The TV program, Shark Tank, has brought the world of venture capitalism into lounge rooms across Australia. As this article will demonstrate; it is all real: the idealistic inventors, the hard-nosed investors, the unrealistic expectations and the low-ball offers.
Taking an idea from the workshop to the market can be frightening. Company founders must know the essentials of capital raising and what to look out for when it’s time to talk to the ‘Sharks’.
What is capital raising?
In the beginning, the founder created his company and he saw that it was good. They worked on their idea for six days and nights, and then many more years after that. They toiled for free and poured in their own money to develop it and perfect it.
But then the founder saw that it was not good for them and their company to be alone. They were ready to grow their business, to take their idea further. They had grand plans but needed money in order to bring them to reality. Today, 72% of start-ups in Australia need funding to continue operating. Some will borrow money from family and friends or rack up credit card debt, but 32.6% will seek private equity funding.
And there is plenty of funding to seek. In 2016, venture capitalist firms raised a record $568 million, although grumblings in the industry allege that much of it remains ‘dry powder’ and uninvested.
Capital raising is usually broken up in several stages. The initial funding stages are referred to as seed, or pre-seed which are financed primarily through family, friends, or angel investors. After the seed stage, and once the company reaches certain milestones, they can approach venture capital firms for larger rounds of funding which are referred to as Round A, Round B, Round C, etc. until the company reaches an exit.
Whatever the amount or the classification, capital raising has the same irreducible core: giving away a share of ownership in your company in exchange for money. Founders should expect to give up around 15 – 20% of their company for each funding round.
What to look out for
There are infinite ways for companies and investors to achieve this simple quid pro quo. Which one is best will depend on the company’s unique circumstances and needs, and those of the investors. It is important for young companies to be prepared and to understand the issues before they welcome an outside investor on board. Your company is your baby, and you would not allow just anyone to watch your baby, no matter how much they paid you.
The biggest and most difficult question is: how much is the company worth? In a normal market, vendors overvalue and purchasers undervalue, and hopefully they meet somewhere in the middle. But in the world of start-ups, the imbalance between inexperienced companies (40% of start-up founders are under 35) and sharp investors often results in companies not knowing their true worth and giving away valuable equity for a pittance. The first-time lure of investors dollars must not blind companies into cutting an overly generous slice of the pie.
Founders can get higher valuations for their company by showing strong traction or having deep domain expertise that isn’t easily replicated by competitors. Getting the valuation right is more an art than a science and founders should be careful not to over or under value their company.
The dangers of under valuing your company is that you may have to give up more equity then necessary, which means less share of the pie in a potential exit. The danger of over valuing your company is that it may be difficult to raise future rounds if growth stalls or you don’t hit milestones as quickly as expected.
Rights and control
The next issue a company must consider is: how much control should investors have over the company? This is a question that is answered by investors as much as by the companies they invest in. Some investors do not want to play any role in the company. They are happy to provide the capital and let the existing management run the business. Other investors expect a high-level of control. They may demand a seat on the board or that certain strategies be pursued. But that’s for investors to think about.
What the company must think about is: what do I want from my investors? Do I want them to provide capital, or do I also want their input? Founders need to be aware that investors have their own goals which may not perfectly align with the founder’s vision for the company. Investors ultimately want a return on their money, which means positioning the company for a potential exit, either through a private sale or an IPO. If too much control is given to investors, founders may find themselves in a difficult situation down the track when these expectations clash.
What investors offer
What role investors should play depends on the company’s needs. Of course, the primary goal of capital raising is to raise capital. But just as importantly, a young company might also need the skills and experience that investors bring to the table. The boards of Silicon Valley’s unicorns are stacked with industry veterans who sit alongside the 30-something founders and provide invaluable advice and guidance.
Bringing the right investors on board can also be a strategic choice. Investors will often have extensive networks and a Rolodex of contacts that the young company can leverage to further expand their business. A dollar is the same no matter who is giving it, but the industry know-how and know-who of investors matters greatly. It’s also becoming more common for large companies to invest in startups in order to gain access to their technology. This can also work both ways as corporate investors sometimes give startups access to their customers in order to help them scale quickly and grab market share from competitors.
Start-ups should have a comprehensive and robust shareholder agreement in place before bringing any investors on board. The agreement will provide the legal framework for the investor’s role in the company: whether they have a seat on the board, their voting power, how they can use their shares, what their rights and duties are. Having a sound shareholder agreement increases understanding and cooperation between all parties and minimises the chance of disputes.
Potential investors will often seek to amend the shareholders agreement to reflect their interests. However, it is important for companies to at least have a starting point from which to negotiate. To hammer out this shareholders agreement, companies will need a technically proficient and commercially minded lawyer who will know how to give legal effect and protection to the company’s commercial interests.
The form of investment
Most commonly, investors will receive shares in exchange for their investment. There are other possible forms of investment, such as loans, convertible notes, and debentures. Each has their pros and cons, both for the issuing company and the investor recipient.