10 Critical Decisions Every Founder Encounters
For the past few months, I have been working closely with founders and technology entrepreneurs in over a dozen disruptive tech startups as an advisor and for the ones I am truly stoked about as an investor. In each case, these founders and their teams have developed either a cutting edge technology with defensible IP or a novel tech enabled business process that will, if executed properly, transform their industry (s). I am drawn to work with companies in spaces that I know—RE-Tech (Commercial real estate) and CleanTech. Out of this field, I see a few “unicorns” in the making!
This article is for those founders that are starting out with an idea, looking to raise capital and need a play book for some of the most daunting decisions in front of them. Your ability to succeed and maintain “control” of your company will be in part determined by decisions you make in the earliest days of formation and financing your startup. Here are a few critical decisions you will encounter along the way and some tactics to consider:
1. Pre-Seed: Don’t go too soon and think you have to raise capital. Boot strap as much as possible with your own capital, go to angels and other successful entrepreneurs before taking capital from “institutional” investors. Nurture whatever relationships you have or networking you can but don’t go too early in the VC/PE courting process – guarantee that when you think you’re ready for this type of road show, you aren’t. [Note to reader, I am not an advocate of the “friends and family” route unless they are truly accredited investors—however I do concede that this is a standard path for most startups and may be the right path for you.] Early stage companies are high risk and investors need to understand that they run the risk of loosing all their money just as much as a 10x return and if a lot of your early investors are friends and family, this may complicate personal relationships if the investment doesn’t work out as planned.
2. Valuation: Care about valuation, but don’t let it be everything. Be able to support your valuation with market comps and financial projections but don’t get greedy. Engineering an insane valuation early on, whether through a trumped up 409A valuation or other commonly misused methods will only make raising capital in future rounds harder. Be able to stand behind your valuation and get your investors excited at every turn, even if its over subscribed—the more cash you raise for growth is a huge asset in early stages.
3. Investor Selection: Pay attention to who you are getting in bed with – you have to live with them going forward – find references, talk to other entrepreneurs who have worked with them. Make sure they have the capital they say they do! Verify investment track record and ensure they have the follow-on capital needed for your growth or for a speed bump you may hit along the way that requires cash to keep you on track. Once you get their money, stop trying to sell them – be honest and upfront with them about the business and leverage them as a partner and growth agent. Savvy founders stay in touch with investors and provide regular, concise updates on growth, new clients and other strategic developments.
4. Types of Capital: All money is green but Venture Capital and Private Equity investors are not the same – PE is focused on control and have a sharp pencil and takes a very formulaic approach to valuation, cash flow (EBITDA) and a steady as you go growth approach. VC’s are much more aligned with a seed stage and startup companies needs and tend to take a more collaborative role (if you obeyed #3 above). And if you go the VC route, pace the round, don’t over shop the market and allow your deck to be sent around without your control. This is a fine balance between pitching the right quantity and quality of VC’s and then herding the cats, per se, to get the round closed. The strategy of raising money from VC/PE will be the subject of an entirely separate piece that I will be publishing in the summer.
5. Get the Best Talent: It goes without saying that early stage companies need to recruit and attract a core team of rock stars that enhance the company’s valuation to a serious investor class. Founders need to create a compelling equity incentive package that recognizes that great teams build great companies—founders should even be humble enough to list these key rock stars as “co-founders.” Structure a fair vesting period after a 20% cliff that is no more than 1-2 years and allow the rest vests in monthly portions no more than 48 months, with immediate vesting upon a liquidity event/change of control. Be willing to give up a meaningful percentage of the company in the seed round to a team that you believe can get you the distance. This will be the most compelling incentive for these key “co-founders” even when they are getting better cash/equity offers to leave for other opportunities.
6. Align Incentives: Founders and early co-founders need to have skin in the game—deferred/lower comp is great, but investing cold hard cash is critical to align incentives with investors. A lot of corporate executives coming from well-established companies might find it sexy and adventurous to join a start-up—with all of their industry experience how could they not be the missing ingredient? Once they realize that a startup requires a major shift in lifestyle and that dealing with the growing pains that come with a high growth culture test their tolerance for risk. Founders need to challenge a recruits “risk tolerance” before bringing them onto the team. Just because you have been successful in a large corporation in the same relative industry does not make you the best fit for the wild ride ahead.
7. Caveat Emptor: While there are a variety of different types of financial investors in the market, groups like “Independent Sponsors” (aka fundless) have become much more common in the transaction ecosystem. Fundless sponsors are NOT traditional private equity—they do not have committed capital. These groups have been successful with more mature and slower growth companies in a "buy-out" scenario, but for a start up company, putting your faith in a fundless sponsor group that does not have bona fide financial backing is an incredible risk for any founder. These groups typically match the profile of former investment professionals, with good pedigree, graduates of top business schools but do not have their own investment track record and do not have committed capital. Most fundless sponsors use expensive debt to leverage their investments, as their equity capital is limited.
8. Don't use Debt too early: Non-dilutive capital from the likes of SBIC’s (Small Business Investment Corps), BDC’s and other providers of secured and mezz debt have allowed for the creation of exotic capital structures. Don’t be lured into valuations only supported by using exotic debt structures before you have created a rock solid foundation. Debt can be an incredibly efficient part of the capital structure and a creative tool for founders to use to prevent dilution, but remember that once you bring debt into the capital structure, it puts a tremendous amount of preference and seniority over all of the equity, especially if you trip up a covenant. Debt structures today, have numerous “equity” like features and have all the down side protection that gives the debt holder several incentives to be a difficult partner for any founder. This should not be confused with "convertible debt" structures that are quite common in early stage companies.
9. When to exit? – The hardest decision of all. Long before you ask yourself this question, stay focused everyday on building a great service, product or technology. Kill it! Only when you have done this for 3-5 years then should you look at your growth rates—do you have the capital structure to sustain your growth and if not you might consider an exit or a partial exit. If you think you are peeking with your ability to finance your growth of operations at the same rate, look for strategic acquisitions of competitors, "acqui-hires" or complimentary offerings that can continue to allow you to build value. Exiting too early is a common misstep that many founders make—look at all of your options before you pull the proverbial trigger. And if you do decide to exit, refer to my M&A article and hire the best investment banker and transaction attorney in your space!
10 . Support other entrepreneurs: As a successful founder of a company you have an obligation to pay it forward! Invest your time, capital, offer access to your network and insights into your success/mistakes to other entrepreneurs that you believe have a powerful vision and a plan to build a great idea into a something worthy of your efforts. This is a small, but ever-growing community that needs to be nurtured and supported.
Starting a company can be a life changing decision that requires founders to make substantial financial and lifestyle sacrifices to bring their vision to life. Living the life of a startup is a daily marathon that requires mental, physical and emotional stamina and sacrifice. Few are prepared for the journey and fewer succeed. But for those few that realize that successful entrepreneurs are one part “dreamer” and most parts “doer”—then the above insights will help guide you through some of the most complex and important decisions you will encounter as a founder.
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