If you have a great concept that needs equity funding, you’ll often find that your first port of call will be the three Fs – friends, fools and family. Whilst it’s great to have potential investors so close to hand, it’s important to remember the choices you now make will impact your venture’s attractiveness to angels and institutional investors down the line.
There are plenty of things to consider when raising funds but the overall goal is to agree something fair all round that doesn’t store up trouble for the future. The key areas to think about are price, structure and governance – or, in layman’s terms, how much of the company backers are buying, what their money gets and what rights they have.
Whilst it’s easiest to talk about price, it’s the hardest thing to agree upon. Too often I see founders reaching for an unsustainably high valuation, which results in the deal falling apart. Alternatively this can make future deals fail when your backers, having taken lots of risk to help grow the company, insist that the share price for new investors should be higher than what they have paid. And this happens more often than you’d think. I recently witnessed a situation where valuation at the seed round meant that a king-making venture firm ended up walking away from the deal since it was a stretch to invest at the same price as the previous investors, losing the three Fs their cash and making the equity worthless.
Often these inflated valuations in the early stages happen when investors aren’t thinking or are being overly kind – easy traps for fools, friends and family to fall into. However, responsibility for preventing this situation ultimately rests on the shoulders of entrepreneurs, as they are the ones that drive pricing. Unrealistic pricing screams that the founders are greedy or their judgement is poor.
Structuring can get around disagreements over value by creating shares that have extra features ordinary ones don’t, in return for paying a higher price. But it’s also a great way to put off for tomorrow what you should have done today and waste time not working progressing the business. All sorts of funky bells and whistles crop up, whether that’s liquidation preferences to offer protection if the company ends up being worth less than the money invested or anti-dilution measures to deal with situations where the future share price drops below its current value. If these are wheeled out this early, you and your backers are in trouble: the business succeeding is what makes everyone rich, not financial engineering.
Structuring looks fine on a spreadsheet but it rarely flies in practice. I’ve seen one company stagnate, losing at least a year of progress whilst management and different investors quarrelled about the exact terms of these kinds of features. If your company is hot, these tricks won’t be needed since people will compete to buy shares but if this stuff does raise its head, you need to take another look at how much of your company you are prepared to sell. It’s more important to secure cash for the business and make progress than to minimise how much of the company is purchased.
The trickiest area is governance. Too many people start businesses because they don’t want a boss – focusing on being in charge however means less attention on the business and time lost to politics. I’d hope that friends would spot this and decline, family should know founders’ characters but may still invest for family reasons and expecting the fools – or, to use a kinder term, the overly optimistic – to sort this area is, well, overly optimistic.
If you are a godlike entrepreneur then you’ll be able to sort the issue by selling shares that have no votes, like Facebook and Snap Inc. have. However, in reality, that is very rare so at some point you will need to think about how voting will work. Rather than go for standard 25%, 75% thresholds, I prefer to think about which groups of shareholders should have to agree for which types of decisions. Striking the balance between freeing the organisation to execute while protecting shareholders is key: easier, swifter approval of, say, the business plan, yet making sure something like a decision to sell requires the agreement of a majority of shareholders.
Another problem arises when early investors join the board. At this stage you want a tight, nimble team directing the company. When angel and VC investors invest, they usually require a board seat and changing a board can be slow, especially if someone doesn’t want to leave. Also, if one person gets a board seat, everyone else wants one and the end result of this is a bloated board, something that is toxic.
Finally, it’s only reasonable to report on progress. The aim here is to keep your backers informed whilst not regularly having to have separate conversations with each investor. At this stage, I’d recommend formal communication to be kept to once a quarter or, ideally, twice a year. Introducing your backers to each other and finding a ‘syndicate head’ to arrange shareholder consent and channel information also helps. When running a startup, communication with your investors is essential: getting practice in will help for when you have monthly board meetings with your VCs.
Since the startup world is all about proving traction and eliminating risks, to maximise your chances of securing your next round, avoid distractions from your key goal. Strike a simple, fair deal and, whilst making sure your investors are informed, move your business forwards.