Robert P. Mollen, Counsel at Fried, Frank, Harris, Shriver & Jacobson (London) LLP.
Having ventured into controversy with my blog on the Trump Factor, I’m emboldened to take on a much more controversial subject -- what kinds of financing make sense for early stage UK and European companies. Here are ten “fallacies” I hear regularly.
1. Highest Valuation is Best
Many founders focus very heavily on obtaining the highest valuation for their early stage financings. While I understand the desire for a high valuation and valid concerns about dilution, I don’t think this makes sense.
First, most companies are likely to need multiple funding rounds. Consequently, it is important for an emerging company to show a trend of continued increases in valuation with successive raises. At best, a subsequent down round will make it difficult to raise further funding and result in potentially higher dilution; at worst, it may make it impossible to raise funding and kill the company.
Second, a company should be looking for more than money from its early stage funding rounds. In particular, securing investors who can add value should be a critical objective. That value can be in the form of expert advice or experience, a network of contacts, or potential credibility with customers or other potential investors.
Third, adverse business and legal terms can offset the benefits of a high valuation. See, for example, the recent blog on preferences from Tom Wilson at Seedcamp. Tom’s analysis is compelling. While companies may sometimes not have a choice, in the current market I would strongly advise an emerging company not to accept a participating liquidation preference or a multiple liquidation preference.
2. It is Better to Raise Less Now
Founders frequently prefer to raise less early stage funding, on the basis that early funding is more dilutive than later stage funding. That is true.
However, funding should be milestone based. It is likely to be more dilutive for a company to return to the market to raise more funds to achieve missed milestones than it would be to raise enough in the first place.
Additionally, fund-raising diverts management attention from focusing on development of the business.
Furthermore, market conditions change, and one cannot assume that the ability to raise funds now provides assurance as to the ability to raise down the road.
For all of these reasons, I would suggest that founders try to raise at least enough to provide a 12 month runway, and consider whether they should raise with an 18 month runway in mind.
3. It is Easier to Raise in the US
Non-US founders frequently complain that they would be better off raising early stage funding in the US because it is easier to raise in the US and the valuations are higher. Both points may be correct.
But early stage investing is predominantly local (with perhaps some exceptions for angels investing in a sector they know well). US early stage fund investors rarely will invest in a non-US business without both: (a) a founder based at a US location proximate to the investor; and (b) US traction (or, at the very least, a compelling US business plan). This reflects two points: (a) early stage funds bring not just money but also experience and network – they need founder proximity to add value; and (b) it is difficult for most US early stage funds to evaluate a non-US business plan.
Additionally, many early stage US funds will refuse to invest in non-US holding companies, although East Coast funds and large funds on the West Coast increasingly are willing to invest in UK or Irish holding companies. While a non-US emerging company can always flip into a Delaware holding company, there are long-term costs involved and it generally does not make sense to do so for relative small amounts of investment (see previous blog here).
4. Bootstrapping is Bad, or Good
I’m not sure how anyone can make a categorical statement about bootstrapping. On the one hand, the fact that founders are prepared to invest their own funds in developing their business, and are inclined to run it leanly as a result, would seem to be a good thing. Reliance on external financing carries certain hazards.
On the other hand, bootstrapping may result in slower growth than could be secured by taking external investment, which may permit a better funded competitor to achieve stronger market share. In any case, bootstrapping may not be possible if founders lack funding.
Consequently, any view on bootstrapping is always going to be context-specific.
5. Don’t Use Early Stage VC Funding
Anand Sanwal, CEO and co-founder of CB Insights, recently asserted at the SaaStr conference that entrepreneurs should not believe that they have to raise venture capital, or feel pressured to raise venture capital. In other contexts, he has said more broadly that entrepreneurs should not take venture capital too early. CB Insights apparently has been self- and revenue-funded.
Anand’s presentation includes useful insights, but I think that a more nuanced approach to the question of VC funding is appropriate. Whether one takes early stage VC funding is dependent on a number of factors, including: (i) the need for funding, and availability of funding from other sources, including revenues or self-funding; (ii) the knowledge, experience, contacts and credibility that the VC can bring to the table; and (iii) if required, the ability of the VC to contribute to securing later rounds of funding due to its relationships with other VC’s.
In my experience, the right early stage VC can play a major role in an emerging company’s development. (Conversely, the wrong early stage investor/s can kill the company.)
Maybe a better way to put this would be “try to avoid taking investment that doesn’t bring significant value other than cash.”
6. Don’t Use Crowd-Funding
I’m frequently asked whether or not companies should use equity crowd-funding for early stage financing. The answer, again, is it depends.
Key factors include: (i) as above, the need for funding, and availability of funding from other sources; (ii) the nature and credibility of the crowd-funding platform, and the quality of the investors on the platform (smart or dumb money); (iii) the role that the platform is prepared to pay post-raise in managing the group of investors as a group; and (iv) anticipated sources of capital in later rounds, especially the next round (some VC’s may be more comfortable than others with a properly-managed crowd-funded tranche in the capital layer).
In particular, angel crowd-funding platforms can provide an efficient mechanism to raise angel capital, as well as potential introductions to angels who can help the business.
7. Don’t Use Government Grants or Matching Funds
Some VC’s don’t like the idea of companies accepting government grants or matching funds. I’m not sure why, unless there are problematic strings attached to the grants, or the process of obtaining the grants diverts too much time and attention from the business.
Investors get the benefit of government grant-funded development without the need to pay for it. Government matching funds take on some of the early stage equity risk without interfering with business oversight, which is typically left to the private investors.
It is true that availability of government funds may cause the funding of businesses that should not be funded, but private investors are perfectly capable of assessing whether that is, or has been, the case.
8. Don’t Take Investment From Corporate Venture Funds
I’ve separately blogged on the pluses and minuses of taking investment from corporate venture funds, and that is a complex topic. For the reasons I’ve indicated previously, it doesn’t make sense categorically to rule out such investment, and there may be good reasons to seek it out.
9. Small Angel Investments aren’t Worthwhile
Angel investments need to be assessed from two separate perspectives: (a) the value of the cash at the relevant time; and (b) the value of the angel’s experience, credibility and network. I suggest that founders give due consideration to the latter. A relatively small investment that is not worthwhile from a funding standpoint may make perfect sense if the angel is “smart money” who can bring significant non-cash value to the venture.
10. Only UK Companies Qualify for SEIS/EIS; Mixing SEIS/EIS Investors and Other Investors Doesn’t Work
This may be two separate points, but I did say ten fallacies …
The UK has some terrific tax-based investor incentives for investment in early stage companies, known as the Seed Enterprise Investment Scheme and Enterprise Investment Scheme. A significant percentage of pre-Series A funding from UK investors is dependent on SEIS and/or EIS eligibility.
There is a common perception that only UK companies can qualify under SEIS/EIS. That is not the case. Non-UK topco’s can qualify for SEIS and EIS so long as they maintain a permanent establishment in the UK for at least three years post-investment and the SEIS/EIS other terms are satisfied. UK investors may be reticent to invest in non-UK topco’s for reasons of familiarity, but misconceptions about SEIS and EIS should not be a driver.
UK investors seeking SEIS or EIS benefits must invest in ordinary shares or instruments convertible into ordinary shares. Non-UK investors typically will want preference shares or instruments convertible into preference shares. It has been suggested that these conflicting objectives are irreconcilable. As I’ve written previously in a blog with Notion Capital, I don’t think so. Both can be accommodated in the capital structure so long as each group understands the positions and needs of the other (see blog here).
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I’ve hopefully stirred up enough controversy with the foregoing, so I think it’s time to quit. Contrary views and comments are very welcome. This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact [email protected] or via LinkedIn here.
You will find Bob’s other weekly blogs for emerging and growth companies on US issues, international expansion and early stage financing here: http://bit.ly/StartupGuides