TechTLV

One of the most painful aspects of working in the VC world is witnessing great start-ups with great teams struggle to raise capital. Sometimes, decisions made two or three years previously can come back to haunt a start-up as it tries to raise additional capital – and, all too often, those mistakes have to do with financing decisions. Financing decisions rarely have the potential to “make” a company, but they can often “break” a company.  While today’s tough times may call for desperate measures (i.e.“raise money when you can get it” because “cash is king”), a few words of caution are always in order before you sign that term sheet:

That said, here is my list of ten financing-related mistakes that can kill a great start-up:

1. Taking money from hobbyists. One of the advantages of raising money from VCs is that VCs are professional investors. VCs are evaluated, compensated, and motivated around one goal: building big companies that can generate attractive returns. Many angel investors are equally professional in their approach. This professionalism means that most VCs (and the better angels) understand the rules of the game. They tend not to panic when things get rough. They don’t stop supporting portfolio companies when public markets collapse. They don’t call the entrepreneur every day to “check up” on progress. They don’t loose their cool when a company misses a milestone by a few weeks. Most importantly, they are in the business for the long run: they build their reputation by selecting and supporting companies and helping them achieve successful exits. Unfortunately, not every investor is a professional – for some it’s a hobby. I have met with several very talented teams of entrepreneurs who have been effectively abandoned by their investors. This is true for some angel-backed companies, but it’s also true for some companies backed by big corporations as well. Someone in the corporation made a decision to back a start-up, but the corporation itself never committed to the VC model and was never committed to the objective of building a big company. Things got rough, the market tanked, budgets contracted – and the start-up finds itself abandoned and with a much tougher fundraising challenge now that main investor is asleep at the switch. Avoid hobbyists, whether they are private individuals or corporations.
2. The wrong strategic/corporate investor. There are several outstanding corporate VCs and, in certain cases, an investment from one of them can make a lot of sense. But corporate VCs can also bring risks that in certain circumstances can kill a start-up. Some senior US VCs have, in fact, told me that they simply will not co-invest with a corporate VC. First, strategic/corporate investors tend to invest because of their strategy, not necessarily yours. If interests diverge, the corporate VC can lose interest which can make subsequent financing a challenge. Second, the competitive dynamics of an industry can work against the start-up. If a start-up is identified as aligned with a certain large corporate, other large companies may be less inclined to work with the start-up because of fears that information will leak or that they will be giving their competitor leverage. Board members from corporate VCs may not be able to participate in some critical strategic decisions due to potential conflicts of interest. Third, be particularly careful with a corporate VC that represents a potential acquirer – particularly in a small eco-system. While the VC arm of the corporate may be interested in the “big exit,” headquarters wants that exit to be as small as possible – which creates an intrinsic conflict of interest with VCs and, in most cases, founders. Even if there are no “rights of first refusal” written into the investment agreement, the market may perceive the start-up as being a captive of the corporate investor which may limit the exit potential. VCs will be reluctant to invest, and the corporate can wait until the start-up gets desperate and buy it on the cheap.
3. Over-emphasis of short-term value-add. I have seen several cases of start-ups who raised money from a particular investor (typically a corporate hobbyist) because that investor was able to help them with immediate business development objectives. No short-term objective is worth jeopardizing the long-term potential of a company. If your product/service/technology is truly valuable and your team talented, you will be able to build the partner relationships and sales pipeline on your own. It’s not worth bringing an uncooperative or inexperienced investor into a company just to secure a pilot. Entrepreneurs should carefully weigh the pros and cons of every investor with whom they choose to work, and too often the long-term negatives dramatically outweigh a short-term positive.
4. Raising too little capital. Ideally, the fundraising process should revolve around milestones. A company should try to raise enough money to achieve a meaningful milestone that validates some aspect of the investment thesis, reduces real and perceived risk, raises valuation, and makes subsequent fundraising incrementally easier. When a company raises too little money, the company can find itself a few months short of a critical milestone and without the capital to get there. This means that just when the company should be sprinting ahead, it needs to cut back on spending. And just when the CEO and the rest of the team should be 100% focused on execution, they find themselves focused on convincing their existing investors to pony up more capital and simultaneously reaching out to new potential investors with a story that is far less compelling than it might be in a few months – a situation that can rapidly become a death spiral, even for a potentially great company. This is obviously easier to observe in hindsight, but it suggests that entrepreneurs should be very careful about (1) making sure they have adequately budgeted the costs of their operations and (2) building in the necessarily reserves. It also suggests that there may be a benefit to waiting for right investor with the right-sized investment rather than racing ahead with an inadequate war chest. When that war chest runs out, it may be too late.
5. Shallow-pocketed investors. Closely related to #4. Nothing ever goes exactly according to plan, and it is the rare start-up that can execute on-target and on-budget. Whether things go worse than expected or better than expected, lots of great companies find themselves needing a bit of extra cash to hit a milestone – and it’s a lot easier to raise that capital from a committed existing investor who believes in your story than from a new investor who is meeting you for the first time. That said, even the most committed investor won’t be able to help you if he doesn’t have the cash. This can be true of angels who bit off more than they can chew, of VCs who have not adequately reserved, or of any investor who simply runs up against his or her own internal guidelines that prevent him or her from committed more capital to a particular investment at a particular time. Try to get a feel for whether or not a potential investor will be able to step up to bridge any funding gaps that might occur. If not, beware.
6. Hypersensitivity to valuation.  Entrepreneurs who are hypersensitive to valuation sometimes manage to raise capital at great financial terms, but this can pose a huge problem down the line. For example, suppose a start-up raised $2M from a friendly angel at a $18M pre-money valuation in the first round (i.e. the angel holds 10% of the company – a great deal for the entrepreneur). Two years later, they go off to raise their first venture round. The VC, however, needs to take at least 20% of the company (according to his own investment guidelines) and thinks the company needs an investment of $3M. This puts the angel in a difficult position. If the VC puts in $3M at a $12M pre-money, the company will have a $15M post-money. The VC will hold 20%, but the angel has been diluted to 8% of the company which is worth $1.2M, well below the $2M he initially invested. Naturally, the angel might resist an investment at these terms and may no longer be the “friendly” angel he was in the beginning. Reality is, of course, much more complex – but the problem should be clear. When an early valuation is too high, it represents a mispricing of risk – and this can lead to all sorts of mathematical and psychological  complications down the line that can make fundraising difficult.
7. Insensitivity to valuation. On the other end of the spectrum, I have encountered entrepreneurs that were far too generous in their terms with initial investors, which can also have strange and dangerous effects. When a start-up gives away 40% or even 50% of the company for a very small early investment, the result is a strange capital structure, a very powerful single investor who can single-handedly determine the fate of the company, and not enough equity to go around for subsequent investors and future (or current) employees. A new investor will want to take a reasonable percentage of the company and will need to make sure that enough equity is set aside for future employees. Without getting into the details, this can often be a mess.
8. Too many investors. VCs prefer clean capital structures that are easy to manage and investors that are easy to deal with. This can be a challenge when a company has 20 different investors made up of friends, family, and angels. Fortunately, this problem is easily solvable with a little attention from a skilled lawyer. Group these small investors into a single entity with a single board representative who has the power to vote for all of their combined shares. A good VC can help you with this.
9. Complex and non-standard terms. The devil is in the details. Too often, strange and unexpected terms from previous investment rounds pop up in late stages of due diligence. These can involve veto rights, control rights, aggressive liquidation preferences, etc. Be very careful about agreeing to any terms that are non-standard, and make sure you are working with a lawyer who has enough experience with VC rounds to block any such requests from your investors. VC term sheets look the way they do because they have evolved over time. If an investor asks you to agree to non-standard terms, there better be a very very good reason, and his or her desire for a “good deal” is not a good reason. When VCs see weird terms, they often lose interest.
10. Reputation. This goes without saying. Check the reputation of your potential investors as carefully as possible. Some investors will make it easier or you to raise additional funds, others will make it nearly impossible.

In the end, all of these come down to one principal: avoid misalignment of interests wherever possible. If you are raising money from a VC, it’s because you believe that, with the right amount of capital, your company can grow to achieve a meaningful exit. Not every investor will share that vision, and not every investor will have the tools, the reputation, the capital, or the motivation to help you get there.

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Reproduced without permission. More of Robert and Kathryn’s wonderful cartoons on the VC world can be found here http://www.thevc.com/index.htm