Early stage investment tradeoffs

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.

Publons angel exit

Daniel Johnston and Andrew Preston at Startup Weekend Wellington 2012

Publons, a company that came out of Wellington’s Lightning Lab accelerator in 2013, and of which I was the first investor and (until 31 May) Chairman of the Board, has been acquired by Clarivate Analytics. Publons provides a platform that gives academics credit for the peer review work they do, and whose mission is to “speed up science through the power of peer review”. Clarivate’s mission is to “accelerate innovation”, and are the main authoritative industry source of, inter alia, academic bibliometrics. Clarivate was formerly known as Thomson Reuters IP and Science, and changed its name when it was bought by private equity interests last year.

It is New Zealand’s first significant exit from an accelerator programme.

I’ll write more about this in the coming weeks, as it bodes well for the New Zealand startup ecosystem. Founders, employees, and investors all did well out of the exit, and much of the proceeds of the sale will be ploughed back into local startups.

The Publons story is a textbook case of how to build strategic value: “‘Publons now find themselves at the heart of the rebuilding programme to support Clarivate’s reinvention, and a vital part of the system of reference and authority needed to maintain scholarly communication in a digital, networked age,’ says David Worlock, a UK-based publishing consultant with knowledge of the deal.” [Nature]

“It’s a huge win for startups, their founders, and investors…” [NZ Herald]

More coverage:
Peer review is thankless. One firm wants to change that. [The Economist]

Funders and publishers will likely be glad to see a visible expansion of the pool of peer reviewers with validated track records. And more researchers may see the benefit of easily creating a record of their peer review work. Expansion and independence of publishers may well give Clarivate Analytics sufficient advantage to establish Publons as the de facto standard for crediting peer review. [The Guardian]

Formal recognition for peer review will propel research forward. [London School of Economics Impact Blog]

The companies describe themselves as the world’s preeminent citation database and the world’s largest researcher-facing peer-review data and recognition platform. [Research Information]

Peer review is at the heart of our ability to trust research but is often accused of being slow, inefficient, biased and open to abuse. By recognising reviewers and bringing transparency to the review process, Publons has built a platform to conform these issues head on. And now, with the worldwide reach, citation network and research tools offered by Clarivate Analytics, we can tackle these global issues on a global scale. [Victoria University News]

Peer review is the last, great, closed part of the research lifecycle. Data on peer review needs to become a core component of the research record. Bringing transparency, recognition, and training to peer review will result in better reviewers and a faster, more trusted research process. [Publons blog]

The Publons deal will give a much-needed confidence boost to the local [NZ startup] ecosystem which is very positive. [Ben Kepes’ Diversity blog]

It takes a village to raise a startup, and I’d like to thank the following people and organisations for their hard work and support:

  • The founders, Andrew Preston and Daniel Johnston – visionary, hard working, resilient, crazy smart, coachable, humble, trustworthy, team players, and rigorously scientific in their approach. That’s really the investable founder checklist.
  • The Publons team, who continue to pull out all stops to speed up science
  • Investor and board advisor Simon Swallow, a steady hand with laser focus who backs up his excellent advice with the hard yakka to bring it to fruition
  • Our local Wellington angel investment club, AngelHQ, and particularly the legendary Serge van Dam and Trevor Dickinson
  • Strategic investor SAGE Publishing Group, and their fearless leader David McCune
  • Institutional investors K One W One and NZVIF’s Seed Co-Investment Fund
  • CreativeHQ, Lightning Lab, and Dan Khan for running New Zealand’s first accelerator programme from which Publons was launched
  • My own family whose trust and support are the pillar of my strength
  • All of the reviewers on the Publons platform