Capitalizing Software Companies 101: Funding Your Business

January 06, 2020

By Fred Kosnac

Investors poured approximately $32 billion into the software sector over the first three quarters of 2019, which put it on pace to be the highest year of the decade. Deals averaged around $12.2 million. Valuations were up to a median pre-money value of $24 million in 2019—the first time the median valuation has exceeded $20 million.

Software companies certainly seem to be in a prime position to reap the benefits of heightened market activity. But before you go diving head first into pitch nights, stalking VCs on LinkedIn, and applying for Shark Tank, take some time to think through the funding process.

Companies often have needs for funding that extend beyond simply keeping the lights on. These may include hiring and retaining developers, sales and marketing costs, hiring a part-time or fractional CFO, even acquiring another business or necessary technology. In the fast-moving world of software, companies also need to continually refine and improve their IP (“intellectual property”) to stay ahead of competitors and attract users. These companies may also find themselves needing funds for IP protection or adding new servers.

Startups and early-stage companies can easily be overwhelmed with the various avenues they can take for obtaining capital for their growing businesses. Funding is an important decision that if taken lightly can hamper a company for years. Thus, it becomes critical to know your options along with their potential benefits and drawbacks. The following table provides a summary of pros and cons for common types of financing available to burgeoning software companies:

Type of Financing PROS CONS
Crowdfunding
  • Access to non-institutional financing
  • Potential for early feedback on software
  • Typically do not give up equity
  • May only receive limited funding
  • Unlikely to attract investors who would add value to the company
Debt
  • Retain ownership and control
  • Potential tax deductions on interest
  • May be required to provide audited financial statements to the bank
  • Need cash to make monthly payments
  • Loan can go in default if certain financial measures are not met
Angel Investors
  • Investor is more accessible
  • Expected level or return commensurate with risk taken
  • More personal relationship between entrepreneur and investor
  • Can close deals quicker than with institutional sources of capital
  • Give up equity
  • Potential personal/strategic clashes between founder and investor
Venture Capital
  • Access to resources and experienced advisors
  • Can scale up quickly
  • Considerable competition for VC dollars
  • Investments are typically less than 10 years
  • Give up equity
Private Equity
  • Access to top talent
  • Can raise large sums of money
  • Less scrutiny than in public markets
  • PE funds can load a company up with debt
  • Lack of attention; one of many portfolio companies
  • Turnover; may be sold to another fund
IPO/Capital Markets
  • Creates liquidity for founders and early investors
  • Greater marketplace awareness
  • Access to even more capital than in the private sector
  • Large potential benefit to founders and early investors
  • Subject to regulatory requirements (e.g., SEC, PCAOB)
  • IPOs can be extremely costly
  • Stock price can fluctuate wildly from internal and external factors
  • Market pressures can influence management to be more short-term focused

So before you jump head first into one of the aforementioned financing pools, ask yourself some key questions:

  • How much capital do I need?
  • Am I willing to give up some equity in my business?
  • If my company is not yet profitable, what is the roadmap to profitability?
  • Is my business model ready to share with potential investors?
  • How reliable are my financial numbers? Do I know them inside and out?
  • How much is my software worth, and at which stage is its development?

Answering these questions honestly and completely will give you a much better assessment of where your company is now and its potential trajectory.

About Fred Kosnac

Mr. Kosnac provides accounting, auditing and business consulting services to businesses in both the public and private sectors. He also contributes to EisnerAmper's technology and life sciences blog.