I was asked recently by one of the companies I’m working with that is post-prototype, but pre-revenue:
How can I make this deal sweet enough for early stage investors without jeapordising future investment or diluting founders further?
That is the dilemma.
As a founder, you need to get cash into the company to grow, often just to survive, and you aspire to create massive value for yourself and investors. You don’t want to be diluted, and you know that later investors will want to see the founders sufficiently motivated. But at the same time, you need to make the deal really attractive to investors now if you’re going to get them to invest in your company so that you can survive and thrive.
What to do?
Convertible notes are one method, but they are no means a panacea. Convertible notes let you avoid the question of valuation (and dilution) until the next round, when ideally you’ve reached a much higher valuation. Some investors don’t like them at all, considering them a way of putting off the hard question of valuation, and avoiding showing progress through a series of successive equity rounds at steadily increasing prices. Most convertible notes come with general security agreements, meaning if you can’t close the next round on acceptable terms, your noteholder might be in a position to bankrupt your company and you could walk away with nothing at all. This rarely happens though, as it’s a “mutually assured destruction” scenario, and your investor would likely walk away with nothing as well.
My wise friend Simon Swallow summed up the issue this way:
[Founders] have to work out their prepared trade-off for speed versus probability of success versus value versus share.
So are they better to bootstrap it and take longer to get to the end point and not dilute as much, or raise money to give them a greater chance of success happening sooner but be prepared to give away a portion of the company?
Companies have momentum and if you generate strong positive momentum then people get on board, but if you don’t, the company sits on the shelf and passes its expiry date eventually.
And finally if you want to get you have to give.
If you’re going to get diluted, you want to ensure that the dilution hit you’re taking results in the percentage you still own experiencing a much great value uplift than had you bootstrapped.
Andy Lark once expressed this one year at Morgo as, “what would you prefer – a small piece of a portion of the hind leg of a cattlebeast, OR THE ENTIRE ANT?” If you’re seeking investment, make sure you’re selling a cattlebeast and not an ant.
A friend who is a startup CEO and founder adds (slightly paraphrased):
There is another tradeoff – remaining in NZ, or raising overseas where investment terms are generally more favourable.
I suspect that many deals are not optimal in that founders leave money and terms on the table, because they are less experienced at negotiating than the investors on the other side. If that’s the case, get someone with the necessary experience on your side, and ensure that their goals are aligned to yours.
Back to the original question: for very early stage companies, how do you balance dilution, current terms, and future rounds? My simple prescription is to figure out how much money you really need to (a) enable rapid growth that you can commit to now and track, showing a path to monetisation, and (b) avoid spending all of your time and energy on raising money for the next 18 months. Then execute and achieve those goals. And as a general rule, if you get an investment offer on terms you can live with, take it.
Sounds easy, eh.