Some tips to make decisions you won’t regret.
When having conversations with entrepreneurs, some of the questions and topics are often alike. That’s why I asked a friend for permission to publish a summary of our latest discussions, hoping they may be of help to anyone in a similar situation.
I am working for a start-up company right now, and we have two potential investors.
First, and probably the most important thing, is how do you want to spend the money. As a company, you need to know where every cent will go, for many reasons.
First one, because when you start spending the money, you must have tight control over allocation, efficiency, timing and milestones, deviations, KPIs and results, impact, further needs, or any adjustment that we should implement on the go.
The second one, because as an investor, I need to be sure my investment is coherent and makes sense. Let me put an example. When a start-up developing a new app or web service, wants to put 90% of the investment to marketing, and 10% to product development, we have a problem. Or the other way round, if we want to invest 90% of the resources to secure an IP (patent, for example), we’ve also a problem. With these examples, I mean that we should have a coherent investment structure. And of course, a coherent volume. Because if a company of a 1 million pre-money valuation asks us for a 100 million investment, maybe we should also be a bit worried.
Third, because investment must be coherent with the product, with the team, the market, and the context. In this case, the type of business will lead the way for many of the checkpoints. It’s not the same if you are a scientist asking for an investment to develop an industrial prototype out of a new invention, or if you are developing a new website or marketplace. Imagine you’re investing in that industrial prototype, and the founders don’t have the technical ability to negotiate the terms with a contractor, or they don’t have the connections to make that prototyping possible.
In short, we need to have a clear direction, a reasonable approach, and credible plans and numbers. You don’t need to have a detail up to the last cent, but you need to be ready to answer any question. So better you did in advance as many questions to yourself, and you’ve been able to convince yourself first with good answers. In the end, you want to provide some certainties to you and your investors, and some feeling of security for everybody’s money (or at least, some control over risks).
The first investor wants to give Cash for Equity and participate with know-how and helps us with sales.
We need to remember a couple of things here, which are paramount. When you think about the easiest deal-breakers, these two ones often come to mind.
First, the valuation is critical. We need to agree on the value of the business, because, of course, this will decide how much equity you can ask for your money. Methods are numerous, though, in many projects, very few are used. But the question, in the end, is how much do you think the business is worth. And it relies on a thousand different variables, but the three main ones are: product, team, and luck. Concerning the three of them, both parts (founders, investors) may have a different perspective. So when you are talking about the percentage of equity you’re giving away, the real discussion is ‘will you give me 10x somewhere in the future?’
And second, the value (or price) of the investor’s contribution. You talk about “know-how and help in sales’. Ok, what are precisely these functions? Are you buying your job? Or are you accelerating your investment? Maybe you are helping because we get along well? To my experience, it’s always good to name names and to set things apart. I put X cash, and I want X equity for it. On the other hand, I add this value to activity, equals this amount of money at market price, and I want an extra X equity for that. You can even say that I’m the first fool believing in your idea, and I’d also like to have additional equity for that. It’s ok, everyone can ask for whatever he wants, but as a company, we need to know what we are paying for. And every investor would agree, would thank, and would be happy with that policy.
This one looks more like an individual investor, willing to put some engagement in the development of the project. But in these cases, as a company, we need to measure the ability of this type of investor to walk the talk, and effectively add value to the business. This kind of relationship implies some amount of trust between the parts, mostly related to people’s bonds.
The second one wants to give a convertible loan, that they can convert into equity after three years. Having them participating would add a very well known name to our board.
This proposal looks a bit more professional, and the formula has become more popular for seed investment. It can be quicker than selling equity, cheaper, and the control about decision making remains mostly on the founders (as equity investors usually have board seats, some veto rights, and things like participation preferred liquidation preference). It provides many options (a coupon if the loan is finally not converted, for example), and gives you richer tools to negotiate in later rounds. Of course, there might be some disadvantages too, like the fact that founders want to maximize the company’s valuation in Series A, while the noteholder’s interest is to minimize it.
Concerning the second point you mention, it’s interesting that this second investor is adding value to your project (co-branding) without any need to perform any action.
What would you say with whom to go within that case? Or would you see other options that we can propose to get the two investors on board? The second one is unlikely to also invest in equity from the beginning.
Founders are usually afraid of equity investors, because they dilute at a sensitive moment (at the beginning, when everything is still uncertain), and because they lose control over ‘their baby’. It’s safer, because you don’t need to pay the money back, but things change a lot when investors come.
In the real world, a combination of different sources are always probably the most sensible option. Because you diversify the risk, you get many more on board, and if you need any loan in the future, it’s easier if the banks see more people believing and invested in the project.
My advice, in this case, would be to prioritize the second investor, taking into account that you might have another one (the first). I would negotiate to get both on board, as the more people the market sees involved in the project, the more attractive you are going to be for everyone. Work on a plan and investment details. Build a valuation that you believe in and go for it. The most important thing is for you to have your own goals, and you find a good match; don’t work the other way round. Be ready to see things differently and to pivot, but I would not ‘sell’ the idea to the first arriving just because they show interest and pledge to put some money on it.
Do not rush into anything. Especially now. And do not sign anything that you think it’s not fair or reasonable. A good deal may be quick, but it isn’t easy to sign a good one in less than six months. My experience is that the faster you sign, the more “winners and losers” situation you have, and this means trouble in the future, for sure.