Congratulations! You decided to launch a business around your brilliant idea, and you’re convinced your company will sell millions of dollars worth of product. Having that strong conviction, and taking the plunge as an entrepreneur moves you to the top of the list, because you have actually acted upon your idea. Now, you need a financing strategy. As the founder, you need to know how your start-up days will be funded and in particular how much money needs to be raised, and when.
Lots has been written by well-known venture capitalists, super angel investors, and angel investors who frequently write small cheques, about partnering with “the right investor”. There is a lot of sage advice to be found in these writings and some great lessons have been shared. Most of these posts however, assume you have lots of people reaching out wanting to invest. When you get past the seed stage and are raising money from institutional investors like VCs, these writings also assume your company is in the position to reject term sheets and be super choosy. If at the seed stage or the post seed stage your company is in this position, that is fantastic!
Whether or not you have competing term sheets the founders and leaders of the business should spend time making sure investment time horizons from the VCs are aligned with how the business is expected to progress. This ensures that the VC isn’t expecting a liquidity event before the company achieves some meaningful milestones. If these two timelines aren’t aligned then the VCs will apply pressure for a premature exit. This could mean a push from the VCs and or the Board to complete an IPO or an RTO (reverse take-over) to have the company’s shares listed on a public stock exchange in the hopes of giving the investors the liquidity they are seeking.
Tech sector history is full of companies that went public prematurely; their stock price dropped shortly after the listing was completed, or the trading volume of shares was so thin that it was nearly impossible for anyone to sell their shares (and in the process realize the cash value of their holdings in the company). In these cases, the management team went through considerable effort to make the public listing happen, the company spent a large sum of money on lawyers, accountants and on listing fees, and the desired liquidity never really materialized. This is not a good outcome, and it’s mostly attributable to a misaligned partnership with the investor(s), from the beginning.
A misalignment between investor liquidity and milestone achievement timelines can also lead to pressure from the Board and VCs to find a “strategic partner”, which is code for selling the business. Again, this disconnect will arise when the investors are seeking to sell their shares in the company prior to the company achieving critical milestones that will maximize the value of the business.
Founders should also spend time getting to know the investor representative who will serve on the company board. Ideally these representatives have considerable operating experience themselves; my experience has shown that this happens only 25% of the time. In most cases the investor representative will have some experience, perhaps 3-5 years working at a big tech firm in product management or product development following which they entered the world of investing at the bottom rung and worked their way up to become an investing partner at a firm. In all cases these people are extremely intelligent, well educated, and very knowledgeable as they read a lot. What they lack however, is decades in the trenches dealing with the daily ups and downs of a start-up business and then later a business scaling-up. That experience, and the ability to avoid pitfalls, see the storm before the clouds are visible, or navigate the business through back-to-back-to-back crises, doesn’t come from reading blog posts or from completing an MBA. It comes from years of doing it, from operating a business. So make sure you spend time getting to know who your Board members are going to be, because you’re going to need to manage them, their expectations, and their “great ideas” that came straight from an MBA textbook.
At the beginning of the start-up journey, you’re likely seeking seed funding from angel investors and often this involves lots of investors writing smaller cheques. This is a very common way to get a start-up launched. There are several investment vehicles for raising funding this way, including convertible dentures, SAFE notes, issuing equity in the form of common shares or preferred shares, or some hybrid model of these. Make sure these early investments are properly documented with an agreement prepared by a lawyer experienced in equity investments in start-up companies. Such a lawyer will ensure both sides are adequately protected without requiring your investors to seek legal advice for a $25K cheque...although there is nothing wrong with that, especially if the angel is making their first or second investment. Which brings us to something a founder also needs to understand before taking in money from an angel.
Make sure you take time to understand the background of the angel investor. Get some sense of their level of wealth without explicitly asking them for a net worth statement. The intent here is to make sure the $25-50K cheque they write to the company isn't their entire life savings, or money they need to live off of, month-to-month. Also make sure they understand the risks; the principal amount invested is not guaranteed; there is no monthly interest or dividend payments coming; as the company grows, additional money will be raised and their ownership stake will be diluted. Often the people who write the smallest cheques are the ones who take up the most time being managed by the founders or the company leadership. Clearly explaining and being aligned on the timeline to a liquidity event is also important with this type of investor. They need to understand that their money could be tied up for 5-10 years, so they shouldn’t count on it coming back sooner if they need it for the child’s university fees.
I have turned down investors, politely declining their cheque, because I knew it would cause too many headaches and they had unrealistic expectations. It was painful to say no because we really could have used the money, but it was the right move to make.
This guidance is easy to follow when you have options or choices. Most start-ups don’t have the flexibility in the early days to pick and choose investors. Regardless, qualifying investors large and small is smart practice so that you know what you are taking on as the founder/leader. You have to be responsive to inquiries and provide updates to all the investors, regardless of their level of sophistication and whether they are high maintenance or or low maintenance. So it’s best to know what you are dealing with when you accept their cheques.
Thank you for investing time in reading this post. Questions and comments are always welcome.
Shail Paliwal
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