When investing in startups, understanding how the startup plans to use the money from the funding round is an important component of due diligence. An investor probably wants to know the money will be used wisely to help scale and grow the business. In this blog, learn more about the ways a startup might use funding round proceeds and how to evaluate a startup’s planned use of funds.
Evaluating Use of Funds
A startup’s use of funds is exactly what it sounds like: how the company plans to spend the money it raised through a specific funding round. This information is typically laid out as part of an investment summary or it also might be contained on a slide within the startup’s pitch deck. One common format is for this information to be itemized by major categories like hiring, operational expenses, sales and marketing, with a percentage or estimated dollar amount attached to each line item. The startup’s planned use of funds serves as a forward-looking view of budget items that could impact future growth efforts.
Use of Funds Examples
A startup’s outlined use of funds will not only vary from company to company, but also industry to industry. The following are some of the common line items an investor might see when assessing use of funds.
Product Development and Technology
If a startup plans to use a portion of capital towards product development and technology, it generally encompasses all costs associated with creating or enhancing a product or service. For a hardware company, this might include engineering, prototyping, and manufacturing. For a software company, this might look like cloud infrastructure costs and any money spent towards developing a minimum viable product (MVP) or new features to an existing product.
Investors can assess whether the development timeline is realistic and if the budget adequately captures anticipated costs to the point of a key milestone, such as product launch or a specific software update.
Inventory
For product-based businesses, a portion of funding may be used towards purchasing inventory, especially in the case of a retailer or a consumer-packaged goods startup. These costs might include the costs of inventory itself, a storage facility for the items, or a product placement fee if that item is on retail shelves.
Investors might want to evaluate supplier relationships, inventory turnover assumptions, and overall supply chain management, in addition to if the portion of funding allocated towards inventory is expected to be sufficient enough to meet customer demand but not excessive to the point of it sitting unsold in storage.
Sales and Marketing
A startup could also allocate a percentage of funding towards sales and marketing efforts, especially with customer acquisition being a challenge for early-stage companies. These funds might be used for paid advertising, content creation, trade show attendance, or customer relationship management (CRM) software costs.
Historical customer acquisition cost and return on ad spend are metrics investors can consider for a startup with allocation towards a sales and marketing budget. If a startup has a low return on ad spend, these funds may be better spent on lowering customer acquisition cost instead.
Operations and Administrative
A constant across all businesses, operations and administrative costs are costs associated with the day-to-day of running a business. From rent, utilities, insurance, accounting, and salaries, the existence of these costs are typically consistent across startups. In very early-stage startups, these costs may exceed revenue, which can create operational losses. An investor may want to consider if the allocation towards these costs is sufficient to get the startup to break-even or its next funding round.
Cash Buffer
Some startups will also build in a cash buffer, or a cash reserve, into their use of funds budget. This is capital typically designed for emergencies, an unexpected increase in operational costs, supply chain shifts, or slower-than-expected milestone achievements. Investors can assess whether or not the cash buffer is reasonable to help support the startup to the next phase of funding for emergency situations while not being a large and unreasonable amount.
Key Considerations
As investors assess a startup’s use of funds, there are some key considerations to keep in mind.
Anticipated vs. Actual Spending
As startups dictate how they plan to use the proceeds from a funding round, that’s exactly what it is: a plan. The use of funds from a round is not a binding contract and how the funds are actually used can change from original outline to when the money is raised. Instead, it represents the startup’s best estimate of what will be needed in order to achieve specific milestones and sustain operations until its next cash infusion. Market conditions or supply chain shifts can cause operational costs to increase from anticipated allocations or rapid unexpected growth could shift the need to hiring additional salespeople to meet demand. Investors should look for a well detailed initial plan, understand those plans could change, and assess the founder’s ability to shift costs around effectively.
Alignment with Milestones
Startup founders should be able to tangibly tie aspects of their use of funds to specific and measurable milestones. For example allocating 20% of the funds to sales and marketing could be tied to a specific metric like “achieve $1 million in sales” or “acquire 300 new customers”. The capital raised in the round should be enough to get the startup to its next milestone, whether a product launch, quantitative achievement, or sustain growth until its next funding round. If the amount the startup is raising feels unreasonably high or it would only create a short runway for the startup, investors may want to ask additional questions to understand how the startup arrived at its funding numbers.
Capital Efficiency
Investors may also want to consider if the capital from the round is planned to be used efficiently. Are there less capital-intensive ways to achieve the same milestones? Does it seem like funds are being allocated frivolously? Understanding the current needs and carefully assessing anticipated use of funds in addition to the costs to achieve the milestones the startup is seeking to hit can be something to consider.
Final Thoughts
For an investor, a startup’s use of funds is more than an outline of how the startup plans to use their funding round: it’s how the investor believes it plans to spend that investor’s money. Therefore, it’s important for investors to understand what goes into the use of funds, what the funds will actually be used for, how they make change, and how they can help the startup achieve specific milestones.
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Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:
- Technical Due Diligence for Non-Technical Investors
- What to Look for in Investment Updates
- Early-Stage and Late-Stage Companies
- Assessing Customer Retention Metrics
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.
