Founders, your job isn’t just to build a great business. If you’ve decided to take VC financing, your job is also to create an attractive investment opportunity.
This is where we see so many early-stage founders make mistakes. They wrongly take investors for sharks, however the most egregious mistakes we see are made by those founders who have a limited understanding of equity fundraising and valuations.
While innocent, these mistakes can have a huge knock-on effect and potentially mean the death of your company.
Understanding how to make your business an attractive proposition to investors starts with understanding how to make it an unattractive one. So listen up, founders, if you want to make your company uninvestable, here’s what to do:
1. Give your investors non-diluting shares
There are three certainties in life; death, taxes and dilution. The phrase ‘non-diluting shares’ is a misnomer. These are shares that don’t get diluted in the next funding round, so other investors — and founders — get diluted so that investors can maintain their equity. If you promise these to anyone, what is actually going to happen is that you will be giving away more shares out of your own pool to top up theirs — meaning founders rapidly become diluted.
We recently saved a founder from giving away 30% equity in non-diluting shares. Had he accepted the deal, the next round would have seen his shares diluted to under 50% by his making good on that non-dilution promise, leaving him as a minority shareholder in his own company.
If future investors see that you’ve been so generous (or taken advantage of) by previous investors, they’ll likely request the same for themselves, exacerbating the problem further.
2. Get people to work on your product without any contracts in place
In the initial stages of a business, you often start working informally, without any contracts in place. However, the absence of contracts for anyone making a contribution to the business can be extremely problematic — without something in place, they can claim to own that piece of the product. If payment is made, typically the company owns intellectual property, but if you didn’t pay them or they did you a favour, things can get very tricky.
As part of due diligence in later-stage rounds, companies will have to assert that they own all the intellectual property used in their product. That usually means a mad scramble to find contracts for everyone who has provided services. If you never had contracts in place with them you’re going to have the difficult task of chasing them down and persuading them to sign now.
3. Go with a crazy first round valuation
Founders see all sorts of amazing valuations in the media, and they know that the bigger the valuation, the less equity they give away. But a high valuation can be problematic and can deter investors.
If an investor does buy into an insane valuation, it’s going to be a challenge to sustain it in the next round, and you’re likely going to have to do a down round — raising at a smaller valuation in the future — making everyone unhappy. An alternative is to slightly undervalue the business so initial investors get a clear upside on their investment and are delighted to invest more in subsequent rounds.
4. Give investors the right to sell their shares back to the company
Some investors want to shorten the odds and stipulate that if the company hasn’t been sold within a certain number of years, it will buy investors’ shares back from them. This is a disastrously bad thing to agree to. What if the company doesn’t have the money at the time? What valuation are you agreeing to buy the shares back at? And even if you agree to it for a small investor, there’s a chance other investors will want the same in the future, at a much larger cost to the business. Founders should say no if this request ever comes up.
5. Have four or more founders
According to SeedLegals data, most companies generally have two founders, and from time to time, there are one or three. The data also tells us that companies with two founders are more likely to complete a funding round than those with one or three founders, and to complete the round faster.
Four is simply too many. Of course, there are exceptions, but there are often founder fall-outs. It doesn’t have to end disastrously if the founders have share vesting in place, but it’s worth exploring other options, such as making some of those early team members a ‘founding employee’ rather than a ‘founder’.
You’ll make mistakes building a company. But there are many — like the ones that I’ve laid out here — that you should never have to live through.