This blog was written by Sam Simpson of FounderCatalyst.
FounderCatalyst is a supporting partner for the Tech South West StartUp Studio, a virtual accelerator for early stage tech companies in the South West.
We’ve got a fab guide to approaching your first funding round but we thought we’d take a light-hearted view on the best ways to NOT get funded.
Idea: “I’ve seen $20m valuations for pre-seed raises in Silicon Valley and I’m going to try the same in the UK”
Reality: Valuations have indeed been ‘a little crazy’ in silicon valley (for example the Airbyte’s 1500x revenue multiple!. But that’s just not reality in the UK. Our friends at Beauhurst have a great blog on first funding rounds. If your expectation (in terms of both valuation and amount to raise) is much higher than the Beauhurst figures then you may need to realign your plans.
2. One huge raise
Idea: “Raising is hard work – I know I need £4m in funding over the next 3 years, so let’s just raise once up front, for the lot?!”
Reality: Absolutely not. There are good reasons why (most) startups raise a relatively modest first round and a low valuation, reach some proof points (or ‘traction’), raise again at a higher valuation and rinse/repeat. First, this approach means that you end up keeping a larger percentage of your business. Second, it is rare to find investors willing to part with a huge sum up front but relatively straightforward to find investors willing to follow the raise -> proof -> re-raise journey.
For balance, I can say I’ve seen a successful funding round raising £4m in equity investment (plus £500k grant) at a £2.5m valuation. Don’t try that at home though folks!
The following (awesome!) diagram from our friends at Robot Mascot demonstrates a typical journey from bootstrap to IPO, demonstrating the growth in valuation and reduction in percentage ownership for the founders through the process.
3. No rush to get SEIS / EIS advance assurance
Idea: “I’ll get SEIS/EIS advance assurance when all of my investors are lined up”
Reality: Seeking funding without getting your ducks in a row is generally a bad sign, and lots of angels, PE clubs and angel networks point blank refuse to look at a potential investment opportunity until advance assurance is in place.
Advance assurance applications have a 19% failure rate according to HMRC, hence most investors will not rush to spend time meeting founders, doing due diligence and negotiating invest in a business that has a one in five chance of not being SEIS/EIS eligible.
4. Create lot of share classes / alphabet shares
Idea: “We’ll create ‘alphabet shares’ so that we can tweak everyone’s voting, dividend, distribution rights. So that….(insert random reason here).”
Reality: Don’t do that. For early stage rounds, one share class across founders, early friends and family investors, any other existing shareholders and incoming seed round investors is fine. People are used to getting ‘ordinary’ shares where all rights are pari passu (or ‘equal’). Sure, at some point in the future a VC may insist on picking up Preference shares when they participate, but worry about that when you get the VC term sheet. Investors won’t want founders to carry more rights than them, they almost certainly won’t let you pay dividends to specific ‘alphabet’ shares and they’ll be nervous that these differing rights will accidentally create a ‘preference’ and put (S)EIS eligibility at risk.
5. Chase VC cash during your pre-seed round
Idea: “I know it is only my first raise, but I’m going to spend 90% of my time chasing VCs and the remaining 10% complaining about VCs.”
Reality: To be fair, some startups do close their first funding rounds via VCs, but it is rare. There are a few reasons for this:
- First round businesses are usually ‘too early’ for VCs. Founders hear this phrase a lot.
- The amazing (S)EIS schemes are meant to support your business with early rounds – they help to de-risk an investment in your business. VCs can’t make use of these schemes, so they look for de-risking by seeing real traction in your business. Which you probably don’t have quite yet.
- Whilst the amount of money invested by VCs has quadrupled in the past five years (see the following graph from this amazing report, the amount being invested in early stages has remained static…VC are throwing money at scale-ups rather than early stage startups.
Even if you can find VCs that are interested, you will find that the terms they will likely insist on will be much more ‘investor friendly’ than angel investors. In general, terms requested by angels are constrained by the (S)EIS rules, which stipulate that the investors shares aren’t allowed to have anti/no-dilution protections, or liquidation preferences etc. VCs have no such constraints. FanDuel is an extreme example of why you may not want to rush to take on VC cash too early.
If you do think that VC may be the right route for your business then make sure you read Secrets of Sand Hill Road to understand the VC model – it’s really rather different to working with angel investors. And certainly make sure you understand the power law.
Once you understand power law, this Twitter thread will make lots of sense. For VCs, who have a broad portfolio of investments, a ‘billions or bust’ strategy makes complete sense for them. As a founder, however, you have no hedging – you don’t have a portfolio to bet on, you are betting on your single startup.
Also worth reading the TechCrunch article on the ‘Marginal Dollar Problem’.
Finally, Focussed for Business have some interesting views from founders regarding working with VC.
Not put off yet? Good, we are absolutely not anti-VC funding – VC represents a vital (in fact, in most cases, the only viable!) source of funding for some businesses. But for a startup undertaking their first few funding rounds, they are rarely the optimal (or even feasible!) choice.
6. Having six founders
Idea: “I’ve heard that investors are nervous about solo founders, so the more the merrier?!”
Reality: It is true, some investors won’t invest in a sole founder, for lots of reasons. But having lots of founders is generally considered just as bad…or worse! Lots of founders means there is significant risk of disharmony, there is likely to be overlap in responsibilities / capability and it means that each founder already only owns a relatively modest percentage of the company. Two or three founders is probably optimal, five or more will often be considered a significant issue.
Very closely related to this item is having obvious and unexplained gaps in the team – a missing sales and marketing capability in a B2C business, for example.
7. Delay Creating Employee Options
Idea: “I’ll tell potential investors I am creating an employee option plan straight after the funding round – investors love being diluted straight after they’ve put their money in, after all!”
Reality: Any sensible investor will tell you to create a sufficient option pool before the round so that they aren’t instantly diluted by you creating the option pool.
8. Playing ‘Investor Bingo’
Idea: “I’m going to sprinkle superfluous references to AI, blockchain and independent coin offerings throughout my deck, nobody gets sick of this stuff, right?”
Reality: Seriously, every investor has seen founders pitching with potentially great ideas sprinkled with the latest fads. If you genuinely utilise something ‘on trend’ in a novel way, then you need to really bring it to life. Otherwise, a cynic may think that you are trying to increase your valuation by playing ‘investor bingo’ which, for the avoidance of doubt, is a big turnoff.
9. I’ve set my new business up as a CIC
Idea: “I’m much more likely to get grants and loans as a Community Interest Company (CIC) and I can get SEIS/EIS with a CIC limited by shares, so angels should be fine with a CIC. Right?!”
Reality: CICs seem like a good idea and in principle you can offer SEIS and EIS benefits to investors, subject to the normal rules. However, there are currently a couple of issues with CICs. First, they are rarely seen by angels and the concept and associated paperwork is likely to be unfamiliar. Second, you can’t produce the paperwork using an automated solution in the UK, so you are back to paying a lawyer who specialises in CICs to produce the paperwork for you. It may be easier to get funding via grants from local authorities etc, but regular angels appear wary of investing in CICs generally for good reasons.
10. Subsidiary / group structure
Idea: “Having lots of companies in a group structure for reason x, y, z will help attract investors!”
Reality: This is almost never the case. Having subsidiaries is possible under the SEIS/EIS schemes, but introduces a number of risks and complexities and is best avoided. SEIS/EIS investment has to be the ultimate parent company anyway, so whatever you are trying to achieve probably won’t work and you’ll just spend more on lawyers / accountancy fees to maintain an unnecessarily complex structure. Investors love simple and straightforward investments – a single company unless there is a compelling reason to do something different.
11. Confused IP position
Idea: “My innovative new product relies heavily on IP that is owned by my university / me as an individual rather than the company. Nobody should mind?”
Reality: Seasoned investors will look closely at the IP position of your business, especially if you are a university spin out. The ideal situation is for the company to own patents in its own right. IP being owned by the founders with no intention of transferring to the business, or IP being owned by a university with only a license to use the IP is less than ideal and may well cause an investor to lose interest.
12. Be unclear on your terms
Idea: “A pitch deck and nice chat without any specifics is a nice way of catching a potential investors interest?”
Reality: Personally, I find this disappointing. Get to the end of a polished deck and reach a ‘Thanks for reading!’ slide. You need to be clear on your ask – how much are you raising, what valuation1, whether under SEIS or EIS and if you have advance assurance, your use of the funds and any other relevant details (ie amount committed so far).
1 Actually, even amongst investors, the jury is out on this one. If you have a valuation set then why not include it (it’s the first question you’ll be asked anyway!), if it’s not set yet then add a range to the deck.
13. Pay yourself a nice big salary
Idea: “When I close this funding round there will be plenty of money in the company bank account. I’ve left a six figure salary, I should pay myself that as it’s only fair.”
Reality: Most reasonable investors would be comfortable with a founder taking a modest salary, as long as it’s agreed pre-investment. Investors will argue that you’re getting a healthy chunk of equity in your business and the price of that is a lower salary than you could get on the open market, working for Microsoft or whatever.
14. Repaying a directors loan with investment monies
Idea: “I have a directors loan account of £100k that I’ve built up before this funding round… Would be nice to repay that with some of the investment cash?”
Reality: Most investors will balk at this – they will want their cash to be used to grow the business, not to repay the founder. It’s very likely that investors will expect you to either flip the loan into equity pre-funding round, or to repay the loan at some point in the distant future from free cash flow. It is very rare that a loan can be repaid directly from a recent investment and you need to keep in mind that it’s against EIS rules to do so.
15. Investors love a lifestyle business, right?
Idea: “I’ll grow a business, take a nice salary, get a management team in to ‘do the do’ and I’ll have plenty of time to practice my golf.”
Reality: Almost universally, angel investors aren’t interested in receiving a dividend – they are interested in you growing the business and the angel finding an exit. There are various ways of achieving this (secondary exits, MBOs, IPOs etc) but by far the most common route is the business being acquired. Any hint that a founder doesn’t plan on exiting the business at some point is therefore a bad sign.
16. Unjustified hockey-stick sales projections
Idea: “Hmmm, the business has been going a few years but sales haven’t really taken off. I’ll just throw in a nice looking ‘hockey-stick’ graph to justify a high valuation without any narrative on how that occurs”
Reality: Without serious justification, your pitch deck will be heading to the potential investors Deleted Items without a second thought.
17. Exaggerating your product / service capabilities
Idea: “Exaggerating didn’t do Theranos any harm, nobody will ever know”
Reality: Taking on investment by lying about capabilities (or any other element of your business!) is not a great way to build a relationship with your new investors…and could well stray into misrepresentation or fraud, both criminal offences.
A particularly relevant example today is the standard ‘We use AI’ in a pitch deck….You scratch below the surface and find out it’s just ‘if then else’ or it’s ‘on the roadmap’. I’ve caught a couple of founders doing this myself and I simply walk away because it just destroys all confidence in the founder.
Of course, there will always be counter-examples for each of the items above, where startups have aced a funding round, in spite of breaching one of these ‘rules’.
A key take-away should be: Investors are busy, they have lots of opportunities to invest in. Often, if they spot a warning sign or complexity in an investment opportunity they’ll just drop it and move on to the next opportunity. So make life easy for them.
We consistently see founders attempting to take on funding without planning a few stages in advance. We’ve got a great guide which details the exact steps you’ll need to take – make sure you are a couple of steps ahead in the process to ensure that investors aren’t waiting for you to catch up.