Editor’s Note: The following is the 10th chapter of the book “The New Prince“, a collection of essays on the counterintuitive lessons Marco Trombetti, founder of Translated and VC firm Pi Campus, learned by building and investing in startups. We agreed with the author to publish all 12 chapters through a guest post series. Check out the previous chapter here.
When a company needs capital in order to grow, there are two ways to obtain it: debt and equity. Debt financing allows the entrepreneur to retain ownership of the company on the basis that they eventually pay back the capital plus interest. Equity financing, on the other hand, involves investors putting money into the company in exchange for shares. In the latter case, the capital will be repaid as a share of the profits (a dividend) or, more commonly, following the future sale of the company’s shares.
In some rare cases, companies do not need capital because they generate the income they need to grow from day one. These are called bootstrapped companies. Translated, my first startup, falls into this category. In the world of technology, bootstrapped companies are so rare that there is no point in discussing them here.
The old economy was based on debt; the new digital economy uses equity. Apple, Microsoft, Oracle, eBay, Google, PayPal, YouTube, Facebook: most of the success stories of the last 30 years were made possible by equity financing rather than debt. More specifically, they came about thanks to a form of equity called venture capital. Unlike private equity (for example), venture capital favours more adventurous and innovative companies.
The reason for this is simple: technology and innovation are changing the world at an ever-faster rate. The windows of opportunity in which to launch a new product are becoming smaller and smaller. To be successful, it has therefore become necessary to increase the risk factor by taking a chance on initiatives that have not yet been validated by the market.
In this high-risk environment, debt cannot be used: banks would have to set a prohibitively high interest rate and entrepreneurs, feeling the pressure of their commitment to repay the capital, would be forced to take fewer risks. In venture capital the investor accepts the possibility of losing everything in exchange for a relatively small chance that the company will be a huge success. In a typical example, an investor loses money in 9 out of 10 cases and recoups 30 times their initial investment from the 10th company. Having an investor who is prepared to lose everything gives the entrepreneur the freedom to take those risks that can greatly increase the value of the business.
Venture capital is not suitable for every entrepreneur. Over the years, I have developed a simple test to help understand when to use it:
Would you rather own 100% of a company worth 100 million or 10% of a company worth 1 billion? Take a moment to think about it.
If the answer is 100%, then the option that will make you happier is debt financing. If the answer is 10%, then venture capital is the right solution for your business.
The investment rounds are called Pre-Seed, Seed, Series A, Series B, Series C, and so on until the company is listed on the stock exchange. Known as the IPO, this last stage is nothing more than an investment round in a regulated market that is accessible to small savers. ICO are public offering based on cryptocurrency in a currently unregulated market.
Although the companies and markets involved can vary enormously, the structure of the rounds is relatively standardised. In the pre-seed round, you will give away 10% of the company for about €50K. In the seed round, you will raise €500K for 20%. In the Series A round, you will raise €2 million for 20%, then 10 million for another 20%, and so on. In some places, such as California, the amount raised and the valuations can be up to 3 times higher, while in others they can be 2 times lower. However, according to the Crunchbase numbers for 2017, this is the general order of magnitude in Europe.
Drew Houston, the founder of Dropbox, owned 13% of the company in 2017 after raising around 1 billion dollars in 10 years. In 2017, Dropbox was valued at around 10 billion. Dropbox raised $15K in the pre-seed round at a valuation of about $300K, then $1.2 million at about $10 million, then $6m at about $28 million, and so on up to $1 billion… The numbers are very similar for Airbnb, Facebook and others.
Raising a lot of money with an excessively low valuation is unlikely to ensure governance and motivation in the long term. A founder who knows that they will end up with 2% of the company immediately starts thinking like a manager rather than an entrepreneur. The investor is not an entrepreneur, and without an entrepreneur the probability of success plummets. Fundraising with an excessively high valuation, meanwhile, raises expectations for the following rounds: it is difficult to get investors to accept a step backwards in terms of the valuation, so you risk not raising anything at all.
How do you decide how much a startup is worth?
Looking at equivalent stages, the best companies in the world attracted financing with comparable valuations. Almost all startups turn to the market to raise funds with similar valuations (the typical evaluation for the round in question); only the best succeed. The selection therefore revolves around who manages to raise the money and who doesn’t, rather than the valuation itself. The most successful startups stand out because they progressed through many rounds with a growing valuation, not because their valuation in each round was much higher than their competitors’.
Many entrepreneurs make the mistake of measuring their success based on the valuation they obtain or the capital they raise. They do it because these figures are often the only ones available in the public domain. Raising capital is nothing more than making a necessary sacrifice to increase the probability of success. It is not a measure of success. Moreover, the quality of a round should be measured by the investment terms and conditions, which are almost never made public.
Why would somebody be willing to invest 100K in the pre-seed round, valuing your idea at 1m, when you don’t have a business that generates a profit yet?
They wouldn’t. They won’t value your idea at 1m in the first place. They will assign a prospective value based on your commitment to developing the project, and they will ask for a guarantee that they will be the first to recoup their investment. They will be convinced that your commitment is the critical element needed to create a valuable company, and that the guarantee can partially protect them in case things go wrong.
Good investors do not ask for too many shares in a startup. They know that the founders will gradually lose motivation and control in the following rounds. What they do is take a small share and ask for protection in return.
Shareholders’ agreements are one way of balancing the equation. They allow for a small amount of dilution and the necessary capital injection. The main clauses of this agreement are called liquidation preference, tag-along and bad leaver. Liquidation preference acts as a guarantee that the investor will recoup his or her capital before the founders do. Taking the previous example, if the company is sold for less than 1m, the investors still recoup their capital (100K). In the most extreme case – in which the company is worth nothing – they lose everything. If the value is more than the valuation for that round, everyone profits in proportion to their share. A tag-along clause states that if a founder sells his shares to a buyer, investors are entitled to sell to the same buyer pro rata and at the same price. For example, if you find a buyer interested in your 51%, you cannot sell and leave the investor behind. The third clause, called a bad leaver clause, is a commitment from the founders. If the founder abandons the startup within 3 years, he or she will transfer most of his shares to the rest of the shareholders proportionately.
Investors are not all the same, and it is a good idea to only choose the best for an adventure that can last many years, and often decades. I recommend that you treat the investor as a rich co-founder, rather than as a bank. Here’s a simple test to identify a good investor: if they ask for several additional clauses on top of the three already mentioned above, they are probably a bad investor. The reason for this is simple: if they need more protection, they are conscious of the fact that they tend not to make good investments, and they are focused on recouping as much as possible from mediocre results instead of concentrating on success stories. There are also cases in which the investor is so successful and sought-after that the founders will accept any conditions to get him or her on board. All the same, I don’t know any successful investors who are aggressive when it comes to their conditions – the opposite is more often true. Success is achieved by choosing the best entrepreneurs and supporting them. I don’t think it’s possible for an investor to succeed by limiting the success of others.
Other conditions such as veto rights, drag-along rights, control of management bodies and so on are warning signs that you should watch out before accepting an investment.
On the contrary, it is inadvisable (although possible) not to include these 3 basic clauses, because doing so can create unnecessary tension during and after. When I raised capital with Memopal, I negotiated an agreement not to offer liquidation preference and I raised funds at fairly high valuations. Upon selling, my co-founder and I were among the few who made money from the process. Causing some investors to lose money was not a pleasant experience, and it certainly won’t help my chances of raising funds from the same investors in the future. I was able to reimburse some people using my profits, but looking back, between taxes and complicated equilibriums that develop over time, it’s never easy to sort things out exactly as you would like.
Given the average success rate of startups, a founder who raises 2m capital with a valuation of 10m, a 4x liquidation preference, veto and drag-along rights will, on average, be worse off than one who raises capital with a valuation of 1m to 5m, a 1x liquidation preference, and no veto and drag-along rights. Only the best founders understand this, and they focus on the terms and conditions.
To make fundraising faster and easier, the SAFE (Simple Agreement for Future Equity) is widely used in California and other places. This is a debt that converts into shares with a certain discount and a certain maximum valuation during the next round. The SAFE also offers investors and entrepreneurs a standard contract, eliminating the need for lawyers. The biggest advantage of the SAFE is that it is asynchronous and high-resolution, meaning you can negotiate and sign agreements with investors 1-to-1 without distributing a contract that everyone has to sign, as is necessary in many countries. The SAFE works well when the demand from investors outstrips what the startup is able to supply. In these cases, investors tend to want to secure a share of the company as quickly as possible, often sacrificing better terms in the process. Y Combinator’s Demo Day provides an example. There, the typical discount is 20% with a valuation cap of 15m. Bearing in mind that 50%2 of startups will not carry out a Series A round in the next 2 years and that their valuations in the Series A round will be about 30m, the 20% discount and the valuation cap do not offset the risk of investing early. In less competitive markets, therefore, the SAFE is not always accepted by investors, since much larger discounts that would make it comparable to equity are not applicable. I also find myself wondering if it might be better to spend a few days identifying the ideal investor rather than using the SAFE to close the deal quickly. The SAFE is very useful, but I would always make sure it was acceptable to the key investors before using it. Personally, I gladly use it when I want to ensure that I secure a part of the capital, and when all the other investors prefer it. I avoid it when I have more time to discuss with the founder.
Another key issue when raising capital is deciding how much to raise at each stage. As mentioned, the process is not infinite and the market is quite structured. The two elements that need to be balanced are the following: raising as little as possible in order to dilute less, and not putting the startup at risk. Startups fail for one reason: they run out of money.
The best founders are charismatic leaders who guide not only their teams, but also investors. They become like this because they have the heart to take care of the interests of everyone around the table, and they feel the weight of this obligation on their shoulders. This heart, along with their knowledge of the technicalities of financing, gives them a clear and fair vision of the future that unites everyone.