Funding your online retail startup

In a recent post, I went through 4 steps for developing a scalable and successful online retail business. In this post, I wanted to touch on how raising capital fits in with the 4 steps.

1. Develop the product concept

2. Scale the offer

3. Measure and increase the lifetime value of a customer

4. Acquire customers at scale

1. Develop the product concept – seed funding

At this stage you have an idea but haven’t yet developed the concept, nor launched and tested it. Shoes of Prey took us nine months to get from the idea to launch. Then, we’ve essentially spent the last year tweaking the concept and satisfying ourselves that our product is something the market wants. For this stage of the business, you’ll need a round of seed funding.

For Shoes of Prey, Mike, Jodie and I funded this stage ourselves. We paid for the business costs as we went from our savings and of course tracked this in our accounting system. At the peak, we had put in a combined total of $150,000. Plus we have only drawn a very basic salary since launch, so there’s a heavy cost in terms of our time too. If we had no savings and needed to draw a basic wage we would have needed at least $250,000 in seed financing to take us through developing the product concept.

Realistically, unless you’ve got a strong entrepreneurial record or some great contacts, angel investors and venture capitalists are unlikely to be interested in your business at this very early stage. A great place to start is with an incubator like TechStars or Y Combinator in the US, or Startmate here in Australia, however, these incubators are designed to provide advice and assistance more than significant startup capital. The simplest place to go to raise a seed financing round is friends and family.

Coming up with a valuation for a seed round isn’t a simple process. I’ve put this as a question to a number of venture capitalists and angel investors and there’s no hard and fast rule for valuations. A good place to start, though, is to look at how much you need to raise, then take the process from there. If you need to raise $250,000 as we did at Shoes of Prey, how much of the business do you need to give away for that? One way to start is to look at what the business should be worth in 3-5 years’ time. Over that time period, given the risk involved, a seed investor would generally be wanting to make a return of three to five times on their initial investment. If your business plan shows your business should be turning over $10m in three years’ time and making a $2m profit, at a reasonable five times multiple, your business will be worth $10m. With a four times return for the seed investor, that makes your business worth $2.5m now, so you’ll need to give away 10% of the business to raise $250,000.

If you’re raising this money from friends and family it’s important to live by the old adage ‘Do to others what you would have them do to you. You want to be very open and upfront about the investment and the risks involved. The last thing you want is for your business to go under and your relationships with your friends and family to go down with it. You don’t want to be encouraging people to invest their life savings in your product concept. There are also fairly strict rules around who you can raise money from and the types of information you’re required to give them, so speak to a lawyer or accountant before going ahead with this or any stage of financing.

2. Scale the offer and 3. Measure and increase the lifetime value of a customer

Once you’ve proven the product concept you’ll want to set your business up so that it’s able to scale and grow quickly, and measure and work on increasing the lifetime value of a customer. Some of the risks have been taken out of the business in that you’ve proven customers like your product but there’s still a significant risk on the operational side in getting your business ready to scale and it may be that you’ve just found a niche group of customers who like your product and the mass market won’t be interested. At this stage, an angel investor or even the right venture capital firm might be interested in investing in your business or, in an ideal case, you can fund these two stages out of your own cash flow as we’re doing with Shoes of Prey.

If you’re looking to raise money at this stage of your business you’re going to face a similar valuation question as in step 1. The process for determining the valuation is likely to be similar, though you may be able to introduce the additional element of a potential exit if there is a good, potentially strategic acquirer who might be interested in your business in a few years’ time. If this is the case you might be able to put a good case forward for a higher valuation than the one outlined in step 1 above. For example, Zappos and Diapers.com were both acquired by Amazon at higher valuations than five times their annual profit.

4. Acquire customers at scale

At this stage of the business, you’re looking to acquire customers at a cost that’s lower than their lifetime value. If the lifetime value of a customer is $1000 and it costs $300 to acquire them, but the lifetime value is realized over three to five years, you’ll likely need funding at this stage of your business to acquire customers at scale. This is the stage of a business that venture capital firms love. The risk is greatly reduced because the business has a proven concept, is ready to scale and marketing channels have been found to acquire customers at a value less than their proven and measurable lifetime value. Venture capital firms are also often well connected and the right firm can often assist you in scaling and growing your business.

Ideally, at this stage of the business, the greater certainty makes coming up with a valuation easier. A strong story about why your business is uniquely placed to scale into a significantly sized business, backed up by sales and marketing data and a strong case for a potential exit for the venture capital firm in three to five years (be it through the acquisition of your company or an initial public offering), will put you in good stead to get a strong valuation.

If you’ve had experience raising money for your startup, whether it’s in the online retail space or otherwise, I’d love to hear your thoughts in the comments.

Michael Fox is the Director of Operations and co-founder of Shoes of Prey.