Potentially Fatal Mistakes Start-Ups Make When Raising Capital, Part One
Founders and CEOs who haven’t participated directly in multiple start-ups—most readers of this article—frequently make errors early in the process. Over the last few weeks at Broadscope, we’ve been in conversations with a few new CEOs who have made or are making what may be fatal errors.
This week and next, we’re going to deviate from our path through the outline business plan and address some potentially fatal mistakes that you want to avoid.
We define fatal errors as, any error that can significantly reduce the returns that the founders would have achieved had they not made the error. For example, we consider a CEO exiting in year seven with $500,000 versus $50,000,000 a fatal error, when the institutional investors in the same deal exited with a 10x multiple.
Errors in valuation can hit founders at any stage in the fundraising process. Here are the first two potentially fatal errors that we've seen recently.
#1: Valuing the Company Too Early
In the early stages of your company before you have much traction, it may be hard to agree on a valuation with investors. So, after bringing in friends and family capital, consider raising money in a non-priced round. Use an instrument that converts with a trigger into equity, such as convertible debt or the SAFE (Simple Agreement for Future Equity). Why?
Lower cost and shorter time to close. A convertible round agreement is typically 5 to 6 pages while a priced round agreement runs 150 to 300 pages. This makes non-priced rounds significantly less costly and faster to close than priced rounds.
Close sequencing. Convertible instruments often close on a rolling basis. This means that as soon as documents are signed and the investor wires money, the company can use the cash. For priced equity rounds, all investors must typically close on the same day, requiring more time and coordination between all parties and delaying access to the cash that you need.
#2: Pricing the Round Incorrectly
Should you decide to raise a priced equity round, under- or over-valuing the company is another common mistake.
Under-Valuing. This causes the company to give away too much ownership early in the process. While you may have to do this to raise the round, for this to work out well for the founders, you must understand in detail your pro forma cash flow, raise amount, and timing of each round.
Over-Valuing. Most CEOs and founders strive for the highest valuation possible, thinking it’s the best strategy. This causes two problems, namely:
1) It may take significantly longer—or never—to raise the round if you’re outside the typical norms for investment dollars and ownership percentage required by investors.
2) It may be more difficult to raise a subsequent round with a desired valuation multiple from the current round, as the next round valuation may exceed investor norms.
Fundraising errors can cause serious problems for companies at any stage. If you haven’t been a start-up CEO many times, you can easily make fatal errors in valuation, pricing, strategy, and method of capital raise. It’s vital that you obtain counsel in strategy, finance, and fundraising to help guide you to a successful raise structure—not just the current round capital.
If you're facing any strategy or fund raising challenges and want help, get in touch with us.
Next week, we’ll cover fatal errors related to the amount of your current raise and why spending time selling your product may be a mistake.
All the best,
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