At some point in their history, businesses commonly have need for external funding to help their growth trajectory.
However, acquiring investment has its dangers and pitfalls and the last thing the Board will want is to invest time and money getting to the point of securing the funding only for it to be pulled. As a commercial lawyer with decades of handling funding rounds, James Fulforth, Senior Partner and Partner in Kingsley Napley’s Commercial, Corporate and Finance team explains some of the reasons why fundraises can go wrong and therefore how best to avoid such a scenario.
Valuation and financials
Investors will wish to see a credible valuation for the company which is raising investment, and the more substance that lies behind this, the better. Is the company already trading? If yes, what financials are available? If any year end accounts have been finalised, these should be disclosed, but ideally they will be accompanied by up-to-date management accounts.
If initial trading is modest, then the focus will be more on forecasts for future periods. These will generally be incorporated within the company’s business plan.
Even if the company has researched the position carefully, financial projections are by their nature highly speculative which is why they are rarely supported by warranties in the transaction documentation. If investors do invest in an early round, future relations between founders and investors will be happier if trust is established early on. If the initial valuation proves too frothy, relations may start to sour quickly, and founders will spend more time on managing relations with grumpy stakeholders than on building their business.
Far better to take a realistic, even conservative, approach to valuations and projections, to avoid overselling the idea, and to then exceed those expectations.
Proposition
The credibility of the company’s business plan will depend on the nature of the product or service, the market, and the degree to which data is available to support the company’s analysis. Investors will consider the extent to which a product or service has already been developed, launched and tested.
Has an expert been engaged to produce a report on the product, service or market, and can such a report be regarded as independent and therefore credible? How original is the business idea, and is it possible to protect the intellectual property underlying it? If there is little substance behind the proposition, then even if the financial performance and valuation is modest, investors will struggle to see future value.
But highly detailed analysis may be of limited value if the founders are unable to articulate the company’s proposition in their pitch. Much will depend on the individuals concerned and the character of the founder team. More introverted individuals may have the technical skills, but they will need to be complemented by those with energy, charisma and leadership.
Many successful businesses are led by gifted individuals, but raising investment involves stiff competition. Balanced founder teams tend to appear a more compelling offering.
Preparation
Careful preparation prior to the fund raising is critical. A well-researched plan and a strong pitch will have little traction with experienced investors if the same level of professionalism has not been applied to the management of the company. The same applies to the organisation of the due diligence process, and the way in which founders engage in the process.
While family and friends may be prepared to rely on their trust in the founders, more sophisticated investors will require detailed answers to detailed questions. Most important is capital structure. Have all share issues and share options been documented properly?
Have terms with key suppliers, customers, employees and consultants been agreed and written down? To what degree are such terms standardised? Has the company acquired ownership or a licence over all key assets, such as intellectual property? What governance is in place around data, cyber security, and regulatory issues? Potential investors may wish to go back to when the company was founded, so ideally founders should start addressing any gaps in these elements early on.
Any obvious issues which are uncovered may be difficult to fix quickly, and may compromise an awful lot of hard work in devising and selling the proposition.
These are not the most exciting elements of running a business, and some founders will simply not have the desire or the skillset to give them much focus but, once again, the key is to have someone in the team who is prepared to understand the detail and to directly address any wrinkles that inevitably emerge.
Other investors
Securing a lead investor is often key to attracting additional investors, especially if that investor is well-known or has significant expertise in a particular sector. Even if that’s not the case, a lead investor is often someone who has already spent time in getting to know the company’s product, service or team, and provided they appear credible and are able to articulate their views to other investors in the course of due diligence, they will help reassure smaller investors and build momentum.
However, founders should be cautious of getting too close to one investor, and again they should carry out their own research on the background and track record of that individual or institution. If a lead investor pulls out of the round, others may follow.
If this happens shortly before completion, the damage may be significant. If a company is fortunate enough to have the option of choosing between investors, it should be strategic about who it collaborates with, and it may not wish to put all eggs in the same basket.
The ideal investor or investors will not only provide capital but also commercial experience and real knowledge of the sector. They may even be a suitable person for the company to have on the board.
Founder terms
Finally, founders should be realistic about their personal compensation and the terms under which they hold shares. Even though they may own a substantial percentage of fully vested shares prior to the fund raise, investors will wish to include appropriate protections, and these may include requiring the founders to offer up their shares for sale in certain circumstances.
Again, the protections required will vary, depending on the nature of the parties involved and their experience, but also on the other elements already touched upon, ie the valuation, track record of the founders, nature of the preparation and dynamic between the investor group.
If a founder can confidently justify the overall proposition, negotiations will be easier. But an unrealistic founder may fall at the last hurdle. These matters need careful consideration alongside advisers and, much like a company’s valuation, the key is to be reasonable and to think long-term.
This also applies to other employees’ compensation. Investors will wish to see that employees are properly incentivised to stay and perform and to add value to the company. Companies that don’t offer equity to their employees (for example, through EMIs) risk losing important talent to competitors.
Securing funding has its pitfalls, and expert advice should always be sought to help guide your business through the process but, if properly managed and executed at the right time, the result can prove transformational for your business.
Read more:
5 Reasons Why Fundraising can Go Wrong