The Pitfalls of Capital Raising

Managing the Pitfalls
of Early Capital Raises

by Tom Imlay


      

Raising capital is a major milestone
that proves other people believe in
you and your business idea


As an entrepreneur, raising capital is one of the most exciting things you can do. It is a major business milestone and proves that other people believe in you and your business idea. Whether you are raising angel funds at the idea stage, seed funds to support product development and marketing efforts or early institutional funds aimed at monetising the business or accelerating commercialisation of the product, bringing in funds to grow your business is akin to the survival of the fittest in the animal kingdom.

Businesses that manage to raise their first institutional round in the first few years of trading have a far higher chance of success than those that do not. Those that do not may have no option but to focus on raising smaller amounts of capital to keep their business afloat while their better financed competitors race off into the distance.

 

Fundraising must be a priority


Daunting, therefore, is a word that can spring to mind when describing fundraising. It can be painful and feel like a full-time job in itself. That’s why many CEOs of young private companies report spending up to a third of their time dealing with shareholders and raising additional funds.

It is important to understand the common pitfalls associated with fundraising and how they can be managed. These include:

  • valuing a business,
  • down rounds,
  • investor fatigue,
  • aggressive dilution,
  • bridge rounds,
  • lack of market tension, and
  • misunderstandings about institutional funds.

 

The first time you raise money
will be the first time you place
a value on the business


Are you offering 20% for a GBP 200k raise (Post-money valuation of GBP 1m) or 10% for a GBP 350k raise (Post-money valuation of GBP 3.5m)? The business does not have trading shares on an exchange, has no revenue or EBITDA and a skinny balance sheet.

So, how do you value it?

You will want to get the best valuation possible for the business so as to limit your dilution. Having a focus on positive aspects of the business such as the potential for recurring revenue, large addressable market and strong feedback on the product idea is helpful.

But should you also be wary of getting too good a valuation from investors? The key thing to remember here is you are on a journey together. You are likely to ask your early investors for more capital as your business progresses towards its first institutional round so it is important that they do not feel cheated.

In addition, you want to avoid down-rounds. A down-round occurs when you raise money at a valuation that is lower than the valuation at the previous round. A down-round hurts existing shareholders as it indicates they may have got a bad deal when they invested and dilutes them more compared with an up-round. As such, it is sensible to try to maximise the valuation within a realistic range.

Investor fatigue occurs when investors do not wish to put more capital into the business and / or want to liquidate their investment. Such fatigue can be avoided by proactively building strong relations with shareholders from the very beginning. If investors feel they invested on bad terms and are constantly chasing for information and being given bad news, it is only natural for them to feel fatigued.

Now onto the D word... Dilution!

Dilution is an inevitable consequence of taking on additional equity. Of course, the hope is that by taking on more capital, you can build a bigger business: you would rather have 10% of a GBP 10 million business than 55% of a GBP 1 million business. However, as the owner of your business you want to manage your dilution. It is in everybody’s interests including shareholders that the founder and driver of the business retains enough equity to be motivated.

Bridge financing is a term many entrepreneurs and shareholders dread in equal measure. It usually means raising additional money from individuals to get the business to its first institutional round. And this bridge can feel like an extremely long one the more times additional money is required.

A bridge round does not have to be painful. Reaching out to new individual investors can be a time-consuming and costly exercise so it is desirable that additional funds can be raised from existing investors. If entrepreneurs have proactively managed their relations with investors from the beginning, raising this bridge is more achievable. Furthermore, bridge financing does not need to involve dilution. The goal is to secure funds that can keep the business running and growing up to the point it becomes interesting to institutional investors. This could come in the form of R&D tax credit financing or convertible loan notes (CLN).

R&D tax credit financing is where the lender loans money against a R&D tax credit due to be received by the business from the government. This is a type of secured loan. R&D tax credits are an incentive scheme offered by the government to encourage innovation. Companies qualifying for these tax credits can use them as collateral to secure short-term financing.

CLN are a short-term debt that can be converted into equity at a later date. The instrument is a loan to the business with the option to convert it into equity at a discounted price at a subsequent fundraising round. This structure ensures the entrepreneur can raise capital without immediate heavy dilution and perhaps without dilution at all if it can repay the loan. If the loan is not repaid, the investor benefits by converting the loan into equity at a discount in the next funding round.

Once you have reached a point where your business qualifies for institutional funds (annualised recurring revenue of 1 million in some cases), the stakes are even higher. It may be very tempting to accept an offer of funding from the first VC or VCT you come across. However, this may mean you do not create the market tension needed to get the best deal possible or the investor you choose does not actually add value beyond the money they put in.

Ideally, you will have two to three interested parties competing for the deal. This will improve the valuation. It is also preferable that the institutional investor chosen has relevant expertise in your sector and therefore can help to steer the business in the right direction. Getting a few interested parties is feasible if you identify multiple VCs that are a good fit for you at least a year before you are ready to seek institutional funding. Indeed, VCs tend to invest in companies they have had a relationship with for at least a year.

And finally, it is critical that you fully grasp the nature of the deal on the table. Unlike angel and seed rounds that see an exchange of pure equity for cash, there are often misunderstandings about institutional funds. This is because their deals are more complex. They can involve ratchets, liquidity preferences, option pools and secured loans to manage their risk (these will be covered in a subsequent post).

It is advantageous to understand these terms and the potential pitfalls well in advance of raising institutional funds. After all, knowledge is power.

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