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LESSONS LEARNT FROM FUNDING, WHAT WORKS, WHAT DOES NOT WORK

Over the course of the past few weeks, we have elaborated on funding for your business, including the types of funding available and how to make your business attractive to potential funders. So, once we have managed to attract potential investors, what are the pitfalls to the early stage funding rounds. This article will explore the common threats related to what is normally the first funding round for entrepreneurs, the angel, or seed, round.

As mentioned in previous newsletters, besides the type of funding options available to entrepreneurs, the more important issues are about the timing of the funding and the level of control that will be ceded by taking on funding from external investors. This is borne out by the potential mistakes entrepreneurs can make from their initial funding round.

Too Much Money

Now there is a problem statement that many start-up entrepreneurs would love to have, especially in the tough, bootstrapping phase of the start-up company. Entrepreneur Magazine (www.entrepreneur.com) explains some of the early stage investing mistakes by making the unexpected statement that you may raise too much money in your first funding round. Upon further reflection though, this makes sense, as raising a lot of capital indicates that you have established your business model and it is now time to scale the business. Rather take the time to figure out what your business is actually all about, and concentrate on building the business instead of figuring out how to spend all the new-found cash. An initial funding round should be viewed as simply the first step in the long journey towards building a successful company. The issue here is really about building the business, and angel funding is to be used to assist you in achieving that goal. Funding should thus not be an end in itself.

Also, do not underestimate the founders’ curse of suddenly having too much cash available. When the co-founders are in the trenches and battling to make ends meet is usually not the time when there is interpersonal friction between them. There is generally a sense of “We’re in this together” and the level of camaraderie and teamwork is likely to be at its highest. However, when there is a lot of cash available, small differences in shareholding percentages all of a sudden make a big difference to the value of each shareholder. One percent of nothing is meaningless, but if one shareholder has one percent more than another and there are a few million dollars available, there is a tangible difference to the actual money due to each shareholder. This does not imply that the money raised by the funding round will be paid to the founders, it does mean that the value of the shares in the business can now be determined and therefore also the value accruing to each shareholder. These small percentage differences take on a new meaning if the business manages to list on a stock exchange via an Initial Public Offering (IPO), when the business may be valued in the billions.

Too high a Valuation

This relates to the issue above of raising too much money in your early funding rounds. A further issue with raising too much money in the early stages will be the impact on later funding rounds. This may adversely affect the value of shareholdings of future investors, where, typically, the funding rounds are far larger than the angel or seed rounds.

As Entrepreneur Magazine states, more is not always better, and you could be setting yourself up for problems later. High valuations early on may set expectations for ensuing funding rounds which may be difficult to reach. You might not have grown into your valuation yet and may find it difficult to exceed your initial valuation, which could result in the next round being flat or a down round. There’s also the question of managing early investors’ expectations. Seed and angel investors will likely expect an appreciation of their money, while later investors could think the company’s value is inflated. With too much money floating around the business, you will have to prove to future investors just how you have allocated those funds efficiently for the long term. This may impact on their perception of your leadership and the viability of your product.

Further, during the early seed/angel stages, you lack the proof points to confidently claim you have the ability to spend efficiently, which can also raise concerns about over-valuation. Rather than shoot for the moon, raise smaller amounts and perform rapid testing for proof of concept stages to fuel revenue growths.

A common error committed by start-up founders is to overestimate future revenue growths. According to BPlans (http://articles.bplans.com/), this is usually a consequence of the founder desperate for the potential funding and project the “magic number” that you think the investor/s want to hear. The past quarter’s sales will not automatically be an indicator of future growth as there are far too many variables to consider that may impact on this number.

The goal should be to bring in the right investors at the right time, not the highest valuation right away. Once again, timing is all-important!

Control versus Leverage

As mentioned in previous articles, bringing external investors on board will dilute your level of control of the business to a lesser or larger degree. This is not necessarily a negative matter, but just who you bring into the business is probably more relevant.

While you may feel that you’re the one with the begging bowl and that beggars cannot be choosers, bringing the right people into your business is of paramount importance. Rather do without the money, than bring investors into your boardroom that may make your life an absolute misery. Besides, you do not want to be saddled with dubious characters who perchance have a lot of money that needs to be laundered via a legitimate business such as yours. Do not underestimate the value of conducting a due diligence on your potential funder.

Investors should bring a lot more than just money to your business. This should be especially true for early stage investors, who should bring an extensive network of potential customers or preferential suppliers to the business. You, as the business owner, should be able to leverage that network and list of contacts, particularly if your investor has access to large corporations and can open doors for you to pitch your product or service to boards of directors. Just by signing one large customer contract normally catapults the start-up into the big league and your investors should be able to assist with this growth progression.

The type of investor is also a key consideration. Institutional investors will probably insist on a lot of governance requirements, in the process taking your eye off the business. On the flipside, they will probably leave you to manage the business fairly independently, with regular feedback sessions so that they can manage by exception. Alternatively, individual angel investors may be more agile and hands-on, but could also require a lot more personal interaction that will again take attention away from managing the business.

Conclusion

Timing is all important in relation to these points discussed above, as it has a bearing on your company’s valuation, your product development and market, and also your team dynamics in the business, including the founding team. Also be aware that funding rounds take time to conclude, so work at least six months into your timing project plan.

Selling off parts of your business to complete strangers is a complicated and probably an emotionally-charged process so do not hesitate to include legal counsel to guide you objectively through the process.

Try to keep things simple; there is much to be said of the unpretentious elevator pitch where you state the problem, your solution and what action you require from your potential investors.  

Sources

Pelletier,R,. Five Early Funding Mistakes that Can Kill Your Company in the Long Run. May 2014. Accessed 18 May 2016 from: https://www.entrepreneur.com/article/234047

Gerber,S,. Don't Make These Common Mistakes When Raising Business Funding. 2016. Accessed 18 May 2016 from: http://articles.bplans.com/9-common-mistakes-avoid-funding-rounds/

Matthews,K,. 5 INITIAL FUNDING MISTAKES MADE BY ENTREPRENEURS. January 2016. Accessed 18 May 2016 from: http://www.smarthustle.com/5-initial-funding-mistakes-made-entrepreneurs/