big company in a field related to your product? If you lack experience in some essential areas, then you will really need other people on your team to fill in some of those gaps.

Anytime you’re raising money, but especially in the very beginning, you must focus on developing a realistic business plan with realistic expectations.

The best way to scare away investors is to have completely unrealistic expectations and goals. Avoid being unrealistic in regards to how simple you think it will be to develop your product.

For example, if all you have is an idea but you tell investors you plan to have manufacturing going within 6 months, you will not be taken seriously. Professional investors will be laughing on the inside, and they will definitely keep all of their money in their pocket.

Also, do not be naïve and boast about ridiculously high sales or how much money your product will potentially make. No one truly knows what will sell until it is actually on the shelf for sale. You do need to have some estimates, but they need to be grounded in reality.

For example, never tell investors anything like “there are 7.5 billion people on the planet, so if we only get 1% of those people to buy, then we’ll make billions”. That’s always a sure sign of an amateur without solid expectations.

Instead, seek out professionals with the experience you need to create a realistic business plan and realistic expectations on what is possible. If you are in the U.S. the website SCORE.org is a great place to find professionals to help you create a realistic business plan.

SCORE is made up of numerous professionals that volunteer their time to help new business owners. It’s a completely free service.

Friends and Family (Beware)

The other pre-seed funding option that you have is friends and family. Although this can be the easiest way to get funding, assuming you have friends and family with money, it has a lot of risks associated with it.

Mainly, you risk jeopardizing your relationship with these friends and family. The odds are you’re going to lose their money. That’s just the nature of startups, especially at the pre-seed stage.

A lot of people that aren’t professional investors can’t really comprehend how risky of a venture this is. If you lose their money, you’re jeopardizing your relationship with friends and family. That can impact you for many years beyond your startup lifetime.

You need to make sure that they fully understand all of the risk. This needs to be money they can afford to lose. Don’t have your grandma take out a second loan on her house to get your startup idea off the ground!

Image result for grandma

I would never recommend borrowing money that your family or friends cannot afford to lose. In general, make sure to avoid financially harming the people you care about the most.

I’ve known people that want to take out a loan to finance their startup. Typically, that’s not something I recommend either, because that just puts undue financial hardship on you if the product ends up not being a success.

Stage #2: Seed Stage

The second stage that we’re going to talk about is the “seed stage.” All these stages are not strictly defined, but I define this stage as where you take a prototype all the way to being something that can be manufactured.

In the seed stage you’ve proven that you can execute, at least, to the point of getting to an early prototype. That really adds a lot of value, and lowers the risk compared to investing during the pre-seed stage.

Image result for seed money

In the seed stage you will need money to take your product from a working prototype to something that can be mass manufactured. I commonly refer to this as scaling costs.

The seed stage includes the costs associated with getting manufacturing set up; however, it doesn’t include the money you will need to actually manufacture inventory. It’s only the cost to get to the point of being able to mass produce the product.

In general there are two dominant costs at this stage. First is the cost of the high-pressure injection molds required to produce your product’s plastic enclosure. Any plastic parts in your product will require custom made molds, which are very expensive.

The other big cost is for certifications. Electronic products require various certifications, and these can cost tens of thousands of dollars in total. There are ways to keep certification costs down, but in general they will be a significant cost at this stage.

As I said in the beginning, the later you can wait to raise money, the better. But I think that this stage is the best “early” time to raise money.

Ideally, a prototype and some early traction is going to be really helpful at this stage.

By traction, I mean having some retailers that have expressed interest, or you’ve got a distributor that has said they like your product and they’d be interested in purchasing an order once you have things ready, or you have some significant pre-sales through your website.

There are more professional investment firms at your disposal for raising seed funding because you’ve lowered the risk compared to the pre-seed stage.

You are less risky to invest in because you’ve made more progress and you’ve put more value into your company. This progress also shows that you are serious and it filters out just the dreamers.

Importantly, you’re going to have to give away less equity in your company, because you’ve built more value into the company.

That being said, investing at the seed stage is still considered highly risky. You’ve gotten through the prototype stage, but you still have to set up manufacturing and prove that the product is going to sell.

In fact, until you have solid proof that your product sales well, you will be considered highly risky. Sales proof is the most important milestone for any business.

You may have the most innovative idea ever, you may have a fantastic prototype, and you may have manufacturing ready to go, but until you prove the product sells you are in a very risky business stage.

Crowdfunding

Having a working prototype is the earliest stage you should try to seek crowdfunding investments. In the past, lots of entrepreneurs raised crowdfunding money before having a real prototype.

These typically turned into massive failures and a lot of angry investors. This is because it’s so difficult to forecast how long it will take you to go from an idea to being able to actually ship a product to a large number of people.

There are just so many unknowns, especially if you’ve never done product development before.

Crowdfunding is almost always best done after you have the prototype. By then you will have at least worked through most of the initial development stage and technical challenges.

Manufacturer Financing

Another funding option you should consider at this stage is manufacturer financing. You may be able to find a manufacturer that likes your product a lot, and is impressed with your prototype and traction.

This is what I was able to do with my own product. I self-funded my startup to the point of having a quality prototype, although not a prototype entirely ready to be mass manufactured.

My prototypes were still 3D printed, but I was very close to being ready to scale up to manufacturing. I also had interest from a large retailer, which was absolutely essential.

At that time I had interest from Blockbuster Video, who obviously doesn’t exist anymore, but they were very well-known and prominent at that time.

The combination of having a prototype and interest from a large retailer allowed me to find a manufacturer that was willing to finance most of the work required to go from a prototype to something manufacturable.

Manufacturing money

That meant they would finance the molds and certifications. Typically, a manufacturer may agree to amortize these costs. They’re not just giving you the money in exchange for equity, instead, they will amortize, or spread the cost out over the first few thousand units.

For example, if they invest $100,000 at this stage, then they could charge you an extra dollar for each of your first 100,000 units. That allows you to slowly pay it back, without interest and without having to give up equity.

These arrangements are rare, but some manufacturers are willing to do this. This strategy will take a lot of work, and you’re going to have to reach out to a lot of manufacturers, but it is possible.

If I was able to do it, then you are definitely able to do it as well.

Stage #3: Series A,B,C…

After the seed stage, comes what is commonly called “Series A,” followed by “Series B,” “Series C”, and so on. These are investment rounds to help the company grow.

This stage of funding is typically very big money but at a lower risk level. This means you have to give away less equity per dollar raised compared to the earlier stages.

You will already be manufacturing your product and you should have some early sales. You have done all of the hard work to prove that you product will succeed, now you just need money to fund inventory.

Funding inventory is a huge financial obstacle for hardware startups because of the payment terms required.

You’re possibly going to have to pay for at least part of the manufacturing costs upfront. In fact, more likely, you’ll have to pay for all of it upfront.

Then, it takes around 30 days to manufacture that order. If you’re manufacturing it in China, for instance, it then takes another 30 days to ship it from China to the US by sea cargo. Then you need time to get it to the retailer in the U.S.

It gets worse. Most retailers want payment terms of at least 30 days, although 60-90 days is also common. So, you’re talking another 30 to 90 days after your customer gets their order before you finally get paid.

In total that is 90 to 150 days after you pay for the order before you finally get paid by your customers!

You’ve had to finance all this inventory this entire time. This is really expensive, obviously. This is where, commonly, you’re going to need outside funding to help pay for this inventory.

Manufacturer Terms

One way around this without the need for Series A funding, once again, is manufacturer financing.

The manufacturer doesn’t have to require payment upfront. For instance, I was able to get an agreement with my manufacturer where they gave me payment terms of net 90 days.

This meant that after they finished manufacturing and shipping my product, I still had 90 days before I had to pay them. This allowed me enough time to get paid by my retail customers, before I had to pay back my manufacturer.

With a lot of hardware products, you’re not going to necessarily be starting off selling through retailers. You may be selling through your website, so you’re not going to have payment terms requirements like with retailers.

Even though you may sell it to individuals and get paid immediately, it’s still going to take probably a month or two to actually sell all that inventory. So you may still run into the same cash flow headaches.

PO Financing and Invoice Factoring

Some alternative financing options at this stage are purchase order (PO) financing, and invoice factoring.

Both of these methods require that you sell a significantly sized order to a large, established company with an established credit rating.

These are not options if you are only selling to individual consumers via your website.

PO financing becomes an option once you get a purchase order from a large established company.

First, this company needs to understand that you don’t have inventory yet. You still need to manufacture the product, so you’re not going to be able to deliver right away. This isn’t necessarily a problem, but you do want to make this clear upfront.

There are finance companies that will fund your manufacturing, because instead of looking at your credit score, they’re looking at the credit score of the company that gave you the purchase order.

A purchase order is, in essence, a guarantee from the retailer that they will pay you if you deliver the product as promised.

This is a fairly low risk investment, and there are companies that specialize in purchase order financing. This is considerably cheaper money for you than giving away equity in your company.

The other similar option is called invoice factoring, and this is an even lower risk for the lender than PO financing. This means it’s even easier to get, and it’s going to be a lower interest rate than PO financing.

Invoice factoring is only an option after you have manufactured the product, and shipped it to your customer. Because you have already manufactured and shipped the order you’ve eliminated a lot of the risk.

A combination of these strategies can work well. You would use PO financing to fund manufacturing until the order is ready to ship to your customer.

Once you ship the order then you can use invoice factoring to fund the order until your customer pays you.

The main downside to purchase order financing and/or invoice factoring is the lender will handle collecting payment from your customer. This may be a turn off in some instances, but as long as your customer understands that you are a startup upfront it usually shouldn’t be an issue.

This stage is all about growth. The faster you want to grow, the more money you’re going to need.

I typically recommend that you don’t rush to grow too quickly. Rushed growth is when mistakes happen. Keep in mind that if you don’t catch a mistake in your product, and then you grow too fast, you scale that mistake along with your product.

If you take things slowly, you will need to raise less money, you can keep more equity in your company, and you have less risk of a small error becoming a really big problem down the road.

Conclusion

In conclusion, if at all possible, try to fund development yourself up to the creation of a working prototype.

If that is not possible, then seek angel investors or funding from friends and family, but only if they fully understand the risks. A pre-seed investment firm may also be an option but they are quite rare and very picky about who they fund.

You’re the one that believes in the product the most, you’re the one that’s going to put in the most effort, and you’re the one that’s going to be the most confident of its success.

So in the pre-seed stage being self-funded or bootstrapped is going to be most likely the best strategy. Unfortunately, everything has a downside, and the downside with self-funding is you’ve put all the financial risk on yourself.

Secondly, don’t rush and scale too fast. Slow growth is going to require less money and it’s just going to be less risky.

Finally, keep in mind, it’s going to be extremely difficult, if not almost impossible, to scale your company up into the millions of dollars without eventually raising some money.

The key to success with a new product is knowledge of the obstacles that lie in your path and a realistic plan on how to overcome those obstacles. Helping you accomplish this is the goal of the Predictable Hardware Report.

If you need engineering technical support, coaching, training, connections, referrals, and resources to help bring your new electronic hardware product to market then be sure to check out the Hardware Academy.

The key to success is knowledge of the obstacles that lie in your path and a realistic plan on how to overcome those obstacles. Helping you accomplish this is the goal of the Predictable Hardware Report.

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Ignazio Lo faroGad Lawson SagoeIsaac SesiVimal Kumar CRJohn Teel Recent comment authors
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Ignazio Lo faro
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Ignazio Lo faro

Very good job, realistic and full of good advices, thx

Gad Lawson Sagoe
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Hi John!
First and foremost, I say a big thanks to my colleague Sesi for sharing this blog link with me. I am greatly inspired by this blog. I have been able to build the prototype and even make some fewer sales. I have been rejected for most of the funds I do apply for. I sometimes get upset and don’t know what to do but this blog has really given me another way I have to approach my case. I say a big thank you for putting up this piece of information to encourage startups to become real companies in future. My question for you, is there a special way one must put together a good piece of writing to win interest of investors or crowdfunding. Again, what is your opinion on startups showing up in events and pitching of their ideas or working prototypes or products?

Isaac Sesi
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Isaac Sesi

John, this is gold and just the resource I needed to share with my friend who is developing a product and trying to raise funding at the same time and confused about which way to go. Your posts are always a great resource for hardware startup entrepreneurs.

Vimal Kumar CR
Guest

Hi John,
Thanks a lot for the article !! I have situation here. Ours is an automotive startup (hardware). We have made a very basic prototype to demonstrate basic functionalities to potential clients/ partners/ investors. Seeing that, few car companies have agreed to market testing/ piloting the product. To make the device in auto- standards, we need more fund. We have approached investors and they all are ready to invest “only after getting market traction”. How to tackle this situation. Its like chicken and egg story.

Ruben Tjade
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Ruben Tjade

Hello John!
Thank you for this article!
Once again, you help us to avoid pitfall on this Hardware Startup Journey!

A least, I know where I stand now to get funding!!


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