Certainly, this is the kind of question you need to answer in order to improve your startup’s chances of success.
While the lack of cash means the end of your startup’s activities, raising too much money may force you into unnecessary sacrifices—delivering too much equity to investors, accepting unfavorable terms, etc.
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As Ash Maurya states in his book Running Lean:
Even though you may need to raise seed funding sooner, the ideal time to raise your big round of funding is after product/market fit, because at that time, both you and your investors have aligned goals: to scale the business.
Getting in the traction stage will certainly boost the value of your startup, because you’ll have proven your hypothesis. But, to get there, you’ll need to focus your resources on one very special thing: learning.
In his book, The Lean Startup, Eric Ries says:
Yet if the fundamental goal of entrepreneurship is to engage in organization building under conditions of extreme uncertainty, its most vital function is learning.
So, let’s rephrase our question:
How much money does your startup need to learn about and validate its business model hypothesis?
Well, to answer this question, I want you to consider 4 factors that will influence the amount of money your startup will consume and, consequently, the funds it will need: the cost of learning, the pace of learning, learning effectiveness and administrative expenses.
THE COST OF LEARNING
This is the cost of building the versions of your MVP, testing them in the market and analyzing their results—it refers to the “build, measure, learn feedback loop” of The Lean Startup Methodology.
To connect learning with cash consumption, let’s understand the cost of learning considering two steps: building and validating the MVP.
Building your MVP
To design and build each version of its MVP, your startup will consume some cash.
For example, to build the first version of the MVP for your startup’s app, maybe you’ll need to hire one programmer and one designer. If this is true, you should consider the money you’ll pay them as a cost of building your MVP.
It’s likely that the second and following versions of your MVP will cost less than the first one, once you may have already built the basis for the next versions.
As we’ve seen in this previous post, you may reduce the cash needed to build your MVP versions—if the people involved in the process are paid with equity, for example.
Validating your MVP
Just building your MVP won’t be enough. You’ll have to put some of your resources on validating it in the market. These costs are related to getting your MVP and testing it with your potential customers.
How do you intend to put your MVP on your customers “hands”?
Certainly, you can do that through several ways as, for example, the travels you’ll have to do to meet your customers or the marketing budget to make your digital MVP to be noticed by them.
Therefore, the cost of learning encompasses the costs of building your MVP versions as well as the costs of validating them in the market. Of course, the higher the cost to build and to validate each version of your MVP, the higher the amount of money your startup will consume to generate traction.
THE PACE OF LEARNING
It means the time it takes for your startup to run one complete learning cycle—building an MVP and validating it. Again, let’s divide it into building and validating activities.
Building Your MVP
It is the time related to building a version of the MVP. If you’re building an app, it’ll be the time to make it ready to be tested. You may assume that it will take more time to build the first version of your MVP than the following ones (considering the structure is already there).
Validating Your MVP
As we’ve seen in the cost analysis, after building each version of your MVP, you’ll need to take it into the hands of real people. Obviously, it will take time to perform the tests.
As we’ve seen in the Cost of Learning factor, the Pace of Learning will consider the time of performing both steps—building and validating your MVP versions. So, if the pace of learning is high (i.e., shorter validation cycles), you’ll consume less money to generate traction.
That’s because the longer it takes for you to generate traction, the higher the total administrative expenses your startup will demand. For instance, if you need 8 weeks on average to build and validate each version of your MVP, you’ll need 2 months of administrative expenses to support that. If you do it in 4 weeks, you’ll need only one month.
Now that you’ve considered the cost and the pace of building and validating your MVPs, it’s important to take into account how well you’re learning. That means how many cycles—or feedback loops—will you need to run until you start seeing some traction.
Yep, this is not easy to estimate. However, it’s important to have in mind that it’s very likely that you’ll need more than one cycle to find traction. Hence, you’ll have to become financially prepared to run several cycles if you have to.
No doubt that the better you learn in each validation cycle, the less cycles you’ll need to find traction. And learning from less cycles, means you’ll need less time and money too.
Finally, we have to consider an element that is not directly related to the learning process: the administrative expenses. These are the costs required for your startup to be “alive”. E.g, energy, rental, salaries, services, etc.
As you might have noticed, you’ll still have to pay these costs even if you simply decide not building your MVP nor validating it. They won’t help on the learning process, but without them you won’t be able to go on with your startup activities.
Clearly, the lower your administrative expenses, the lower the cash consumption will be—which would allow you to concentrate more of your funds in the validation cycles.
Okay, let’s go back to the question: How Much Money Does Your Need To Generate Traction?
The 4 elements we’ve seen so far will help you on that. In fact, the best way is to consider how these elements influence your startup’s cash metrics.
To do that, you may use the spreadsheet I provided you in the beginning of this post, replacing the yellow cells by your own estimates.
The lower the cost of learning, the better: once building and validating each version of your MVP will consume your startups’s cash, reducing the cost of these activities will lower your cash burn rate. Always focus on learning cheap!
The higher the pace of learning, the better: speed is something valuable for your startup in this very beginning. Therefore, if you are able to improve the pace through which your startup learns, you’ll need less time to run each cycle and, clearly, pay less administrative expenses. Keep your focus on learning fast!
The higher the learning effectiveness, the better: to be effective is to focus on what really matters. It means learning about your most fundamental assumptions and being sure the efforts involved in building and validating each version of your MVP will give you the answers you need. Achieving traction in less cycles, will reduce the total time to achieve traction and consequently, will demand less administrative expenses. Focus on the fundamental assumptions!
The lower your administrative expenses, the better: this one might be more obvious, once paying less administrative expenses will reduce your cash burn rate and raise your cash runway. Keep asking yourself: “do I really need this cost to my business ‘alive’?”
DISCLOSURE: The content of this post as well as the spreadsheet provided is for informational purposes only. Therefore, you should NOT consider any information on it or the results of its calculations as an advice of any nature (financial, legal, etc).
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Alexandre Azevedo (LinkedIn)