Most entrepreneurs rely on venture capitalists for their investment rounds. So why are startups suddenly searching for ways to break the traditional funding cycle?
In mid-April, Anthony Rose, CEO and founder of SeedLegals, the legal tech startup, published a post on Medium, declaring it was time to break the traditional VC funding cycle. “It seems unduly difficult,” he says. Raising a new investment round is usually a long and complicated journey. Founders often spend months chasing investors and hashing out the terms of the deal, time that’s vital in the beginning of a company’s journey. And then, about a year later, they generally have to repeat the exercise, round after round. What Rose proposed essentially boils down to one question. “What if you could have some flexibility?” he says.
This query came from his own experience of supporting other startups and launching ventures of his own. “Sometimes finding funding is very hard and sometimes it’s very easy,” Rose says. Not only do founders actually have to locate investors but must also negotiate the term sheet, the agreement of how the round will look like, with them. The contract could for instance stipulate things like the round’s closing date and what the minimum total of dosh provided from all investors must be for people not to back out. “Everyone has to be on the bus,” Rose says. “There are no late-comers. There are no early comers. And if the bus doesn’t get full, it just can’t leave.” Anyone not on the bus would just patiently have to wait on the platform for the next round.
This was exactly the problem Rose claimed to have solved by using tech to demystify the legal complexities surrounding VC investment. “Funding rounds used to be a dark art,” he says. Essentially, SeedLegals’ solution is a platform that can provide the legal documents needed to set up a round within minutes instead of months of legal wrangling by lawyers. The documents enable startups to raise money continuously instead of looking for one big payoff every year by opening up for additional investments before and after the round, according to Rose. That, of course, is still only if the lead investor agrees. “You’ve got the freedom to choose what you want,” he says. Easy peasy, lemon squeezy.
However, SeedLegals is hardly alone in attempting to reshape the funding landscape. The last few decades have provided more opportunities for entrepreneurs to raise money. Crowdfunding platforms and initial coin offerings (ICO), which enable startups to raise money by issuing their own cryptocurrencies, are just two examples. “Compared to VC funding, that’s much faster and much easier,” says Igor Shoifot, founding partner at TMT Investments, the VC firm, and TMT Blockchain Fund, the investment fund for blockchain startups. But it’s hardly a secret why entrepreneurs may want to skip pandering to VCs. “It usually takes a lot of time and resources from the founders,” he says. “You need to make a bunch of calls, take on a bunch of meetings and it gets pretty emotional when, after another four or five meetings, they say ‘thank you but that doesn’t work for us.’”
But up until recently, founders had few other options than to chase VCs. “There was pretty much no alternative,” says Shoifot. While this enabled founders to get access to money and tap into investors’ expertise, the process of wooing these firms wasn’t just usually long and complicated but also came attached with a few disadvantages for founders. Given VCs put their money where their mouths were, they often wanted influence in the running of the business and things like first refusal in subsequent deals. “So you [can also get] rather unpleasant terms with the money,” says Shoifot.
Of course, that’s only if you can find a VC willing to bet on your business. “There just aren’t enough VCs to manage and vet and work on the number of investment opportunities that are out there,” says Simon Ramery, CEO and co-founder of Capitama, the private capital network. Not only is it difficult to raise money from VCs but it has also become increasingly tricky. Having looked at more than 1,000 startups raising seed rounds, CB Insights, the VC database, revealed only 46% managed to raise a second round of funding and only 14% went on to actually raise a fourth.
With all the difficulties around raising money from VCs, you can hardly blame founders for making the most out of each round. Ironically, this could also present them with the disadvantage of raising too much money. “Even though it sounds counterintuitive, money can actually ruin a company,” says Shoifot. Jawbone is a great example of the damages overfunding can bring. The scaleup was once touted as a heavyweight in the wearable device market. Having raised over $983m and getting a valuation of $3.2bn, it certainly seemed as if the company had enough financial muscles to deliver a knockout punch against competitors like Fitbit. The problem was that its fitness trackers didn’t take off, which eventually led to the collapse of the company in June 2017, making it the second costliest startup failure ever, according to CB Insights. While other startups facing similar woes could’ve saved themselves through an acquisition, Jawbone’s overvaluation meant it wasn’t an option. “So it’s a very poisonous sweet deal,” says Shoifot.
Given all these issues with the traditional funding cycle, many startup founders are unsurprisingly jumping on alternative funding opportunities like crowdfunding and ICOs. However, this increased flexibility means some enterprises that shouldn’t get investment do. “Probably 95% of the companies raise money literally a year or two before they actually have a product,” says Shoifot. The result is that these startups artificially prolong their existence. “For better or for worse, usually for worse, people investing in ICOs invest in things that they don’t understand,” says Shoifot. The result is that they can risk losing a lot of money, which is one of the reasons why regulators have been cracking down on this market.
Importantly, while entrepreneurs can use these alternative funding methods to raise money, they don’t provide the huge advantages of having a VC on your side. “You are actually getting absolutely priceless consultancy by just having them on the board or having them be your investors,” says Shoifot. Moreover, having one well-connected VC onboard can also help you attract other investors. “You get access to a much bigger rolodex and you are introduced to a greater number of potential partners and distribution channels, marketing channels, ploys, etcetera, ” says Shoifot.
But maybe there’s a way of merging these two worlds – the one of traditional rounds and that of alternative funding. “The world is not binary,” says Shoifot. “It’s not just zeros or ones.” The way he sees it, the next obvious step for VCs is to look for ways to merge ICOs and the new ways of prolonging the traditional funding cycle through things like SeedLegals’ solution. So rather than destroying the old ways, what we’re seeing now could actually be the next step in the evolution of startup funding. “There is a whole new breed of investment coming to the market,” he concludes. But it’s up to each entrepreneur whether they’re ready to embrace the brave new world of startup funding.