The Dos and Don’ts of Financing Rounds: What You Must Know as an Early-Stage Founder
As the umbrella organization of Swiss startups, one of our goals is to provide our Startup members with relevant educational content which will help them take their startups even further. One of the topics we’ve noticed our Startup audience requires the most support in is that of how to finance your venture. Therefore, we invited three experts to share their knowledge with us at an Education Session held at the Prager Dreifuss Office in Zürich.
First, Guy Deillon, Associated Partner at Prager Dreifuss, discussed the documentation aspects that need to be kept in mind in order for a startup to be ready for a financing round. Thereafter, Dr. Johann Schlieper, President of Business Angels Switzerland, offered insights from an investor’s perspective into the various things which should and should not be done during financing rounds. Finally, Mark Meili, Legal Counsellor at Prager Dreifuss, explained the different financing methods which can be used when looking for investment. In this article, we have summarized the most important statements and explained them according to the following three questions: What should you keep in mind when planning and executing your first financing round? What are the different funding options? Which of these options would be the best fit for your startup?
Things to Keep in Mind When Preparing for Your Financing Round – Guy Deillon, Associated Partner at Prager Dreifuss:
1) An Unsexy but Necessary Task: Recordkeeping
Ensure that your documents are in order from the beginning, as professional investors will expect them to be. All of the relevant documents, such as customer contracts, employee contracts and documents needed for accounting purposes, etc. should be stored safely, with a trusted backup policy in place. Some examples of common storage services include Dropbox, Microsoft 365 and Google Drive.
2) The Shareholders’ Agreement: Don’t be Too Generous
In the case of Co-founders, it is important to establish a professional structure within the relationship from the start by creating a simple shareholders’ agreement. However, this is not only necessary for the relationship between co-founders, but rather also with other shareholders, too, including family, friends, the first few employees (in which case an Employee Stock Option plan is advised), and professional investors. The agreement should be kept simple, but complete with all relevant and important points. As it is vital to understand your shareholders’ agreement, it is advised that you ask your lawyer or legal advisor to explain the nature and details of the agreement to you. However, there are many templates for a shareholders’ agreement which can be found online, one of which is from SECA (Swiss Private Equity & Corporate Finance Association) which is known to be investor-friendly.
Additionally, it is important to be cautious in the beginning, as what you offer in the seed round in terms of the shareholders’ agreement will generally be the minimum you have to offer in the Series A round etc. For example, veto rights should be avoided, as they would allow a party to block certain decisions later on in the process.
Furthermore, the regulation of share transfers among founders (with employees etc.) should be kept in mind. It is advised that you maintain flexibility regarding the control over the shares throughout the process, as the transaction in your exit strategy, once your company is ready for it, may be blocked due to the unwillingness, and/or lack of readiness of one of the other shareholders to sell their shares.
As such, smaller investors and shareholders, including employees, should not have the right to block the next financing round and/or exit.
3) Data is the New Oil
Data protection law is becoming more and more important, and it evolves dynamically. Therefore, it is necessary to keep up with the changing regulation, and to take it into consideration early on. Though it may be expensive, you should seek advice regarding data protection law from experts, as the sanctions are extremely high and have the potential to ruin your business. It is recommended that you:
- Implement an acceptable level of compliance in your company to ensure the data security.
- Protect your data: It is more difficult to protect than to protect physical assets. Think carefully about how to do so and set up proper agreements to protect confidentiality.
4) Own and Control Your Immaterial Asset From the Start
It is vital that you protect your intellectual property, as it can become a key value driver of your business. Here are some of the most important tips shared by Guy:
- Use state-of-the-art NDA’s or patents.
- If you hire freelancers or agencies, whether it’s developers, marketing, etc., make sure the Intellectual Property right (IP) is transferred to you
- Avoid disclosure of confidential know-how
- Be careful when using third party sources, including open-source software. You may not have to pay for it, but there may be strings attached.
In the following section, we will discuss the various things which should and should not be done during financing rounds, from an investor’s perspective.
What Needs to be Kept in Mind During Your Financing Rounds – Dr. Johann Schlieper, President of Business Angels Switzerland:
The first question which a Founder needs to ask him/herself is: How much money do we actually need? How do we know that we are asking for the right amount?
1) Calculate Accurately:
Many founders do not know how much money to ask for, so they simply say that they need CHF 500’000. This is an immediate indication to investors that the founder has not invested enough time and/or effort into understanding how to valuate their company. On the other hand, it is crucial not to ask for too much money based on a too high valuation. If the valuation is too high, it will be difficult to justify this value in the future, leading to a lack of credibility on the founder’s side. This could also lead to a potential down round, which would be the cause of various disadvantages for the founder.
However, even if the valuation of the Startup itself is accurate, it is necessary to also calculate how much money is actually needed. If more money is raised than needed, too many shares end up being given away. Furthermore, startups that have an excess of money tend to get lazy and inefficient, and spend money on initiatives and projects that are not helping goals be reached. But the question of how to accurately calculate this number still remains. Only a proper cash flow calculation can provide an answer.
2) Build in a Small Reserve:
Once the amount of money needed for the Startup’s next milestones has been calculated, it is advised to add a small reserve on top of that sum. This is because things are unlikely to go exactly according to plan, in which case additional funds may be needed. However, this is not to say that the added reserve should be exceedingly high, as this will lead to unnecessary dilution. A reserve between 10 and 15 percent of the calculated amount in the first step is acceptable.
3) The Financial Plan Shows Whether Founders Understand the Business:
Business Angels will read the financial plan carefully, as this is the biggest indicator as to whether the founders understand the business. It is crucial that founders do the financial plans themselves, rather than outsourcing it to an accountant. While accountants are very good with numbers, they most likely do not understand the business of the founder, in which case the financial plan may not make sense economically, because the context of the business has not been taken into consideration.
4) There is a Maximum Amount which a Business Angel is Willing to Give:
Business Angels are often considered for funding after the 3Fs (Friends, Family and Founders). The maximum you can get from a Business Angel in their network is CHF 800’000. Venture capital firms (VC) may give you more money, but they start at 5 Million CHF, and they want to see traction – Otherwise they won’t even consider you.
As previously mentioned, 80% of the startups ask for CHF 500’000. As it’s statistically impossible that 80% of companies need the same amount, asking for this amount indicates to investors that the founder has not done the necessary research regarding their cash flow planning. Important to note, one should not ask for different scenarios or a range of money (i.e. “we are looking to raise between CHF 400’000-600’000”). Instead, only the calculated number should be presented. In this case, even if CHF 500’000 turns out to be the needed amount, it is better to ask for CHF 520’000 or CHF 480’000.
5) The negotiation with the investors / business angels:
When in a financing round, it is important to know how to interact with investors appropriately. Here are some of the most important tips shared by Dr. Schlieper:
- Be agile: Follow your plan, but be also flexible enough. If you are too stubborn about your plan, you will most likely not close the round. On the other hand, if you are willing to change everything to get an investor, they will lose their confidence in you. Being agile is a sign of a real entrepreneur.
- Inform yourself about venture terms beforehand. You should at least know about the terms like ABV, pre-money, Liquidation Preference, Anti-Dilution etc. to have a good discussion with the investor and make a good impression.
- Do not bring your lawyer to the first meeting. The investor could think you are not confident with what you are presenting.
- Show a high level of self-esteem in your business and have different options for how to reach your goals. Business Angels and Investors often look for or ask about that. The Investor must have the feeling that the founder will do everything to succeed.
The Various Financing Methods that Are Available to You – Mark Meili, Legal Counsellor at Prager Dreifuss:
Once the amount of money needed has been calculated, it is time to think about the financing method. There are several methods that can be chosen from, of which some of the most suitable for early stage startups are explained below.
1) Equity: The 3Fs
Most founders get their first set of funds from the famous 3Fs: Family, Friends and Founders. This is the easiest and fastest way to raise a small amount of money that helps build the first prototype or MVP. That being said, it is still advised to be cautious and prepare a shareholders’ agreement, so that the boundaries are set from the start. Often times, founders make the mistake of offering one of the 3Fs a seat on the Board, just because they invested in the Startup early on. This is not recommended, as money alone is not a qualifying factor for a board seat, the relevant skills and experience are.
2) Equity: Business Angels
Business Angels are able to provide so-called “smart money”. In comparison to the 3Fs, Business Angels have the relevant experience to share valuable information about how to found, build, fund and run a successful startup. They can share insights, connect you to people, and help you to avoid pitfalls along the way. Oftentimes, Business Angels join you before you even have your first revenue, but only have a prototype or MVP ready. There are multiple Business Angel networks which can be contacted, such as Business Angels Switzerland.
3) Equity: Venture Capital
Venture Capital firms (VC’s) can join at various stages of the Startup’s journey. Some participate in seed rounds, while others only participate from Series A rounds and later. Each VC has a specific sweet spot on the round, the amount, and the industry in which they invest. VCs mostly want to see a strong and international business case, otherwise they are not most likely not interested in investing.
4) Loans and Revenue Financing
When talking about financing a startup, it’s mostly about equity. However, there are other types of financing that don’t affect your cap table, as discussed below:
- Loans allow you to get a certain amount of money that has to be paid back over time, including a certain interest. Compared to equity, loans can be implemented very quickly – there are only a few formalities. However, a profitable business case is needed for banks and lenders to be willing to invest. Therefore, especially for early stage startups, this is often difficult to obtain.
- Revenue financing has become increasingly popular lately, especially among tech and software startups. If the startup were to charge their customers on a monthly basis, but have 12 months contracts, this form of financing would provide the money upfront. As with a loan, this can be implemented quickly.
While there are many more financing methods than listed above, it is important to be aware of the token. Professional VC investors shy away from companies with half-baked token issuance.
Conclusion – Five Key Takeaways:
- Be prepared and think about the exit from the beginning
- Try to keep control over any financing rounds and the exit
- Understand your business and its financing plan
- Never ask an investor or business angel for CHF 500’000
- Choose people with the right skills for your board, so they can advise you when you need.
Every month, we organize exclusive networking events and educational webinars. Do you want to find out more about our events? Or do you want to hear more about fundraising? Subscribe as a member of the Swiss Startup Association and be invited to our next sessions!