Philani Mzila, Investment Manager, Founders Factory Africa advisory on ‘How to avoid rookie mistakes when looking for investment’
In the startup universe, one of the most valuable (if not the most valuable) finite resources you have at your disposal, as a founder, is equity. This is because startups generally don’t have the capital to scale in market or products developed significantly enough to leverage in order to fund ongoing enterprise growth.
This makes your startup’s capitalisation table (cap table) an integral representation of how your venture is funded from an equity perspective (including convertible notes, warrants, and equity ownership grants). The cap table represents how much of a claim each party has on the value created by the business and what they paid for their ownership stake.
Managing the cap table well is therefore a strategic imperative for any startup founder. As a startup scales, the evolution of its cap table has serious implications on how easily the venture can attract and raise new investment.
Cap tables and investor risk tolerance
At the beginning of a startup’s journey, the founding team owns 100% of the company. Depending on the resources they have available, founders tend to self-fund the venture as much as possible (called bootstrapping) up to, and including, the pre-seed stage in order to protect their equity value.
At some point, however, the resources they have can only take them so far and they need to raise external capital.
At the pre-seed stage, a startup hasn’t necessarily found product-market fit and its revenue is often not the best measure of its potential because founders are honing their minimum viable product.
At best, the venture has signals of product market fit, i.e. user growth, engagement and active usage and retention. The lack of product market fit, and bankable recurring revenue is typically a deterrent for investment by later-stage investors due to their inherently lower risk tolerance.
This is where angel investors and early-stage venture capital (VC) firms step in. Angel investors are high-net-worth individuals who are highly risk-tolerant and have the financial means to invest in startups and their potential future returns, at the right price. That “right price” is usually an ownership stake in the business, ranging anywhere between 5 and 15%, with that percentage being a symbol of the risk angel investors accept in return for their capital and operational expertise.
Early-stage VC firms, on their end, typically provide additional institutional capital, operational and governance support as well as credibility to ventures.
Angels and other types of early-stage investors, like Founders Factory Africa, play a vital role in the VC ecosystem. Without the high-risk tolerance these investors bring to the table, most early-stage startups would not break out of the pre-seed stage due to a lack of funding.
The role of a term sheet at the point of investment
Given the importance of a startup’s cap table in its future trajectory, it’s worth highlighting the vital role a VC term sheet performs at the point of investment.
A VC term sheet is a document that outlines the terms and conditions of a VC investment. It includes details on the amount of money to be invested, the equity being granted to investors, the timing of investor liquidity, and investors’ rights in the venture.
Some of the key terms founders and investors must be familiar with when reviewing this document include:
- Valuation – The value of the company which is being used as the basis for the investment.
- Pre- and post-money valuation – The pre-money valuation is the value of the company prior to the investment, with post-money valuation the value of the company after the investment.
- Voting rights – A representation of how much say investors have in the future strategic direction of the business.
- Liquidation preference – This is a clause that determines the order in which investors and founders are paid back in case of a liquidation or bankruptcy. Be aware: liquidation preference typically relates to any liquidity event, not just a liquidation.
- Anti-dilution-provisions – These clauses can help protect investors from dilution because of a future financing round of financing. They can have the effect of decreasing a founder’s shareholder value.
An alignment of interest with the future in mind
As both an investor and a venture builder that helps startups improve their product and find product market fit, at Founders Factory Africa, we often advise founders to be extremely careful when exchanging equity for capital.
When an investor decides to invest in a startup, they are looking for an alignment of interests where the founders can make a meaningful return for starting and scaling the venture, thereby providing a higher chance of a successful exit for the investor.
Some of the errors we typically see include founders raising their initial funding at too high a valuation. This creates unrealistic expectations for future funding rounds.
At times, founders ask for too much capital without deep thought into what metrics and milestones they would like to achieve with the capital, leading them to give up too much equity very early on without considering the need for future funding rounds.
These scenarios, in turn, stunt the venture’s ability to raise funding and scale, due to the lack of alignment of financial interests with investors.
As a startup matures and goes through its different funding rounds, the equity allocated to founders is diluted as larger sums of investment are raised at Series A, B, or C. If the cap table is not thoughtfully constructed, the startup may find it increasingly difficult to raise capital as questions around incentives for later-stage investors increase.
The startup ecosystem is binary. Either a business grows and succeeds, or it fails. There is no in-between. The value that a startup places on its equity, the partners they choose on its journey and collectively creates is the golden thread that runs through every startup’s success or failure.
A thoughtful cap ensures that a startup can become successful. A badly designed cap table can do the exact opposite.