Avoiding the funding trap

Posted in Investing, Funding by Alastair Stewart on Mon, 9 Jan 2012

One of many things we look out for when looking at new investment opportunities: a funding trap. If we can see a high risk of being stuck in one of these, more often than not we will pass on the opportunity. How do you avoid getting "rejected" for this reason?

 

 

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Many companies raise capital from investors with the intention of raising another round in future. Usually the intention is to do this around the same time as hitting some technical or commercial milestone so that the valuation will be increased (see “Plan” on the chart).


The need for new funding often comes sooner than originally anticipated (milestones take longer to hit and cash burn may be higher than forecast) but this should never be a surprise to those sitting round the board table (see “Reality” on the chart).


So, we have a start-up which is unprofitable (losing money) which is approaching cash-out in a couple of months. Assuming nobody wants to let the company run out of money there are a couple of options:

  1. raise money from existing investors only
  2. raise money from a combination of existing and new (external) investors
  3. raise money from new (external) investors only

We'll ignore 1 for now - if the existing investors can (and are willing to) fill the whole round if need be, then all is fine. Things get a little more complicated with 2 and 3, and here we reach our point:


There are few better ways to lose value in your portfolio as an investor than having portfolio companies being forced to take on capital from new “external” investors at times when they really need it.


The mechanism for losing value is dilution, purely and simply. New money has all the pricing power. Investors do not like getting into this position.

 

How do you avoid getting "rejected" for this reason?

  1. Make sure you give PLENTY of time for any planned future fundraisings. Even if you are hitting technical and commercial milestones, external factors like a general shortage of capital in the market may make things difficult (as was painfully demonstrated in 2009). Plenty means six months, not three.
  2. Make sure you're out on the road fundraising well in advance of the milestone which will trigger an acceptable price. You can guarantee incoming investors will demand to see that milestone hit before writing a cheque at an acceptable valuation.
  3. Many funds like to see at least one year's gross burn going in in a funding round so this can be a guide as to how much to raise. Nobody wants to be constantly on the road looking for money.

 

 

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