Funding the journey to ‘the promised land’
Over the course of my twenty-year career as a business school academic, and the co-founder of Cambridge’s largest technology accelerator, I have been fortunate enough to mentor over 250 high growth ventures. I’ve witnessed spectacular success in the form of IPOs and nine-digit acquisitions but, perhaps more importantly, numerous failures and ‘close escapes’ along the way. Moreover, as an entrepreneur I have had some reasonable exits but also made some truly horrible mistakes, the latter being a source of great amusement to my MBA students.
In this article I will share some of the lessons I have learnt and how these might be relevant as we navigate the on-going Covid-19 pandemic. My brief from Kate was to write about funding, which, of course, opens up a whole range of issues. Simply put, your funding strategy is an integral, and mutually dependant, part of your business model and overall strategy for growth. It cannot be considered in isolation.
Starting at the highest level of abstraction, you and your board have three responsibilities: Governance, Strategy and Execution. These responsibilities should be viewed as intersecting circles in a Venn diagram. Perceived weakness in any one of these domains will turn-off investors for the simple reason that they will likely sink your venture.
Evidence suggests that the relative importance of each domain changes over time, but for those entrepreneurs in the early stages of their venture, during which oversight is often overlooked, I would recommend that you do not neglect the ultimate importance of governance. This is simply because its importance is usually only recognised after significant damage has been done. Simply put, in the absence of a stabilising influence, the personal morals of individual founders dominate the ethics and culture of an organisation. Enron and Theranos are both cases in point. The pragmatic advice, therefore, is to read the zeitgeist of your investor community and to remember that ‘faking it until you make it’ has a limited shelf life.
By governance I refer to business ethics, legal compliance, and investor relations. Although governance is the ultimate responsibility of the Board, I would strongly recommend that the positions of CEO and Chair be separated. The role of the Chair is to manage the Board, but if this power is vested in the CEO all manner of transgressions might take place. This is more common than you might imagine and, rest assured, investors learn from past mistakes. The roles of CEO and Chair should be performed by different people.
In terms of strategy, investors will obviously be interested in what your proposed, or current, strategy is. The key metrics used by investors to benchmark your strategy against industry standards are readily available online. Do your research, but feel free to deviate from the norm if your insight (secret sauce) suggests different metrics. This, after all, is where most unicorns come from. Just be prepared to defend your assumptions to sceptical investors and to pivot as necessary.
Your strategy, of course, will only be as good as the ‘quality’ of your team. Almost every investor is clear that the quality of the team is their most important criteria when evaluating proposals. Likewise, there is ample research to suggest that team related issues contribute to at least 65% of failures in high potential ventures. What is certainly clear is that the capabilities and competencies of your team will need to change as your business grows. In high growth firms this can present a significant challenge simply because the rate of change exceeds your capacity to develop new knowledge and skills, something known as the ‘Penrose Constraint’. At some point you (or your board) may reach the conclusion that you are the main barrier to the firm’s growth. In practice, if you decide to step down investors invariably view this in a positive light.
For example, research by Harvard’s Noam Wassermann suggests that by series C, 52% of founding CEOs have been replaced. Of these, 27% stood down voluntarily whilst 73% were fired. In 96% of cases, those who stood down retained a board seat, as opposed to only 60% of those who were fired. Know your limits, do the right thing, and emerge as an even more investable CEO.
Given the high churn rates in start-up teams I certainly recommend that all equity held by team members be subject to a vesting schedule. Obviously, this does not include equity purchased with cash or awarded in return for the assignment of IP rights. Vesting in the US and the UK works quite differently due to differences in tax laws, but the end results are the same. Remember that shares awarded to non-executive Directors should also be subject to vesting. If you don’t put a vesting schedule in place, it is very likely that your series A investor will insist on it.
In terms of your access to equity, it is important to remember that your bargaining power relative to investors decays very rapidly as you reach the end of your runway (i.e., running out of cash). Just like any commodity, the cost of capital rises when the seller knows that you are desperate. For example, a $5 million series A might result in 20% dilution if you have an 18-month runway, rising to 35% with only 6 months remaining. I’ve made this mistake myself and it hurts. The lesson is clear, start raising your next round of funding while you still have plenty of runway left and make sure you build in a contingency.
In this regard Covid-19 does appear to have had an impact, but much will depend on your business model and funding round. Most commentators agree at there is plenty of ‘dry powder’ (uncommitted capital) in the system but that the deal process (sourcing, evaluation, due-diligence) has been slowed down by the pandemic. Specifically, investors prefer to meet to start-up team in person as part of their decision-making process, something that has become far more difficult during periods of lockdown. Further, in the early stages of the pandemic some investors tended to focus on their existing portfolios at the expense of seeking new deals. Fortunately, this dynamic does not appear to be as pervasive as once feared.
Paradoxically, the volatility caused by Covid-19 may have a positive impact on the venture capital industry. Agile ventures with innovative business models tend to perform well in volatile, ‘high-velocity’ environments, which may mean that VC portfolios also receive an uplift. Also, the flow of capital from limited partners (the real customers of the Venture Capital firm), is unlikely to diminish. The looming prospect of inflation, combined with low returns in many other asset classes, will likely boost the attractiveness of early-stage equity.
To close, I would like to highlight a number of issues that continue to affect firms on their journey to the promised land of profitability and stable cash-flows.
The first is that location matters. Specifically, it is far easier to raise sizeable series B and C rounds in the US than it is in the UK. The lack of scale-up capital in the UK is a recognised issue, and one that the Government and British Business Bank are endeavouring to resolve. The problem is that fund sizes in the UK are generally too small to be able to make £20m + investments.
Secondly, quality matters. In recent years there has been an explosion in the number of small and micro-VC funds which often provide an overseas home for ‘foreign capital’. The key issue is that the General Partners in these firms often lack experience in deal structuring and have limited social capital within the investment community. Further, they may not be sufficiently resourced (or skilled) to offer the advice you need. This may make the transition from seed to series A more difficult that it need be. My suggestion would be to accept a slightly lower share price (e.g. pre-money valuation) from a respected firm who is able to provide follow-on investment, sound advice and a reputational halo. Big name firms with deep pockets are also less likely to engage in ‘grandstanding’ whereby ventures are forced into a liquidity event (using drag along rights) well before their potential exit valuation has been reached.
T’s & C’s
Finally, beware of ridiculous terms and conditions! In recent years convertible debt has become very popular, especially in pre-seed and seed rounds. Properly structured, convertible notes can work well, but often they are not. The key is to understand that the loan will convert into equity at a share price determined by either a conversion discount (say 15%) or a valuation cap, whichever is lower. In practice you need to be very careful when negotiating valuation caps which are often set too low and effectively penalise you for achieving a realistic valuation in the subsequent funding round. More significantly, a low valuation cap frequently alienates future investors and makes it harder to raise your next round at a sensible valuation. In the US at least, I’d recommend a SAFE (simple agreement for future equity) as a better deal for entrepreneurs.
In pure equity transactions pay particular attention to the liquidation preference. For example, a VC firm invests $10m in return for 25% of total equity. A few years later you achieve an exit at a valuation of $100m. With a 1X liquidation preference, the VC receives $10m (as a loan), plus 25% of the remaining equity ($22.5m). That’s $32.5m for the VC and $67.5m for you. Now imagine a 4X liquidation preference, a far from uncommon occurrence. The VC receives $40m (as a loan) and $15m from the remaining equity. $55m for the VC and $45m for you. Now combine this with a lower exit valuation caused by grandstanding and imagine the consequences. Yes, you could exit with nothing!
To avoid these, and many other pitfalls, I wholeheartedly recommend that you engage with the team at Briars. For me they exemplify the 3-Es possessed by a professional advisor firm: expertise, experience, and ethics.
I wish you all the best on your journey.
Simon Stockley – Senior Faculty in Management Practice (Associate Professor) at Cambridge Judge Business School.
Cambridge, January 2021