It is a big step for a company to take on its first external investment, and a huge amount of time and effort will go into closing the deal. Even before getting there however, it is important to look at what comes next.
Some companies will need a little money at the seed stage, but will subsequently be able to grow organically based on customer revenues. Others, especially in the biotech and semiconductor sectors are likely to need millions before their first product comes to market.
There are a number of different sources of investment, with different compatibility problems…
- Friends, Family and Fools are a great source of startup cash, but future investors will need to see the right paperwork – see my blog on Rolling the Dice: Friends, Family and Fools
- Borrowing is a useful source of cash at many stages of development, but be aware that investors don’t like seeing their cash used to repay loans, they prefer to see it creating value
- Angel Investors are the most common source of cash for high-tech businesses in Scotland, with groups typically investing between £100k and £500k in a deal (some of the bigger groups can invest £1m or more). As Sandy Finlayson writes in his blog Preferences and Angels, UK angels don’t like to bring in VCs at a later stage as VCs demand preference shares which can wipe our returns for the angel investors. Some angel groups may be able to fund a company with many successive rounds on this scale.
- Venture Capital funds usually invest £1m or more, although some have seed funds which will do rounds of a few £100k.
There is an important point in there that I am going to bring out again, because it is a respect in which Scotland is very different to the best-known USA markets such as Silicon Valley and Boston. Companies that take money from Angels in Scotland are probably never going to do a VC round. Instead, the Angels are likely to prefer to keep funding the company in small additional rounds until it is possible to make an early exit. The one exception to this is in biotech where the vast costs of clinical trials mean that angels need VCs deeper pockets. An early exit can be highly profitable for everyone, but it is a different model to the USA.
Nearly every business plan (in Scotland, outside Life Sciences) for a first round investment suggests that the cash raised will be sufficient to take the company to the point where it is cash positive. Even assuming a founding team passionately believes this (few companies actually manage with only one round), it is worth looking for investors with the ability to fund potential future rounds. The most obvious reason is that progress may take longer and cost more than first believed, but the most expensive thing a company can do is grow rapidly, so more investment may be needed if the company is more successfully than the initial plan suggests too. Taking on additional investment accelerate entry into global markets will be much easier if existing investors have deep enough pockets to support the company, compared with trying to bring in new investors.
With angels, looking at the history of their portfolio and whether they have a track record of following their own money in future rounds may be a good indication. VCs are likely to ring-fence a large part of their fund for follow-on rounds of investment, but it is worth checking on the life of the fund to ensure that it is not close to the end of the period during which it can do investment deals.
Sometimes, where it is absolutely clear that more money will be needed beyond the first round, it may make sense to do a “tranched” deal. For example, a company may raise £500k in two tranches of £250k each. The first is paid to the company immediately, and the second is released to the company when agreed milestones have been reached. In this way investors manage their risk by limiting the amount of cash they commit until they see evidence of progress, while entrepreneurs are not forced into the time-consuming (and often nerve-wracking) process of trying to raise the second part of the funding from scratch. This mechanism may also have lower total legal, accountancy and due diligence costs than doing two separate rounds.
Raising a first round of investment is a huge step, and thinking about what future funding needs might be right at the start helps to ensure it is a step in the right direction.