The Road to Investment

 In Blog, Insights, Partner Insights, SOSV, Tips for Startups

Before you even think about getting investment you really need to get some traction ..if you want to succeed.

Investors get bombarded with ideas all the time. But the only true way of proving an idea is to test it in the real world rather than in a slide deck.

Getting an idea to the point where it is sufficiently proven by gaining traction is one of the hardest things to do. Investors know this and want to see that real effect effort has been put in before they invest.

Startup is hard, hard work and real effort cannot be substituted by how good an idea is or how slick a presentation might be. Nor can it be replaced by “experience”.

Adding to this difficulty is that far too often everyone you know (and even the ones you don’t) will tell you how good your idea is in order to encourage you.  And while you must remain insanely optimistic to be an entrepreneur you must also be data driven enough to be realistic. People who know you believe in you, because you are you and not because your startup has a chance. So… their opinions can be very misleading.

Startup is hard.  And unless you are pretty much obsessed with what you are doing — it’s not going to work. Unless you can share what you are doing in a way that excites people to join you, you will not be able to put together a great team.  And lone founders are not what investors want to see.

People who try to startup by copying something else successful almost never succeed. Very often a big part of what they lack is the drive to make it work because they are just focussed on making money.

People say: “ Well Google was not the first search engine.. so I can copy an idea out there and succeed”.

Rubbish. Google was founded by the huge efforts of Larry and Sergei and their obsession with figuring out how to rank and sort the Internet information explosion. Their passion, brilliance and determination was baked into their product along with a bunch if stuff like simplicity and a Google like success is a total moon shot even given the above.

You must work on something you are interested in and are passionate about. You need to work in a team with people you get along with ..who produce results.

You cannot work with do-nothings and dead wood and you cannot be dead wood. You must also seek and remove problem generators (people who add to your problems rather than solutions)

If you are focussed on making the thing you love work in the real world then you must be looking to get accelerating traction (usage, sales, awareness) and this is what investors are looking for.

Perhaps you are unsure if you really like the field that you are planning to start up in? If this is the case you should learn as much as you can and a really good way to do that is to take a real job in the area. Learn as much as you can first and save some money so you can afford to startup by pulling yourself up by your own boot straps.

Even if you have great traction, investors don’t owe you an investment. Nor do the government agencies. 

Many entrepreneurs feel that if they can just get investors excited enough they have to invest traction or not. Very often they end up feeling a sense of broken entitlement when their traction-less startup fails to get funded.

Even if you do manage to get traction accelerating in a sustainable way (keep your costs low) investors are going to want to strongly protect the money they invest.

Investors over the years have been ripped off in a number of ways and also generally see more failures than successes. Indeed,  the number of times investors have lost money vastly outweighs the number of times serious investors has ever ripped off entrepreneurs.

The fact that investors have had to deal with the same problems over and over has lead to a fairly standard set of legal forms for investment. And still, new entrepreneurs keep hearing bad stories of investors being greedy and ill intentioned. They often mistake the terms of investment documents as being designed to harm entrepreneurs rather than protect investors.

Of course there are a few “bad apples” (investors) out there, most of them are not serious. And very often the horror stories heard are tales spun by failed entrepreneurs who have become, or always were, haters.

Every amazingly great startup we admire is helmed by passion and haters just don’t fit in to that picture.

There is a risk as well of having too many investors in a deal as different investor types can have different motivations at different stages of the business. The legal paperwork and future deals can be hampered by having too many investors with different motivations, especially if those investors are not professional ones.

Once you do manage to get to the stage where you are negotiating on one of the two types of term sheet that are commonly available, it’s very helpful if you understand the terms and what they mean. There are a number of useful resources out there to assist you.

One of the most common forms of early stage investment vehicles these days in early stage start-ups are convertible loan notes. These are a form of loan from an investor that can be turned into equity (shares in the business) at a later stage. They are relatively simple documents that really do not require much negotiation as valuation discussions are kicked down the road except for the cap on valuations. The cap is the maximum valuation that can be reached in the next round of funding above which the outstanding principal on the loan will convert to equity.

The other most common investment is an equity only investment commonly referred to as a ‘Series A’ investment. Some key points to negotiate in this form of investment are:-

-Liquidation Preference: This is to protect investors from a situation where the company does not do well and sells out too cheaply or fails. These days it basically means the investors get paid their investment money, costs and returns back before the other share holders do when a company is sold or is wound up/liquidated. Previously it was common for investors to get a significant multiple (i.e. 2x or even 3x or more of their original investment) in their preferences but this in now uncommon.

– Vetoes: These are another common requirement for investors as there are several ways in which investors have lost money after making investments in the past such as having key assets in a business disposed of to other parties. This has resulted in many common veto rights that investors will want.

– Anti-Dilution: This is also a common requirement for investors to prevent being crunched down by future investment rounds made on less than good terms. 

– Limited Warranties: No investor can know everything about the businesses that they invest in and so it is customary for investors to require that entrepreneurs provide warranties that provide for a mechanism of recompense if something is not as stated in the due diligence material (e.g there is an anomaly with the ownership of the relevant IP or there is outstanding personal injury claim pending against the company from an employee/member of the public). Generally the best thing to do with warranties is to disclose everything as transparency is the best protection all round. 

– Reverse Vesting of Founder Equity / Founder Vesting: This is one of the more controversial terms that investors require and yet this is one term that actually protects founders, entrepreneurs and companies. It is quite common for a founder’s circumstances to change (health issues which prevent them from working) or for one founder to become disinterested in the business. Under these circumstances and others, it is important for the vested equity in the company to be clawed back so that the company has a chance to attract new talent. Founder reverse vesting is an excellent way of doing this.

 – ESOP (employee stock option plan): Early stage companies need to attract and keep talent. Typically 15% of the companies equity is going to be needed to ensure that there is sufficient incentive to retain the best possible talent.

Valuation is by far the most focussed on term to be negotiated and yet there are some pretty simple ways to look at valuation. The best guide that we have is that the company is going to be worth roughly 3 times the money raised. This means roughly the more cash you raise the higher the valuation will be. This may appear counter intuitive at first. The key here is that it is unhealthy for any company to raise too much or too little money at any stage of the business.

The stage a business is at and the level of traction it has is what drives the amount of capital raising that is appropriate for a company and this in turn tends to drive the valuation through the above formula.

Now, it’s going to take more time and money than you expect to make your business work and yet our experience is that the leaner you keep the company generally the better this means that a series of investment rounds that are not too crazy in size will likely be appropriate.

There is a time in a super successful business where a large capital raising can create a breakthrough in value and size and it is then that bigger valuations can really make sense. It is crucial that traction be the driver as more traction is better than and must proceed more investments.

Crucially when you search for investment it’s really important that you get along well with your investors as no human relationship ever goes perfectly smooth and it’s the good will between you and your investors that is going to make the difference in these times.

We recently were doing some paperwork with our portfolio company Mavenhut which I am happy to say fulfilled all the above requirements and their legal counsel David Ryan who remarked that we were a pretty straight forward company to deal with so we asked him for a guest post to elaborate;

“At a recent board meeting of Mavenhut Limited (the stellar re-builder of classic social games) I commented that SOSventures were one of the more benign and supportive early stage investors that I had seen. I was asked to elaborate on these points. 

On the supportive investor side you need to find the right investor fit and not just any investor. FOD’s advice to companies seeking investment has always been to try to find an  investor who likes you and your team personally, gets what you are doing and is willing to invest emotional capital in you as well as hard cash. 

The SOSv-Mavenhut relationship epitomised this. 

An investor who is with you from the start is more likely to be more understanding, more supportive and more likely to invest further if you nurture them and their interest in you. 

They are also more likely to invest at a marginally higher valuation and to forgive you certain failings (common to all start-ups), they are also more likely to promote you to their wider investor community. 

The number one rule is to look after your current investors and keep them in the loop in respect of challenges and solutions thereby building the trust required to extract more investment! 

With Mavenhut and SOSv that chemistry was there from the start with good people being backed by more good people.

On the investment practicality side the suite of investment documentation from SOSv was relatively simple and was played by SOSv with a straight bat. 

There was no need for complex legal wrangling. Here at FOD we pushed SOSv on a few key points and made some ground around the edges which was all done in good spirits. 

As an established Series A investor it was clear that the deal we were doing with SOSv was the same consistent approach they had adopted with others. 

Our advice is to have the tricky conversations at the heads of terms/LOI stage and beyond that it should be streamlined otherwise it’s not a great start. 

Once the start-up is properly advised and understands that certain things are a fact of life with Series A investors (Liquidation Preference, Vetoes, Anti-Dilution, Limited Warranties and Reverse Vesting of Founder Equity) then the process will run smoothly.

There is no real need to waste money negotiating for the sake of doing so and at FOD we avoid getting into this trap. Get good commercial legal advice and get the investment in so that you can start to shift the needle and this is exactly what has happened with Mavenhut.”

If you have further questions on investment feel free to connect to our office hours program for advice and please bear in mind these times are not set aside for taking investment requests they are to provide free advice to founders.

If you do try to use one of these times to ask for investment you likely disqualify yourself from investment because another trait of successful entrepreneurs is that they can listen.

Bill Liao is Managing Director at RebelBio and General Partner at SOSV.

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