Anthony Rose, CEO and founder of SeedLegals outlines 5 ways to make your investors run for the hills.
As you look to scale your business, especially when preparing for a funding round, it’s important to look at your business through an investor’s eyes to really get a sense of how ready you are, or if you might be falling short.
At SeedLegals, we’ve helped thousands of startups successfully navigate and close investment rounds, and there are a few things we’ve learnt along the way. From common pitfalls to unexpected roadblocks, the daily life of a business owner is faced with challenges. But some mistakes are bigger, and more impactful, than others. So, we have outlined five of the biggest errors we’ve seen founders make that have sent investors running for the hills – all so you can avoid following in their footsteps.
Give away 40% of your business to your first investor
Giving away too much of your company early on is one of the most unrecoverable start up mistakes. It is often the result of well-meaning friends and family who invest in the company for a 30/40% share (You spent a few weekends on it so it can’t be worth more than £100K… I’ll give you £50K for 33%), and usually comes from simply not understanding how equity fundraising and company valuations work at an early stage. This makes you very uninvestable very quickly as later on the investors know that you have so little equity personally that you’ll be tempted to leave the company and get a paying job, or start a new company. So they won’t want to invest until you’ve restructured that first investment. This means you will somehow have to persuade the original investor(s) to give back a whole bunch of their equity. If it’s a well-meaning family member they may be persuaded to hand back half that equity, but sometimes it’s not so straightforward, meaning the business could suffer serious problems raising money and may even be forced to shut down.
Give yourself shares with multiple votes per share
In a startup the founders usually have 85% of the shares after the first round, investors closer to 15%. So, investors are looking for extra protections for themselves, to safeguard their investment from the founders who have majority voting rights. But if they see that the founders are giving themselves even more votes that’s going to ring alarm bells, it’s the opposite of what they’re looking for. So when we see founders giving themselves 2, or even 5 votes per share, then basically 100% of the time this doesn’t survive to the next funding round, the investors insist that the founder undo that before they’ll think about invest – and undoing it can be a lot of work. Just because Zuck gave himself special shares doesn’t mean you can, it’s just going to add friction with investors who have many other companies coming to them without these issues.
Create Alphabet Shares
Alphabet shares (A Ordinary, B Ordinary, C Ordinary…) might seem like a good idea at the time, but be aware, these shares will only create friction, and every single time we see companies start out with these multiple share classes, it ends up having to get undone. Multiple share classes in theory allow different rights to be set for each share class, but in practise they’re never set up correctly, aren’t useful anyway, and make everything harder down the line. The irony is that it’s often accountants who know nothing about growth startups that set this up (My accountant told me to do it), and often with all the shares having the same class anyway (which means no good reason at all for doing this). Your goal is to not create more friction, so just create Ordinary shares for the founders, and then that’s one less source of friction with investors later.
Not getting everyone to sign an IP assignment
It is important to get everyone who’s worked on your project to sign an IP assignment. Without a signed IP assignment in place, if there’s a dispute with your co-founder / CTO / graphic designer, etc., they could claim that all the work they’ve done (particularly if it was done without payment) belongs to them, not the company. The worst case scenario is that the company comes to a standstill while you try to resolve the dispute. To avoid this, you should do an IP assignment early on – if you forget about this, you’ll struggle in your first round of investment as investors will asking to see copies of those IP assignments as part of their due diligence.
Treat your company like your hobby
While your business might have started as a hobby or ‘side-hustle’, when it comes to securing funding, you will need to make it your full-time gig. Moonlighting with a day job, having two companies, not paying yourself a salary and doing consulting work to pay for things, are all necessary in the very early stages. At some point, you have to get past that ‘mind the gap’ moment to move your business to the next level. If you go into a funding round and you are still running your business as a hobby, you will either need to commit to your full-time business, or continue your startup as a side-project… which is fine, but one day when a competitor launches ahead of you, you’ll be kicking yourself for not making it a focus earlier.