Three mistakes to avoid as a startup when raising capital
This article was written by Mirko Kikkamägi, Senior Associate at TGS Baltic.
It should not come as a major surprise that raising sufficient funding is one of the key necessities for a startup to realize its vision and bring the relevant idea and/or product to the market. However, even though one needs to keep an eye on the main prize during fundraising, it is also vital not to forget to pay attention to smaller details when raising capital. Below are three easily avoidable mistakes we have seen in practice in the fundraising process.
Mistake #1 - Focusing only on the investment amount, valuation and equity percentage
When raising capital, founders often focus on the investment amount, valuation and the equity percentage they have to share with the investors. Although these are obviously some of the very key matters to pay attention to in a fundraising process, one should not neglect to pay attention to other non-financial terms of the investment.
These other non-financial terms are often negotiated at the beginning of the process prior to entry into definitive transaction documents in the form of a term sheet.
Such other terms may relate to rules and procedures on how various decisions affecting the startup are adopted, restrictions on founders’ ability to sell or otherwise transfer their shares (time-limited lock-up provisions), an agreement on how in certain situations the existing assets of the company are distributed (liquidation preference) and other matters which in certain cases may be rather restrictive towards the founders.
Therefore, it is important to keep such other non-financial terms and requests of the investors in mind during negotiations in order not to find oneself in a situation where although only a minority shareholding has been given to investors, the investors in essence will still have almost full control of the activities of the company. As a first step, it is strongly advisable to familiarize yourself with at least a very basic understanding of such provisions. A good source of freely available sample documents together with footnote explanations is available from Startup Estonia’s Model Documents section. These materials should allow founders to better understand what is behind various terms or concepts requested by the investors. However, the good news is that at least in Estonia the market has become rather mature in the sense that investors usually have relatively reasonable asks. However, it is still always advisable for a founder to keep in mind that following an investment, part of the control (either by way of granting certain veto or blocking rights to the investors) will be relinquished forever, and thus this is not something to treat without care.
Mistake #2 - Too generous equity sharing
Another somewhat surprising mistake we have seen in practice is that founders are sometimes too generous with equity sharing when it comes to potential co-investors, early employees or investors.
It is important to understand that, ultimately, the equity is the only asset the founders have.
Therefore, if at early stages equity is too generously shared, founders may end up in a situation where at a later stage they either do not have sufficient equity to share to properly incentivize new employees or following additional second or third round investments end up in more diluted ownership that would be common for a startup of their development stage. This may further have the unintended consequence that some investors might even be put off from potential investment due to concerns about whether the founders, who usually are the key persons for a startup’s success, are appropriately incentivized and motivated.
Thus, founders should be especially careful in the early stages when making hiring choices and sharing equity in the form of options, or when providing ownership to the early investors. However, on the other hand, this does not mean that founders should withhold from sharing equity with employees as at least with initial hires it is extremely important to have employees’ interests aligned with the founders’ interests to ensure the proper success of the company.
Mistake #3 -Waiting a bit too long to ask for help
Although this might sound a rather obvious and self-serving warning from the author, the one critical mistake we have seen in practice is not taking advantage of the resources, knowledge and help available in the ecosystem. After all, Estonia’s awesome and supporting startup ecosystem has been highly praised around the world.
This does not only mean the use of professional legal advice, seeking of which often makes sense already at an early stage, but rather the more general use of wider assistance and advice available. At least in Estonia, there is plenty of free information and guidance available from websites like the above-mentioned Startup Estonia’s resource page, but also from various members of the ecosystem (incubators, mentors, etc.) who are often more than willing to share their views and advice. Timely use of such available advice may result in avoiding making mistakes such as committing oneself to financing with way too onerous terms and interest, ending up in situations where founders may potentially lose control of their intellectual property or where previous shareholders and co-founders may potentially hold founders in ransom in lieu of existing shareholders’ agreement.
Unfortunately, these are all examples we have seen in practice, and a majority of them could have been avoided by either speaking to startup incubators, legal advisers, investors, mentors or friends and acquaintances more familiar with startup investments. We at law firm TGS Baltic are committed to contributing to the success of outstanding startups, and therefore we are opening TGS Baltic Free Legal Advisory also during STARTUp Day this year. Reach out to us via firstname.lastname@example.org in order to secure your personal free advisory slot!