The % Error

I’ve been looking for the opportunity to restart my posting efforts on the blog here, which I’ve done a terrible job of updating lately. Today, I read this on twitter and it made my blood boil. Hey presto, the words came flowing.

Good call out by Pat Phelan on a behaviour that’s absolutely inexcusable for anyone who claims to be trying to help the entrepreneurial community develop. Every strong entrepreneurial ecosystem is based on a simple principle of giving back once you’ve made it, or when you can. In Ireland, we’re particularly strong at this.  I’ve often explained it as follows; anyone who’s been there and been through the pain has scars and will gladly give of their time to stop others going through the same pain, it’s in our nature. This sort of crooked behaviour, while entirely legal, is the real sign of a bad actor in the community who’s looking out for no-one except themselves.

The consequences for any startup looking at something like this as a viable idea are best highlighted by Cork’s own Connor Murphy, who’s graduated from founder and CEO at Datahug, to his new life at the centre of the Berlin startup scene (tis a long way from Ballincollig, Murf!) where Connor now runs the SAP accelerator program for the world’s largest startup accelerator business, Techstars. In his day job, Connor comes across hundreds of startups and hundreds of investors so he’s pretty qualified to speak on these matters.

In this case, it’s far more serious than that. Leaving the poor behaviour of an individual aside, there’s a much deeper issue at work here – the idea that someone else can raise money for your company instead of you, or that it’s something you can outsource. I can’t even begin to explain how bad an idea that is for an early stage startup.

Let’s look at some of the issues involved;

(1) Fundraising is DIY

First things first, this is an area that you have to deeply understand, you can’t be guessing or relying on odd watches of tv shows to inform you. If I actually have to explain that Dragon’s Den, Shark Tank and other TV shows are entertainment shows and bear no resemblance to what goes on in a funding negotiation, then I’m probably too late to help you. Assuming that you recognise that they are as different as watching premier league football and playing premier league football then we have somewhere to start!

No one can really raise money for your company apart from you. Lack of an ability to manage the fundraising process is a huge warning sign for investors; if you can’t even ‘sell’ your own business to them as potential investors, something that you’re meant to be incredibly passionate about, how the hell are you going to sell to customers?

I read recently that at an exit, less than 10% of founders will be left with more than 10% equity in their businesses. Great if you’re the billion dollar breakout success story, not so great if you’re one of the 99.99999% other cases. Result: equity is a damn important thing to keep hold of, the idea of trying to shortcut a process by giving it away is just insane.

Don’t get me wrong; Fundraising is incredibly hard, for everyone, even those who’ve been there dozens of times. Getting someone to buy into and believe in your vision is tricky stuff. It’s particularly difficult if you’re a first-time founder or don’t have a track record of successes behind you. In fact it might even be a little easier for those with a track record of failures behind them, at least they have a record.

Your investors are far, far more than your bankers and if that’s all you see them as them then it’s going to be a terrible, terrible relationship. The dream investment scenario for any company is smart money; money that comes with the huge added benefit of having intelligent people behind it that can be a huge asset to you in terms of advice, connections and mentoring. It’s almost impossible to imagine a smart money scenario coming about as a result of a hired gun. You need to be able to do due diligence on any potential investors, just as they’ll do due diligence on you.

Now if you’re really lucky you’ll have investors that are passionate about you and your business and they might even help find other investors. If you have great financial advisors who have confidence in your business, they’ll more than likely be able to do some introductions to potential investors. If you’re known in the community as being hard workers with a well thought out product, people will have no problem introducing you to potential investors.

But the idea that a ‘hired gun’ is going to be able to represent your business to an investor is nonsense. The idea that you can outsource this passion that you have for your business to a third party and get a successful outcome is pre dreamwork.

(2) West Coast Valuations

Ok so this is only loosely connected but based on my own experience, this is where Irish startups get it all wrong; how they value/overvalue their company.

Sadly most of us find ourselves on the west coast of Europe, not the west coast of the United States. 80% of the USA’s VC funding is spent in California so to say that there’s an oversupply of capital might be an understatement. An oversupply of capital means cheaper valuations. So if you want the sort of investor valuations that you read about in TechCrunch or other online publications then off you go to the West Coast… of the USA. We don’t live in a single, unified, global money market so the valuation of your company is based solely on the availability of money in your local market.

Here’s the thing that also really sucks – your valuation is based primarily on what you have right now, not what you’ll become.  If you have a completely game changing concept with multiple investors chasing you down then that puts you in a very strong position. The best position of all to be in is if you can bootstrap your way along and get traction and press, you might even find investors approaching you (always a great position to be in). If you’re a first-time founder, with a product that hasn’t yet gone to market in a meaningful way, looking to raise €100K then an investor looking for 20% equity of your business would be a really great offer, grab it fast before they change their minds!

Let’s be very clear too by the way that these sort of valuations only apply to software and ‘pure’ technology companies. If you’re a more standard ‘goods’ or non-tech business then you won’t get close to this valuation. That’s because the nature of how a technology business scales and deploys capital over time is exactly the sort of business venture capital is designed for. Plus the standard exit routes for a tech business (acquisition/IPO) lend themselves to attractive returns for venture investors because of the way tech companies are valued. A ‘standard’ company won’t get anywhere near the level of returns/multiples of capital that will appeal to VC funders.

And that is the bit that’s often forgotten – this is a business transaction, an investor needs a return on their capital commensurate with the risk that they are taking. And the reality is that they have a much better perception of the actual risk profile of the investment than you do. As entrepreneurs, our risk profile and outlook is usually very positive and optimistic, built based on the principle that when something can go right for us, it does. An investor’s viewpoint is probably the opposite – they need the proof and evidence or the assumption is that it ain’t going to happen. This usually materialises where an entrepreneur has ‘promises’ of great deals/customers/distributors etc all waiting to happen, the second the fundraising is over. Sadly unless there’s signed legal agreements/purchase orders or deposits in the bank, a potential investor is going to dismiss a lot of this as purely speculative.

(3) Vested Interests

Advisors getting equity is always a dangerous place to play in. In the last 12 months alone I’ve come across several companies that are now absolutely crippled for future investment as a consequence of allocating too much equity to advisors, who are now in fact doing absolutely nothing for the company. The first thing a new, potential investor looks at when they’re considering an investment is look at the current shareholding and how it’s allocated; alarm bells go off very quickly for anyone who owns shares but isn’t a full time employee or who hasn’t paid in for their shares.

In the extreme case that you decide to allocate advisory shares to someone, you should be looking at low low single digit % (1%-2% max) that vests over time (more on this below). Be massively careful about those who suggest that they’re going to provide such huge value to your business that they’re worth 10%/15%/20% – trust me it’s complete nonsense, if they are that passionate about the company then they should invest money for their stake. I’ve sat on advisory boards with VP and C level executives from Google, Facebook, Microsoft and other companies and even they don’t try to demand anything more than 0.75% – 1.25%, so ignore the guy/girl who thinks they’re better than them. If someone is looking to be an advisor to your business then you have to do your due diligence on them, just as you would with an employee; check out their references. Ask them who they’re already working with, speak to founders at that company, ask around the community about them. If they have a track record of delivering value then they should have absolutely no problem with you doing this.

Vesting – one of the most important terms that any business will ever learn about. If for any reason whatsoever you find yourself in a position that you are giving someone shares in your business, for any reason, there is only one way to do it; by vesting the share options. This should be standard practice for co-founders, employees, advisors, your grandmother or anyone else. Your solicitor can best advise on this but the basic principle is that you promise them a certain number of shares, that they earn over time (usually 2-3 years). If they’re not performing and/or the relationship fractures apart then they’ve only earned what’s vested at the time. Normally, nothing would vest for the first year (often referred to as ‘a one year cliff’), then maybe half of what they’re owed vests after 12 months and then the remainder vests on a monthly basis over the next 12-18 months. Once the first year is out of the way, you pretty much know what’s what in a relationship. This way your exposure is limited to what they’re actually contributing. If they’re delivering value then their shareholding continues to vest.

And, as usual, Joe’s hit on the main takeaway; raising money in this way gives out two equally bad messages. First, if the proposition is so good, why isn’t the ‘connected individual’ putting his own money in the game and secondly, that future investors will never, ever understand the lazy approach that was taken and will always ‘punish’ this sort of attitude with larger than usual demands in future fundraising rounds.

There’s just no shortcuts in the life of an entrepreneur when it comes to funding. It’s a hard battle. Ask any entrepreneur who’s been through it and the trauma will flash back into their eyes. If you’re going to build a business on the back of someone else’s money, there’s a hell of a lot of work involved.

If you need help or advice, hit me up at me@dc.ie (it’s always free).

DC

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I've spent a lot of time starting, scaling and building businesses. Now I'm helping others start and scale theirs through REPUBLIC OF WORK and BUILTINCORK.

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