Friday, December 10, 2010

Financing approaches most likely to kill your company (if it is already on the edge)

Too Many Seed Companies Chasing Too Few VCs
Over the last 6-12 months there have been a crapload of seed stage companies that have been funded.  In another 6-18 months these companies will be running out of money, and all will be pitching the same small set of VCs at the same time.  While the number of angels (and the amount they have available) has expanded dramatically, the sames does not hold for venture funds.

What does this mean for your company?
There will be 3 tranches of companies:
  • Superstars/Hot Companies.  These are companies that have traction, and/or are perceived as market leaders, and/or are in a hot space (e.g. Foursquare in 2010 or GroupMe recently). VCs will cherrypick these companies and will compete aggressively with one another to fund them.  They will have massive valuations reported in TechCrunch and long comment threads about how the company "suxxxx" and does not deserve such a crazy valuation (remember all the comments every time FB raised a round?).
  • Middle of the pack.  These companies will not have had break out traction yet (e.g. will have 50K users), but will have built a  reasonable product and have a "great team".  Some of these companies will be able to raise additional capital, or be able to survive based on cash flow (and may need to cut their teams from e.g. 6 people down to the original 3 founders).  Some of these will end their lives as "large small acquisitions"  - e.g. sell for $5-$20 million depending on timing, technical assets, size of team, and market.
  • The dead or talent hires.  These companies will shut down or, best case, will be "acquisitions" where the team is paid a slightly larger then normal hiring bonuses or option packages to join an "acquirer".
Your Funding Structure Today Impacts Whether You Are Middle of The Pack or Dead Tomorrow
The line between "Middle of the pack" and "Dead" will be a fine one.  One of the characteristics that may tip companies from Middle of the pack into Dead is the existing cap table/financing structure of the company.

Worst Financing Structure to Have:  Equity round, high price, with multiple VCs
  • Multiple VCs.  Having multiple VCs in the round is going to lead to very bad signaling characteristics for you if your company is only doing so-so.  
    • These same VCs who a few months earlier were competing with Superangels to get into your round will suddenly realize you did not grow into the hot company they were hoping ("We love you and the team", they will say "This is strictly a business decision.  We are big fans of yours but can not invest any more")
    • They are used to doing $5 million investments.  The $100K they invested to you does not impact their fund economics.  And the opportunity cost of partner time is too high.  They will not do a follow on round with you (as they can invest the same $3-10 million in a company with real hockey stick traction instead).
    • All the other VCs you pitch will ask why non of the 3 VCs who invested in you are driving the round.  They will call said existing investors who will say "we love the team, but they just don't have the traction we are looking for".
    • This will kill your ability to raise money unless you are a "Hot Company".  Goodbye company!
  • High priced equity round.  The second worst thing to having too many VCs in your round and the associated signaling risk, is to have a high priced equity round. 
    • Doing a down round (raising at a lower valuation then your last round) often invokes a lot of dilution due to the equity financing deal terms.  You may go from owning 30% of the company each as a founder to a few %, depending on the terms and the next round you do.
    • This will kill your incentives as founders and early employees.  Do you really want to work 14 hours a day for so little of the company?  
    • Have you read your equity financing docs closely?  Do you really understand all the terms? Make sure you read the section about down rounds closely.
    • People with low equity valuations will be fine.  If you raised at a $2 million valuation, the next bump up does not need to be huge to de considered a success.
Best Financing Structure to Have:  Convertible note, no VCs (i.e. only superangels and individuals)
  • No VCs in the round.  The fact you did not include VCs (despite their promises of all the value they will add) means you have no signaling risk.
  • Convertible note.  Many recent convertible notes are structured with a cap but no discount rate.  This means if you have a convertible note with a $6 million cap, but you raise a round at a $3m pre-money valuation, the note will convert at the $3m valuation.  As an entrepreneur you get diluted more then expected, but no ratchet is triggered, and no big penalty is paid.
Obviously, what financing structure you have is secondary to whether the company hits it out of the park or not.  If your company is doing awesome, or is perceived as such, your existing cap table becomes pretty unimportant.  However, if things are only going so-so, your past financing events can impact things a lot.

What do you think?  What besides past financings can tip a company from being "middle of the road and fundable" to "walking dead"?

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