How to Lose a Startup: Options for Proper and Improper Investment in Developing Companies
A poorly thought-out scheme and structure for financing a company can lead to the loss of your startup. To understand the reasons for failure and how to avoid them, it is necessary to consider the conditions for the development and financing of a new business. How to avoid losing control over the company or the company itself when attracting investments through various options—venture capital, IPOs, and equity crowdfunding.
The idea of using private capital is an excellent solution for situations where a company is just starting its development. Additional funds raised from external sources can make your startup successful in the market. But what are the conditions for investment? How and in what ways do founders pay, and how beneficial is this for them? Let's try to understand the pros and cons of crowdfunding, public offerings, and venture investing.
Attracting Venture Capital
Venture capital, or private capital, is attractive for startups. However, when investing in a growing company, venture shareholders demand specific conditions to secure their investments. This is understandable, as such financial infusions are considered risky and must therefore yield higher returns. This cost of capitalization is advantageous for venture shareholders but is not always acceptable to founders, who must compensate for the financial resources by transferring control over management and a significant portion of profits.
Conditions for Venture Investment
Professional investors involved in funding developing companies and businesses at risk include venture capitalists, angel investors, and private equity funds. By offering their financial assistance, they impose several strict conditions, including priority returns on investments. All earnings are tightly controlled and directed toward returning investments, often at the expense of the company's development and expansion. Additionally, membership in the board of directors with the right to a decisive vote on determining the company’s overall financial policy is mandatory, including decisions about selling the company to a strategic investor and liquidating shares owned by the founders themselves. Such concessions by the founders of the business in favor of investors lead to the former losing control over the company, handing it over to professional venture shareholders.
Moreover, in the event of a company’s less than successful development, for which only the founders are responsible, venture investors may take very harsh measures: dismissing the founding entrepreneur from their own company, depriving them of (devaluing) their shares.
Example
To understand the essence of the issue, let's consider the example of the successful company Slack. This company has succeeded in the market and has become a "unicorn" (a term for companies with a capitalization of over a billion dollars). Slack reminds us of the real cost of venture capital: after investment, the founders received 8.6% and 3.4% of the company's value, while the largest shareholders—venture firms Accel Partners, Andreessen Horowitz, and Softbank—acquired 24%, 13.3%, and 7.3%, respectively. Thus, the shareholders gained control over the company, and the majority of profits also remained in their hands.
Initial Public Offering (IPO)
The simplest and most advantageous method for entrepreneurs to attract investment is to make the company public, which implies an initial public offering (IPO). This option is convenient for founders since a single type of stock without management rights is offered for issuance and sale, meaning no one other than the entrepreneurs has any levers to manage the company. Unfortunately, this method can only be used by profitable companies that have been on the market for several years.
For small companies with a product that urgently needs money for development and production, there is another excellent financing mechanism: Pre-IPO. In fact, it is a sale of shares, similar to an IPO, but the sale amount is limited to $1,070,000.00.
Pre-IPO is the fastest path to an IPO. A company that successfully raises the entire amount for Pre-IPO ($1,070,000.00) can go for a real IPO within 4 to 6 months. However, there are pitfalls. If Pre-IPO is unsuccessful and only 10% to 30% of the funds are raised, then the IPO is postponed for at least a year, or even several years, until the company achieves real profitability. An unsuccessful Pre-IPO indicates a lack of investor trust in the company and/or the management’s inability to work with investors. The company may be excellent, the product magnificent, and the team phenomenal, but this information may not be communicated to investors in the right way.
Risks of Public Enterprises
IPO resolves several issues at once: influx of finance, access for a wide range of investors to objectively (by market standards) valued securities, freedom of action for owners in managing shares, and increased liquidity of shares. Regarding investor-shareholders, such public companies maintain the principle of accountability and transparency of all actions.
However, even in the case of an IPO scenario, entrepreneurs are also exposed to risks, which can be conditionally described by three types of scenarios:
- Business Errors. The results of mistakenly made decisions are neutralized by the board of directors, which fires the CEO, recapitalizes the company, and takes away shares owned by the founders. Another solution to the problems is selling the company and distributing the revenue obtained among investors.
- Insufficiently Rapid Growth of the Company. The consequence is a financial crisis due to the inability to cover rising expenses with increasing income. The exit is a second round of fundraising, which becomes problematic due to low confidence in profitability. If investors are found, they will agree to reduce their stake in the business, but the founders are left with nothing but to transfer their own shares.
- Rapid Growth of the Company. As it turns out, this option is also risky for the founding shareholders, as investors benefit from independently managing the "unicorn," leading them to fire the CEO or try to sell the company altogether, securing a profit of about 20%. In a favorable outcome for the founders, investors may wait for the IPO. The problem is that a rapidly growing company can choke due to a lack of cash. Founding shareholders can obtain this cash only under very unfavorable conditions.
Examples
Among the companies that have succeeded in their development by announcing an IPO are well-known names: Alibaba Group, Visa Inc., Facebook, General Motors.
A notable example is Mark Zuckerberg and Evan Spiegel, who received a tenfold voting right through a dual-class voting structure. In this structure, the business can issue new shares that have only 1 vote (or none) compared to 10 votes per founder's share (and possibly early investors). This means that founders retain their voting rights regarding their business. For example, Zuckerberg and a small group of investors own nearly 18% of Facebook's shares but control almost 70% of the voting shares.
The same is done at Google, where the "founding fathers," owning only 16.6% of the shares, fully control the company.
Equity Crowdfunding
Equity crowdfunding is a way of acquiring investments in which founders, receiving financial inflows in the required amount, continue to maintain control over the development of the enterprise, profit generation, and distribution, as well as the retention or sale of the company.
This type of capitalization first became possible in 1933 with the enactment of the Securities Act. It was then that the general public gained the opportunity to invest their funds in developing companies and startups.
Advantages of Crowdfunding
In addition to maintaining control over the company, founders gain the advantage of crafting the terms of capitalization. A significant convenience is working with small investors, who do not require special treatment and do not wish to take control and management. Such investments do not tighten the noose around entrepreneurs' necks, providing them with freedom of action.
Another feature of equity crowdfunding is that founders can practice continuous capital raising from investors, unlike the first option of attracting venture capital. Investment in the first type occurs as needed, that is, in case of necessity or favorable growth forecasts. In this scenario, the founder, upon reaching the necessary level of capitalization, often shares a significant portion of their stake or even loses it altogether while obtaining a unicorn company.
On the other hand, the concept of equity crowdfunding does not involve the rush to immediately gather the required funds; there are no demands to meet planned sales, but rather a systematic and ongoing collection of money. The key to this concept is the ability to properly part ways with majority investors who have the right to direct management of the company.
Equity crowdfunding can be implemented in several stages. For example, in the first stage, it is possible to raise 1 million dollars (in fact, this is Pre-IPO), spending 100 thousand on legal and auditing services, and then gather another 5 million (or more) dollars through a Regulation A+ campaign. And in both stages, the sale of common shares is permissible, which is entirely not risky for the founders.
There is another attractive side to equity crowdfunding: an army of shareholders emerges, becoming brand ambassadors and the most loyal customers the world has ever known.
Example
A striking example of crowdfunding is the company Uber, whose first investors received $2000 for every dollar invested. This, of course, is a rare occurrence, but it sparked immense interest among the public, and investors realized how beneficial and advantageous it could be to inject money and acquire shares at an early stage of the company’s development.
Risks
Unlike venture investing, the risks of diluting ownership, profits, and losing control of the company are minimal. The key to this process is correctly assessing the company and, consequently, the value of the shares. Founders can raise 1 million dollars while valuing the enterprise at 10 million dollars. The work will continue, revenues will grow, and the price of the company and shares will increase, allowing for further fundraising of 5 million dollars with the company’s valuation now at 25 million dollars. And all of this will happen without any magical indicators that defy meticulous financial assessment, which only 1 in 100,000 companies at early development stages can provide.
The concept of continuous capital raising is a new and well-functioning tool for entrepreneurs who need additional capital for growth.
How to Maintain Control and Not Lose Your Startup
When choosing any investment option, it is crucial to maintain control over the company. This task is no less important than obtaining funds, as losing control triggers a dilution process followed by the devaluation of shares. Such a situation is especially characteristic when the investors are venture shareholders, who may allow unnecessary funding rounds to increase the shares (and profits) of investment funds while reducing the founders' stake.
Another danger is attracting unnecessary people at the insistence of investors, who receive enormous salaries and bonuses that essentially become part of the investments or profits.
It is also advisable to avoid the practice of dual voting standards typical of IPOs, as it contradicts real management and suppresses the CEO's voting rights.
By being aware of such undercurrents, one can choose the best investment option at the early stages of startup development or in a challenging business period. The financial experts at our company can help structure deals with investors properly and avoid losses of money and management.
