Top Ten Startup Funding Fallacies
For a number of years I’ve given a workshop addressing the business side of early stage startup funding — whether and when to raise, how to identify the right investors, how to go about the fund-raising process, how much to raise, and how best to pitch. My focus, in particular, is on seed and Series A funding.
While reasonable people can have different views about approaches to funding, I disagree with a lot that I hear. In particular, many of the assertions discussed below are often stated as absolutes — and they are frequently wrong.
Here are my top ten funding fallacies:
1. Highest Valuation is Best
Many founders focus very heavily on obtaining the highest valuation for their early stage financings. While I understand the desire for a high valuation and valid concerns about dilution, I don’t think this makes sense.
First, most early stage companies are likely to need multiple funding rounds. Consequently, it is important to show a trend of continued increases in valuation with successive raises. At best, a subsequent down round will make it difficult to raise further funding and result in potentially higher dilution; at worst, it may make it impossible to raise funding and kill the company.
Second, a company should be looking for more than money from its early stage funding rounds. In particular, securing investors who can add value should be a critical objective. That value can be in the form of expert advice or experience, a network of contacts, or potential credibility with customers or other potential investors.
Third, adverse business and legal terms can have a clear economic effect, offsetting the benefits of a high valuation. For example, certain kinds of liquidation preferences, entitling investors to a greater than the usual preferred position in an exit, can have a significant adverse effect on founders and employees. Similarly, certain anti-dilution provisions can have a substantial negative impact in the event of a subsequent “down-round” financing. Two VC’s, Tom Wilson (Seedcamp) and Charles Yu (Bling Capital), have written very helpful blogs on Medium addressing these subjects. The bottom line: emerging companies need to obtain knowledgeable professional help in analyzing these terms.
2. It is Better to Raise Less Now
Founders frequently prefer to raise less early stage funding, on the basis that early funding is more dilutive than later stage funding. That is true.
However, funding should be milestone-based, with the objective of doing further raises at a materially higher valuation based on achievement of the milestones. It is likely to be more dilutive for a company to return to the market to raise more funds to achieve missed milestones than it would be to raise enough in the first place.
Additionally, fund-raising diverts management attention from focusing on development of the business.
Furthermore, as we have seen over the past year with covid-19, market conditions change, and one cannot assume that the ability to raise funds now provides assurance as to the ability to raise down the road.
For all of these reasons, I would suggest that founders try to raise at least enough to provide a 12 month runway, and consider whether they can raise with an 18 month runway in mind.
3. It is Easier to Raise in the US (or Some Other Foreign Market), and Therefore We Should
Non-US founders frequently complain that they would be better off raising early stage funding in the US because it is easier to raise in the US and the valuations are higher. Both points may be correct.
However, early stage investing is predominantly local (with perhaps some exceptions for angels investing in a sector they know well). While there are exceptions, most US early stage fund investors will not invest in a non-US business without both: (a) a founder based at a US location proximate to the investor; and (b) US traction (or, at the very least, a compelling US business plan). This reflects two points: (a) early stage funds bring not just money but also experience and network — they need founder proximity to add value; and (b) it is difficult for most US early stage funds to evaluate a non-US business plan.
Indeed, even within the US there are substantial disparities in the venture capital markets in different markets, and differing appetites of investors to invest outside of their local areas. For example, it has been difficult to get investment from early stage Silicon Valley investors, especially smaller to medium-sized funds with a sole office there, if the startup is not based in Silicon Valley or the San Francisco area. That restricted view has broken down a bit in the past couple years, but at early stage it is still a significant factor. Investors in other US regions may take a broader view in thinking about the localities in which they will invest.
Additionally, many early stage US funds will refuse to invest in non-US holding companies, although some East Coast funds and large funds on the West Coast have been willing to invest in UK and Irish holding companies. While a non-US emerging company can always flip into a Delaware holding company, that may impede securing investment in their local market and there are long-term costs involved. Consequently, a “Delaware flip” generally does not make sense for relative small amounts of investment.
While my discussion above speaks in terms of the US market, the same points are equally relevant to efforts to raise in other non-local markets. However, outside the US, more early stage investors may take a multinational view. For example, in Europe, some funds may take a national approach, others a regional approach (eg, a German fund focusing on opportunities in German-speaking countries), and others look to Europe as a whole.
4. Bootstrapping is Bad, or Good
I’m not sure how anyone can make a categorical statement about bootstrapping. On the one hand, the fact that founders are prepared to invest their own funds in developing their business, and are inclined to run it leanly as a result, would seem to be a good thing. Reliance on external financing carries certain hazards.
On the other hand, bootstrapping may result in slower growth than could be secured by taking external investment, which may permit a better funded competitor to achieve stronger market share. In any case, bootstrapping may not be possible if founders lack funding.
Consequently, any view on bootstrapping is always going to be context-specific.
5. Don’t Use Early Stage VC Funding
I sometimes hear experienced founders say that entrepreneurs should not take early venture capital fund investment. A more nuanced (and, I think, correct) version of this is that entrepreneurs should not believe they have to raise venture capital, or feel pressured to raise venture capital.
Whether one takes early stage VC funding is dependent on a number of factors, including: (i) the need for funding, and availability of funding from other sources, including revenues or self-funding; (ii) the knowledge, experience, contacts and credibility that the VC can bring to the table; and (iii) if required, the ability of the VC to contribute to securing later rounds of funding due to its relationships with other VC’s.
In my experience, the right early stage VC can play a major role in an emerging company’s development. (Conversely, as I wrote recently, the wrong early stage investor/s can kill the company.)
Maybe a better way to put this is: “try to avoid taking investment that doesn’t bring significant value other than cash.”
There is a related point that bears mentioning — while securing VC investment may be important to the development of the business, and the right VC’s may add credibility, investment is an input, not an output. Your pitch decks shouldn’t show securing an investment round as one of your startup’s achievements.
6. Don’t Use Crowd-Funding
I’m frequently asked whether or not companies should use equity crowd-funding for early stage financing. The answer, again, is it depends.
Key factors include: (i) as above, the need for funding, and availability of funding from other sources; (ii) the nature and credibility of the crowd-funding platform, and the quality of the investors on the platform (smart or dumb money); (iii) the nature of the business, and its attractiveness to crowd-funding investors (for example, a b2c business is likely to have greater appeal than a b2b SaaS business); (iv) the role that the platform is prepared to pay post-raise in managing the group of investors as a group; and (v) anticipated sources of capital in later rounds, especially the next round (some VC’s may be more comfortable than others with a properly-managed crowd-funded tranche in the startup’s cap table).
Additionally, for b2c businesses, crowd-funding can be a form of marketing, building a group of supporters and influencers who are invested (literally) in the success of the business.
7. Don’t Use Government Grants or Matching Funds
Some VC’s don’t like the idea of companies accepting government grants or matching funds. I’m not sure why, unless there are problematic strings attached to the grants, or the process of obtaining the grants diverts too much time and attention from the business.
Investors get the benefit of government grant-funded development without the need to pay for it. Government matching funds take on some of the early stage equity risk without interfering with business oversight, which is typically left to the private investors.
Grant and match funding is particularly important for emerging life science and deep tech companies, or other startups in less-favored verticals, where investors may perceive greater risk at early stages of the business.
I accept that generous availability of government money in some jurisdictions (perhaps unfortunately, not very many ...) may fund businesses that should not be funded and may remove commercial pressures that would otherwise sensibly apply. However, private investors are perfectly capable of assessing whether that is, or has been, the case.
8. Don’t Take Investment From Corporate Venture Funds
I’ve separately blogged on the pluses and minuses of taking investment from corporate venture funds, and that is a complex topic. I find that, for the most part, minority corporate venture investment adds credibility — for example, other investors may value the technical or market assessment of the corporate venture investor, and potential corporate customers or partners may take comfort if a large corporate is an investor. I also find the usual concerns raised about corporate venture investment, such as worries about corporate interference or the effect of such investment on potential partnerships with other corporates, are overstated. In any case, this needs to be considered in the round — it doesn’t make sense categorically to rule out such investment, and there may be good reasons to seek it out.
9. Small Angel Investments aren’t Worthwhile
Angel investments need to be assessed from two separate perspectives: (a) the value of the cash at the relevant time; and (b) the value of the angel’s experience, credibility and network. Founders need to give due consideration to the latter. A relatively small investment that is not worthwhile from a funding standpoint may make perfect sense if the angel is “smart money” who can bring significant non-cash value, such as advice or network, to the venture.
10. Don’t Raise Until Market Conditions Improve
The timing of startup raises is necessarily influenced by a number of factors. Some of these relate to the business itself (such as when milestones will be achieved, and what is the remaining runway), and some are extrinsic, such as general economic and market conditions or seasonal issues (VC’s take vacations too!). With covid-19, we’ve gone through periods, particularly in late March and April 2020, when fundraising became more difficult, and market conditions today may not be as good as they were a year ago. Further, some business verticals, such as travel and entertainment, have been disproportionately affected by covid-19. However, funds have money that they need to invest, and intelligent venture funding takes a medium to long-term perspective on business opportunities. Further, VC’s and angel groups have adapted to lock-down-associated restrictions, such as by much greater use of on-line video platforms. Consequently, while startups need to take extrinsic conditions into account, you shouldn’t assume that future circumstances will be better. Manage risk sensibly, and raise when it is prudent to do so.
* * *
In short, categorical statements about funding are frequently wrong. Do remember, however, that for non-revenue producing businesses, cash is king. Don’t run out.
This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact robert.mollen@friedfrank.com or via LinkedIn here.
You will find some of Bob’s other weekly blogs for emerging and growth companies on US issues, international expansion and early stage financing here: http://bit.ly/StartupGuides
