Fundraising is an ongoing effort that entrepreneurs and founders need to manage when starting and scaling an early-stage company.
Savvy and well-read founders seeking to raise funds from investors usually use the phrase “smart money” to explain the type of investors they want to take a stake in their business.
“Smart money” means money raised from an experienced, smart, and well-informed investor. A “smart investor” provides both cash and invaluable benefits to your company like opening new doors to other strategic investors, partners, or potential new customers.
“Dumb money” means exactly what it means. A “dumb money” usually described an investor that invests in nothing more than capital with no real influence on growing the business.
Unfortunately, many entrepreneurs and founders can quickly end up as “dumb entrepreneurs” by making frequent and easily avoidable mistakes. These mistakes often create another risk of the venture and startup’s success and expose the entrepreneurs to even criminal offences.
After helping venture funds, funding agencies and early-stage companies for the past several years as a venture and startup lawyer, I have seen several founders and entrepreneurs ended up becoming “dumb entrepreneurs” by making some of all of the following mistakes below.
Using an introducer to secure investment
In your entrepreneurial journey, you may come across people claiming that they can link you with this investor and that investor. In exchange for securing the investment, the introducer will get a ‘success fee’ (also known as ‘broker fee’ or ‘introducer fee’) that you must compensate for his “expert” investor matching services.
Consider the challenges of compensating a broker carefully. I have not met an investor who is okay for a percentage of his investment money is deducted to pay off a broker. I also know some investors that reject outright any pitch unless it is done by a cofounder or a senior team. As an entrepreneur, you should ask yourself whether you are serious about outsourcing your investor pitch to brokers you do not really know?
All or most investors I know are usually approachable people. You can reach them out easily on places like LinkedIn or even Twitter. Drop a note and ask if they are open to a quick phone call about your company. So, think carefully if you need to get a broker to help you with your fundraising. An early-stage company using a broker to get a pre-seed or seed round tends to be a ‘red flag’ and give a ‘poor signal’ to potential investors.
Approaching investors too early
Here is a blunt truth. Elon Musk or Mark Cuban can raise money with only an idea. The rest of us mere mortals need to have a strong and solid management team, unique products, innovative technology, a perfect and compelling pitch on the business potential on the targeted market and a visible exit strategy.
Suppose you try to raise money when you are not ready or even building a track record or demonstrate any form of success. In that case, it usually ends up a waste of valuable time (for both the founder and the potential investor as well).
We all have been to pitching competitions before. You would have seen how unprepared founders get slaughtered all the time by ruthless venture funds and investors. You need to know the hard numbers about your business and explanations on how you come up with their “X” mil valuation, financial model, revenue strategy, you know the rest.
There is also another challenge if you pitch too early to investors. Bad pitch can also result in you losing credibility, i.e., “social capital” among potential investors. It may be better if you spend some time building some tractions or solid numbers before you start pitching. And spend this time to also get yourself educated about what goes into fundraising. On a side note, I enjoyed reading Cheryl Yeoh (entrepreneur and first CEO of Malaysian Global Innovation & Creativity Centre (MaGIC)) piece on fundraising for a first-time entrepreneur doing capital raising. And I suggest you should read it too.
Aspiring entrepreneurs or founders may get a shock or disappointment whenever I tell them that a typical fundraising timeline is between three to six months.
Institutional investors like corporates or venture funds may even take longer than this depending on the intensity of their assessment and due diligence process. I have said this before, but I’ll repeat it. No investor wants to inherit your company’s problems. Remember that you are trying to get people to part with their (hard-earned) money. They deserve to know what they are getting themselves into when they invest in your company, especially your company’s legal and financial health.
In other words, you need to have a fundraising roadmap to manage your internal expectations on your current funding needs and expected external funds. Many founders made a mistake of raising too little money. If you think about it, the physical and emotional bandwidth in raising RM250,000 or RM500,000 is similar. To avoid having to start fundraising again just six months after you closed your last round.
Ask any entrepreneur that has been through a fundraising process. Or even founder that raised money on an equity crowdfunding campaign hosted on a crowdfunding platform. Fundraising can be emotionally and physically demanding.
Ignoring securities and companies’ laws
Early-stage entrepreneurs like to think they are immune to company law. As a company, they are a set of securities laws that need to be satisfied before shares can be issued to an investor. If you are a director (which is indeed the case if you are a founder), you can face penalties and fines for failing to issue shares according to the securities laws.
Remember I told you earlier about the founder that took money from an angel without signing any paperwork? Doing future fundraising can be hard when you cannot be clear as to the current ownership structure of the company. It is unlikely an investor may want to invest in your company if you have violated securities laws when raising earlier capital rounds.
Be that as it may, companies’ law do allow a small narrow exception if you are offering to close members of the company like a close family member of an employee or a shareholder of the company. Realising that this can be prohibitive for many, the regulator has permitted equity crowdfunding as another fundraising option. A start-up or small business can raise capital with relatively large numbers of investors in exchange for shares. You can also host your campaign, publicise, and facilitate such equity offers to crowd investors.
Overvaluing or undervaluing the company
While vetting potential investors, startups, and founders need to avoid overvaluation or undervaluation of the business.
In my experience, it is surprisingly easy to get money from unsophisticated investors at unrealistically high valuation (for instance, taking money from your ‘rich uncle’ that has too much money laying round). But think about the implications of taking in too much money at such an early stage of a business. You and your co-founders may end up with problems in the next several months when you want to do another fundraising with other investors at an appropriate valuation. It is difficult and may have to take up new money at a lower valuation (also known as a ‘down round’).
You may end up having to address a group of frustrated initial investors that will be forced to accept an unexpected reduction of their stake and dilution of their ownership or rights as an earlier investor in the company.
Additionally, undervaluing your company can be just as bad. Raising funds at an unreasonably low valuation means you will give away too much equity to the investors. As a founder, you may reduce your potential financial success in the future during an exit scenario like an initial public offering (a corporate exercise where a private company becomes a public company and sells its shares to the public for the first time) or a trade sale (like selling to a strategic partner or a corporate). You may end up getting paid less because you get diluted too significantly at the early stage of the business.
Taking money from any investors that offers money
As a founder, you must carefully assess every potential investor as much as a potential investor is assessing your company. Different investors have different characteristics and preferences. Take your time to know them well before you agree to take their money.
For example, more angel investors especially business owners and professionals are now getting involved in pitching competitions to find good companies for investments. News about unicorns and how investors achieved financial success in investing in startups attracted startup investing as another asset class.
I recall a founder who told me that an angel investor was telling everyone that the founder now works for him as his employee, simply because he decided to invest in his company. I also recall another founder telling me that an angel will invest in his company only if he agrees to designate the angel as another cofounder. In reality, the designation does not carry much difference, so the founder decided to such a request. This kind of stuff does happen.
You may end up struggling to manage your business while being obliged to listen to unsolicited advice on how to run your business from unknowledgeable or inexperienced investors. You need to know how to put them in a box (usually covered inside a good shareholder agreement) while ensuring that you don’t neglect their rights as an investor like being regularly updated about the business progress.
Using a complicated and technical investment structure
There are only a few financing structures that can be used by a company like issuance of either issue ordinary shares or preference shares to an investor. The legal fees associated with such structures are generally reasonable.
In my experience, entrepreneurs who try to reinvent the scheme may incur more legal fees over the usual amount. In practice, creating complicated and onerous deal terms tends to create issues for future investment rounds when introducing new investors with non- industry-standard terms.
There is a general trend in Silicon Valley for early stage deals to be two types. One is the Y Combinator’s accelerator “simple” investment agreement called SAFE (Simple Agreement for Future Equity) document. A second most popular option is the 500 Startups’ KISS (Keep It Simple Securities) convertible note. I will not delve into details on the pros and cons of any of these instruments. But for any of them to work here in Malaysia, the commercial and legal terms need to be considered and localised carefully to fit into the company’s laws that we have in Malaysia.
On a side note, they are inherent complexities in both instruments (you can read them on the web like pricing the round and managing founders’ future dilution). So, you need to know what you are dealing with before happily signing off on the dotted line. It may be most appropriate to stick to a straightforward vanilla instrument like selling your company’s equity in practice. The usual way is to offer your company’s equity in exchange for money so that you can get back to growing your business.
Raising money for the sake of raising money
There is a common saying that “equity is the most expensive form of financing”.
Consider carefully, why do you need to raise outside capital. I do know some founders that fundraise because that is what everyone is doing.
Some founders I met do not even consider bootstrapping (i.e., running a company using your personal savings or resources). Do not get me wrong. I am not asking you to bootstrap forever. For example, you should try to generate revenue for your business before you attempt to raise money.
Some successful bootstrapped companies that have been successful are Mailchimp, Lynda, Shutterstock, GoFundMe, GitHub, Shopify, and many others.
Ignoring the important legal and fundraising agreements
In my experience, early-stage entrepreneurs usually like to brag on how their angel investors trust them so much by putting in money in their bank account. Once an investor invests in your company, the investor becomes another shareholder in the company together with other cofounders. You should have a formal agreement in place (usually a shareholder’s agreement) setting out the rights and obligations between the cofounders and the investors.
Raising money from investors may be the most important corporate exercise you will undertake as an entrepreneur or founder. Treat it seriously and with respect.