SternFisher Blog

Envestors is an intermediary connecting entrepreneurs and investors. They focus their operations in the UK region and have a network of 400+ business angels looking to invest between £20k to £2m in high growth companies.

Entrepreneurship is a team game and the relationships between the founding members are key to long term success. What is important is not merely complementary skill sets but similar, or at least complementary visions, values, and styles. Founders need to recognize each others’ value and respect what each brings to the project.

What makes the relationship between founders hard is that often they  start off as best friends or worse still, family. This makes it difficult to discuss the softer issues that need to be brought into the open. Which is a pity because a high percentage of  startups fail because of ruptures in the founding team.

So my advice: don’t postpone talking about the touchy feely stuff till its too late:

1. why are each of you doing this - money, the desire to become a legend, to ‘make a dent in the universe,’( Steve Jobs), to be your own boss

2. what are the core values you want the startup to embody? growth, fair-play, openness

3. What do rules mean to you and how far are you willing to go to bend the rules?

Discussing such things is important right from the word go. Of course there are exceptions. Steve Jobs and Steve Wozniak fell apart due to a difference in values. In their case I can’t help feeling, given Jobs intransigent personality, that it was best that differences were swept under the carpet in the early years, giving the partnership the longest lease of life it could hope for. What do you think?

And more importantly, how are you feeling about your co-founder right now?

During the past decade, entrepreneurship has become a commonly taught subject in universities. Today, most business schools offer majors in entrepreneurship along with majors in more traditional business areas such as finance, accounting and marketing. However,  the effect of entrepreneurship education is unclear. The main question is the extent to which entrepreneurship is a function of people with definitive personality traits or whether entrepreneurship concerns knowledge and skills which can be developed through education.

If you believe, as I do that entrepreneurship is a function of people with definitive personality traits, along with technical knowledge, ( as opposed to functional knowledge of business), then you should ask yourself to what extent would a b-school foster your innate entrepreneurial fire. While it is true that there are more entrepreneurs emerging from b-school programs focussing on entrepreneurship as compared to b-school programs with other specializations, the vast majority of entrepreneurs have not been to b-schools. This phenomenon is not just because b-school education for entrepreneurs is in its nascent stages ( relative to other specializations) but also because there is something about b-schools that deadens the e-spirit, numbs the risk taking appetite and co-opts a would be entrepreneur into a comfortable fat-check status quo. So my take - forget b-schools, and find other ways to pick up basic accounting.

We return to the question of how much money you should try to raise. There are some businesses which by their very nature require huge upfront investments. Infrastructure which is a hot area today is one such.

A startup which is attempting to raise a huge amount of money for such a project must be realistic about its current assets ( as opposed to its future value as perceived by its promoters).

Take for example a startup that wants to raise $100 million. A VC firm invests in a number of proposals to diversify risk. Only a VC fund with $ 1-2 billion or so in capital could contemplate investing in such a proposal. There are very few such firms.  

Further, given that neither the startuo nor the VC would want the VC to take more than 20% stake in the company, the startup would be in effect valuing itself at around USD 550 million in asking for this amount. 

Even a great team with a great idea may not merit this valuation unless it is backed with tangible assets like patents.

In order to increase its chance of succeeding the idea needs to be broken into smaller components. How best to do it will depend on the context. 

So think big but don’t become too big to succeed. In this way, one day you may become too big to fail!

Some investors, particularly individual investors, don’t want board seats because it exposes them to some legal risks. However, most private equity firms (including early stage venture capital firms) would seek at least one board seat so that they can protect their economic interests.

The number of seats required by a VC/PE firm depends on the size of their investment, the total number of seats in the company’s board, the presence of other investors, and the rights enshrined in the company’s shareholders’ agreements and memorandum of association. If the company already has a large board, then a VC may feel that only one seat would not provide veto power to block certain decisions, such as raising more money from banks or investors. On the other hand, the presence of another friendly VC/PE firm on the board may obviate the need for another board seat. Alternatively, certain decisions of the board may require unanimity according to the shareholders’ agreement; this too would reduce the need for more than one board seat.

Another reason to have multiple board seats is to allow for flexibility in case one board member is unable to attend a meeting. This problem can also be handled through the concept of a board alternate, whose role is to act only as a substitute when required.

In a VC/PE transaction, the number of board seats required by an investor will be a matter of negotiation. One must consider the issue in the context of a broader negotiation with regard to control and economics, and be prepared for some give and take.

Private equity firms, including early stage Venture Capital intevestors, often insert a clause for mandatory redemption of the preferred shares that they have purchased. That means that the company is required to return the money that they received from the investors after a stipulated time (say 5 years), plus interest. Since many companies would not have enough resources to redeem the shares, this clause can trigger a “liquidity event”, such as the sale of the company.

Many VC/PE investors include a redemption clause because the money they have invested in company is not their own; it belongs to their investors, also known as “limited partners”. The like having some assurance that they can exit the company within a reasonable time period, so that they can pass on the proceeds to their investors. However, having to redeem shares is a suboptimal result for VC/PE firms. The goal of VC/PE firms is to reap capital gains that are multiples on the money they have invested, so earning a debt-like interest is an outcome that they hope to avoid.

The redemption of their investment is something that is at the option of investors. It is unlikely they would agree to a redemtion that would be at the option of the entrepreneur, as this might limit how much the investors could earn. Since VC/PE investors take large risks, they would typically not like to limit their potential return.

Dilution is a function of your company’s value and how much you plan to raise. For example, let’s assume that your company is worth $9 million. In other words, the total value of the equity shares that have been issued equals $9 million; this is called the “pre-money valuation”, since it’s what the firm is worth before receiving investment. If you now want to raise $1 million, then you clearly cannot continue to own 100% of the shares, so your percentage ownership will necessarily go down (or “get diluted”). After receiving an infusion of $1 million, your firm would now be worth more than before, since it now has $1 million of extra cash — in fact it would be worth $10 million ($9 million + $1 million). This is known as the post-money valuation. If you originally owned all of the shares, then you will go from owning 100% to owning 90% of the equity shares. You have been diluted by 10% (100%-90%). As you can see from this example, dilution equals the funds invested divided by the valuation of the firm after receiving the investment (”post-money valuation”, which in this case is $9 million + $1 million = $10 milion).

There is no hard and fast rule regarding how much dilution to expect from an early stage investor, but it can range from a few percentage points up to close to 50%. A VC may want a board seat, so it’s not in your interest to give up a board seat for a very small amount of investment. On the other hand, an angel investor may be happy to make a very small investment with no expectation of a board seat, in which case the dilution would be minimal. If you are looking for a large investment, you may get diluted significantly, but a smart VC investor would not want to remove your incentive to make the company a success. So if the dilution is very high, say around 50%, the VC firms may actually lose interest because they feel there’s not enough incentive left for you.

The challenges are

1. Cognitive: coming up with and constantly tweaking an idea till it works
2. Emotional: Patience, pluck, leadership, risk taking ability, staying together 
3. Financial: Conserving cash till the idea is proved. Finding the right investor
4. Competitive: Establishing and sustaining advantage through customer relationships, brand, patents, copyrights 

Must Haves:

great team, workable idea( not necessarily the big bang, but an idea that with massaging can go somewhere), potentially big market,  linkages with suppliers, partners, customers, incubators, government.

  Good luck!

Recession is the best time to start a company as the opportunity cost is low and resources are available cheap. It is a time when old models are seen to fail and when the market for new ideas is on the upswing. Of course, investors are also wary, but you can’t expect them to come in before a year or two is over in any case. So if you start in the recession by the time the recession is over you are ready for their money!

The mantra for success should be ‘ Think big, but take one step at a time. Don’t get attached to the first idea you have. Keep the team together, and don’t run out of cash.’

Its amazing how many of the factors that determine the success of startups are outside the control of of the team. These include regulations, the state of the economy ( boom/bust), and the readiness of markets, both on the input side and the output side.

Infosys could not have made it big without the pool of engineers created by the educational infrastructure, the downturn in the US economy in the 1990s, and the development of communication technology in the 1980s. They could not have made it without the patronage of the government which granted land at concessional terms, and a plethora of tax breaks which continue to this day despite Narayan Murthy’s view that the IT sector no longer needs sops.

In the light of the above, spend a lot of time thinking about the external environment and what it means for the success of your idea. What in your external environment is favourable/unfavourable to the success of your idea?