Rookie Mistake #3: Strategies Behind the “Use of Funds” Statement

by JGARCIA

The Mistake

From an investor's perspective, one of the most baffling mistakes made by an entrepreneur is when they do a better job of "selling the front end" than they do "selling the back-end." What does that mean? It's simply a way of expressing how an entrepreneur may spend an enormous amount of time and money building their case for why someone should invest in their company, yet fail to justify how said investment will be used to achieve any result. It seems that the entrepreneur's logic must go something like this:

• I have a really great idea that will make us all a lot of money.
• It will take someone else's money to get this idea off the ground.
• My goal is to get potential investors excited about writing checks.
• My responsibility is not to know exactly how the money will be spent nor what it will accomplish.
• TRUST ME! I know what I'm doing!

During the ".com" era, this strategy worked better than it should. Too many dollars chased ideas that were not well thought out and not well monitored. Those days are over and, if an entrepreneur wants to impress an investor, they need to demonstrate a fiscally responsible attitude about how they intend to handle their investment. Thus, failing to properly appreciate the logic and strategy of how to build an acceptable "Use of Funds" statement can be a fatal Rookie Mistake.

Why is this viewed as a Problem?

It's amazing to see the number of entrepreneurs asking for money who know exactly how much they need, but can't tell you what it will be used for (much less justify each expense). Frankly, this turns off most investors. But, what is sometimes even more frustrating, is the entrepreneur who has not thought through the implications of their proposed budget. Take for example the following real life illustrations of some "typical" uses actually proposed by some serious entrepreneurs:

1. The Disconnect: An entrepreneur proposes they need $1 million to take their product (which is still just an unproven concept) to market. Inventors expect to see a budget that focuses on product development, patent applications, and manufacturing scale-up. Instead, 50% of the budget is allocated for developing infomercials. The disconnect comes because the budget does not support the stage the product is in.

2. The Greed Factor: Some entrepreneurs seem to think that they should get paid according to their title and/or local, big company market rates. We've seen some that budget $200,000+ salaries for companies that don't even have a product. Investors believe salaries should be kept to an absolute minimum until the company can support a market-rate wage from its own sales. When an investor sees this type of budget, they assume the entrepreneur is either greedy, risk adverse or doesn't really believe in their own company (or, perhaps, all three).

3. The "Other" Factor: Another way to turn an investor off is to put a significant part of the budget (>10%) into an undefined "other" category. Whereas it is OK to allow some provision for the unknown, too big an allocation will arouse suspicion. What would you do if an entrepreneur said they needed $1 million and the budget read: $50,000 for product development; $100,000 for marketing; $350,000 for salaries and $500,000 for "other" with no further explanation?

The Solution:

The best solution is for the entrepreneur to realize that they need to be very thoughtful and strategic when preparing their "Uses of Funds" (UOF) Statement. No other document they prepare will provide more help to a potential investor in creating a comfort level that their investment is in good hands. In planning the content of your UOF, the following questions, issues and strategies should be carefully addressed:

1. How Long Should the Money Last?: Ask for enough to last at least 6-9 months (More, if times are tough and few investors are writing checks). A general rule of thumb;, if it takes six months to raise money in today's market, then add a 50% buffer and ask for enough money to last nine months.

2. How Much Dilution is Acceptable?: Here's the dilemma. Setting a proper "Use of Funds" strategy is a balance between asking for enough money to enable the company to achieve some meaningful milestones and preserving the founder's dilution. For the first seed round of funding, we'd recommend not selling any more than 15-20% of the company. However, if valuations are depressed, that might not be possible and still get enough capital to achieve anything meaningful (Immediately after the ".com Bomb," valuations were so low, companies were being forced to sell as much as 30% in their seed round!) The goal is to ask for just enough money to allow the company to achieve its maximum potential growth in valuation before a new round of capital is required. Thus, at that next round, the existing shareholders will minimize their dilution (Please refer to Rookie Mistake #10 on Valuation Strategies, which is soon to come).

3. What will be Accomplished & When?: It is not enough to say what you need the money for, you must also answer the questions:

a. What will be accomplished?
b. In what timeframe?
c. Why is each accomplishment important?
d. What's your back-up plan? How much more will it cost? In the beginning, an investor wants to know what they will get for their money. After they write the check, they will use the above information to measure your progress and effectiveness.

4. Don't have a "Debt Payback" Category: New investors don't like to see their money used to pay old debts (Refer to Rookie Mistake #2 on common mistakes with debt).

5. Layer your explanations: Start with a category and an amount. For each category, have a detailed explanation and sub-category breakdown. Next, have a layer that shows exactly what will be accomplished with this portion of the money, when and who will be responsible for making it happen. Such detail is often relegated to an addendum of your business plan, BUT it is extremely important to have thought through each layer. Before someone writes you a check, they most likely will ask you to explain your logic and defend your position. After the funds have been invested, you will be asked to account for your ability to perform on your promises.

6. Are the Ratio's in Balance?: The ratios change depending upon the stage the company is in. The chart below gives just a rough idea of what is considered appropriate: Stage Major UOF Categories Strategy % of UOF

It should be noted that, in some cases, hiring consultants can be a nice way to minimize your salary expense as they can be brought in on an "as needed" basis. One should be careful to ensure that any consultant signs all appropriate paperwork to protect your intellectual property and corporate secrets.

Another important caution is to watch what you quote for web site expenses. The days of spending hundreds of thousands of dollars for "really cool" sites is over. Investors are sensitive about how little return such expenditures provide in most cases.

7. Expenses should reflect where you are: If you are at the "R" stage, marketing expenses are irrelevant (See #6 above).

8. Avoid Leasing Office Space Until Necessary: Office leases have destroyed more companies because, like employees, they are a regular, high fixed expense. Unlike employees, they are very difficult to lose the obligation. With today's technology, it's easier to operate in virtual mode until the issues of running your company (and/or its profitability) dictate that a central location is required. We hope that this article has helped you better appreciate the subtle strategies of what needs to go into a proper UOF Statement. There's more to it than you think!

owever, if you take to heart and use the concepts outlined in this article, we think your investors will be impressed and, who knows, it may make the difference in getting them to write that all important check sooner, rather than later!