ABCs of Startup Financing
Feb 13, 2016
Aussies Be Coming. Got an idea for a new startup? Need to maximise your runway to make it happen? Here's why Australia is possibly the best place to do it.
A number of people reached out after my discussion on the differences between the Australian and Bay Area startup scenes, pointing out that I'd actually left out a lot of important detail on the financing front. That in many cases things were even better than I made out.
So meet Kylie.
Kylie is a fictional character to support a narrative construct. She's also a budding startup founder. She's building a infrastructure platform that is going to change the way developers think about security and integrating services.
The pre-seed stage
Back in my day we paid $40k per server. And we had to wait 6 weeks for it to arrive. And then we had to plug it in, ourselves, in a cupboard somewhere.
And that's the way we liked it.
Kylie did some research on Google and LinkedIn, identified the type of firms that invest in the big ideas she had. She dropped an email to a couple of VCs and asked if she could meet them.
They said yes! Who knew it would be this easy?!
They met in a coffeeshop and she delivered her really rough pitch. The VC listened intently. And then gave her some really good feedback. The challenges they saw. The previous attempts they'd seen fail. The sectors where this idea, with some tweaking, might get some traction.
And then came the gut punch.
"Come back to me when you've got it working". They talked a little more. The VC admitted they didn't invest in ideas. That products like Heroku had reduced the infrastructure cost for getting a prototype into product to virtually zero. She didn't need their money. She needed to find the time to actually build it.
She setup a company. She felt like making it "real" would help keep her honest.
The VC was right. So she found an hour or two in the morning to hustle. Set up calls/coffee/whatever with potential customers. Then she went to work. She'd get home at night and spend 2-3 hours coding. Because of the disjointed nature of the work she had to be even more organised. But that was fine. Thankfully that regular planning each morning meant the evenings were hyper focussed.
It was getting done.
And then each weekend, two whole days to work on it uninterrupted! Oh the luxury! She didn't need to build the whole product. Just enough to demo. Enough to maybe close that first sale.
After 3 weeks she was mostly there.
Kylie had a little bit saved in the bank. A few months to cover all of her living expenses, longer if she cut back on her recent Tim Tam addiction (hey they we're $1.89 a packet, don't judge me! You're not my real mum!).
She bit the bullet. Handed in her notice at her day-to-day job. She had to give a month, so she still had about 4 weeks of income while she tried to line up something else.
She hustled. Hard. She met with lots of companies who she suspected had the problem she was trying to solve. Many of them did. Most of them were trying to build some hacky workaround to buy them more time. So they didn't have to address it right now.
She asked if she could come in on a contract to build that workaround for them.
They said yes.
They scoped out the work, agreed a rate, and when she left her job she walked straight into a new one. Approximately 6 weeks of effort, at a much higher rate than her previous salary.
She got to experience first hand the problems the customer faced. The competing priorities. The compliance requirements. The deployment work flow the solution had to fit into.
It was the type of customer research and feedback you just can't buy. And she had multi-billion dollar company paying her for the privilege.
Each night she came home and worked on her startup. The days lessons feeding back into the product design. Making it better. More polished. More fit for purpose.
The contract ended. She moved on to one of the other potential customers that said yes to her offer. The arrangement was the same.
But the cash-flow was like sugar water. The company now had money in the bank, but somehow 6 months had gone past. Where did all that time go?! It was time to cut the cord and let the product try and find it's way in the world.
Maybe just one more client? Another month of contract rates in the bank? Things would be easier. Less risky then. Right?
Kylie had a good friend who talked some sense into her. One more month of earnings wasn't going to make or break it. It wasn't a significant enough impact on anything. And she was still really just selling her time, not a product. It wasn't scalable.
If money was what she needed then she needed much more than one more gig. Meanwhile each gig ran the risk of the opportunity moving past her.
Family & Friends round
Kylie had a rich uncle (of course she did, she lived in the wealthiest country in the world. She invited him over to talk about her plans.
He was impressed at how she'd approached it. Bootstrapping the business through consultancy. The breadth and depth of feedback she'd gathered. The way she'd been able to incorporate that into the product.
But then came the part that made he feel really uncomfortable. She said she needed money. More than she had. And that's why she'd asked him to come over. Her stomach was in a knot. She felt sick. She new this would be a feeling she'd have to get used to. Meanwhile he just stared at her blankly, unflinching.
"Sure. How's $200K? I want 10% of the company."
What?! Yes! Of course!
The timing was perfect for her uncle. He had a property he was trying to sell, and some mining stocks he'd made a nice profit on but were suddenly looking shaky. He was about to liquidate assets and needed somewhere to re-invest the money.
And thanks to recent tax changes for angel investors he'd get a $40K tax offset for investing in her business, which would help reduce his tax elsewhere.
Those changes didn't come into effect until July though. And he had to wait for settlement on the sale of his house anyway. So it'd be a few months before Kylie would get the money.
More traditional sources
Most of Kylie's friends were up to their eyeballs in debt. She'd never been too concerned about new flat screen TVs or limited edition retro Air Jordans. So she had a credit card, with credit to burn.
While she was waiting for uncle to transfer the money she filled the immediate gap with a card. Servers by the hour from Amazon Web Services, they had pretty much everything she needed. A logo and branding from 99Designs. She found an illustrator who's work she loved on Envato and worked directly with them on content for the website. To make it look professional.
A week later she was done, for now. If someone searched for her or the company they didn't get a parked domain page.
It felt good. But she also didn't want to depend on the credit card. She had cash in the bank from the consulting, so she had no problem paying it off. But she also had no reason to be paying 20%p.a. in interest if she did need the cash.
She was going into her bank anyway that afternoon. She spoke to someone there about getting a business loan. They looked at her history. The business income. They suggested a line of credit. She could access up to $50K at just under 8%p.a. if and when she needed it. It'd cost her $400/year for the privilege.
She decided to think on it for a while. It was good to know it was an option though.
The seed stage
All the previous efforts had worked. Kylie sold to her first customer (one of the potential consulting roles that she never got around to). And then her second. And third. One of the companies she consulted to was thinking about buying the product too so that they didn't have to manage that piece of infrastructure themselves.
Things were going great.
The extra money meant she'd even been contracting out development work to some local devs to speed things along. But there's now so much to do. She's trying to juggle sales, product management, and development. As well as managing a team of loosely related contractors.
She wanted to grow the team. Make some of these contractors permanent. She needed more cashflow to support that though. She'd get that if she could close more deals. But she didn't have enough hours in the day because she was doing at least three jobs. And she couldn't afford to fill one of those jobs with a full-time person because, well she needed more sales to justify it.
:chicken: and :hatching_chick: problems.
Time to go back and speak to that VC. Or is it?
R&D Tax grant
Kylie has always been organised. She had to be in those early days where she was juggling a full-time job and starting her company. Everything has always been very methodical.
- What do I think the problem is?
- What are my assumptions?
- How do I either validate or invalidate that hypothesis and move on?
We're approaching the end of financial year anyway so Kylie was speaking to her accountant about her situation. He mentioned that the government offers an R&D tax incentive and that he thinks she might qualify.
They do the numbers. She's been paying herself a small wage since the company started. And then there's the contractors she's been using. The odd expenses here and there to support the activities. They go back over all of the story cards for the past year of work. Work out which bits qualify for R&D, which bits are sales & marketing, etc. They work out who spent what time on each.
Eventually they work out that there is $150K in R&D costs this year. And that Kylie's company is eligible for a 45% rebate on those expenses.
She's been pouring all the money she can into growing the business. She's not actually going to make a profit this year (or a very slim one if she does). So that rebate comes back as cash.
That's $67.5K back from the government.
Enough to bring on a junior developer or sales person to take some of the work off her plate. She has a decision to make.
The accountant wonders if she had to make a decision at all. "Why not hire both?", he says. Hah! An accountant who is actively encouraging me to spend more money than I have! Who is this guy?!
He says he helped another client apply for the Accelerating Commercialisation Grant . They'll agree to split the bill on eligible expenses, up to $1M. And the one of the motivators for growing the dev team is to build out a new product and revenue stream based on an opportunity she's seen.
There's a couple of large deals closing straight after the end of the financial year. The $200K from her uncle should finally land. They submit the expression of interest. Time passes. They speak with people at AusIndustry. Milestones are set and agreed to.
They've been given an extra $400K to spend over the next 2 years.
Closing that seed round
What a year! $400K from the AC grant. $67K from R&D grant. $200K from her rich uncle. It's built a team. A product. Some serious traction.
Let's turn the heat up on this thing.
Kylie decides to finally go back to that VC she spoke to over a year ago now. They're seriously impressed with the progress she's made. The team she's built. This is an entirely different discussion to the previous one. They obviously want to give her money now.
It's just a question of how much, and at what valuation.
One of them leads the round, a couple of others join in to fill it.
She's now got a fantastic group of investors who can help grow the product into the places she needs help accessing. And an extra $1M to do it with.
The post-seed stage
The investors were all excited about the global potential of the product. That's always been part of the plan. But now that Kylie and the team have proven it out locally. It's time to take that cash injection and grow internationally.
Export Market Development Grants
That accountant is worth his weight on gold. As part of her quarterly catch-up she tells him about the success of the recently opened office in San Francisco. He asks her to identify all of the costs associated with that international expansion. The flights to and from. The marketing visits. The local consultants you'd hired to help bootstrap the required local market expertise.
He trawls through all the receipts. He works out there's $80K in eligible expenses associated with growing the export market for the business.
Kylie's company is eligible for $40K in EMDG rebates.
The infinite runway
The various government programs in place have worked. They've said "if you, or someone else, is willing to commit money to growing this business into something successful we're going to meet you half way". And it's mostly no strings attached. No equity stakes by the government. They trust they'll get their money back in the long-run via company tax, GST, and income tax on your well paid local employees.
And they will. Because the company is profitable.
But even then they'll continue to offer you rebates for qualified R&D activities as you try and validate and grow into new markets.
And that's what Kylie continues to do.
But because she's not had to raise round after round. Because she's basically gone into partnership with government to launch the business. She still owns the majority of her company. Which is a damn sight better than the outcome for most founders in more typical places to start a tech company.