So far in this series of articles discussing the state of the Entrepreneurial space sector we have set the stage for our little space opera, and we have talked about the hero of the piece – The Founder of the space start-up company. As we discussed in the last article, founding a company is normally a journey that starts out with a great idea for a new technology or a novel application of an existing technology. Normally the journey then progresses through the stage of turning the technology into a product that customers want to buy (for more than it costs to make) and eventually ends up at the stage of creating and maintaining a business that can produce and deliver the product to those customers at a profit.
Needless to say, this not a journey for the faint of heart. It is also not a journey that can be completed alone. On this epic journey the founder will no doubt be joined by other characters: possibly friends and family, partners, and employees for sure, almost certainly advisors and mentors, and eventually customers, of course. In many cases though, the most important support for the founder will be provided by perhaps the least well understood character in our drama.
I refer, of course, to The Investor.
Above all other things, starting a company requires capital. FUNDS. MONEY. CASH! This is the one inescapable truth of starting a business. Before money can be made in any enterprise, money must be spent. Sometimes a lot of money. While some founders start the journey with enough resources of their own – or that they have accumulated from the friends and family. Most founders will need to raise capital from external sources at some point – or many points along the journey. Of course, as that journey progresses from technology development through product validation through to commercial execution and scaling, the nature of the investors will change as well.
Because, like founders, investors come in all shapes and sizes. In fact, investors may be a more diverse group than founders. Some are small scale investors using their own funds, some are professional fund managers who raise capital from others to create an investment fund. Some, turn to investing after other careers, some chose to work as an investor professionally for their whole careers. Still, there are a set of broad characteristics that they share, and which are unique to the world of the professional investor.
Before continuing, I want to make clear that I am not a professional investor. My impressions and descriptions of typical investors are purely those of an outsider to that profession. Those impressions have been formed by working with investors over the years, including time spent advising and coaching founders alongside other advisors who are professional investors. In the end my impressions of the world of investing are just that, MY impressions, and I do want to apologize in advance to any of my colleagues who are investors if I get some of the details wrong based on those impressions.
One simple way to define a professional investor is as someone who buys and sells companies, or portions of companies, for a living. Within that broad definition though, it’s possible to divide investors into a few categories. In truth, there are lots of ways of categorizing investors, any one that I choose is likely to look like a cartoon picture to someone more familiar with investing that I am. But, with that in mind, I find that one helpful way of categorizing investors is based on when, in the life of a start-up company, they tend to invest.
The earliest stage investors in a new company are often referred to as “Angel” investors. This stage of investing may also be referred to as “pre-seed.” These investors typically invest relatively small amounts – usually less than $1M – often less than $100K. Because they are investing at a very early stage when risk is assumed to be very high it is not uncommon for Angel investors to say that they are investing in the founder rather than in the business itself. This is not to say that Angel investors do not have a keen eye and well-tuned filter for a good business plan. But as a rule, they will tend to be more holistic in their assessment of the business, the founder, and their idea. As a result, Angel investors will often be prepared to be patient in watching the business mature.
The next stage of investment is often called the “Seed” round, or rounds. These are the investors a founder typically encounters when they working to move their idea from a Technology to a Product. Broadly speaking, this is because seed investment is often tied to overcoming a particular challenge.
Seed investors are generally interested in an idea that has been developed to the point where a pathway to a viable product and business can be identified but where there is a definable goal or milestone that has not yet been reached. Often this goal is a technical breakthrough such as a proof-of-concept demonstration or the creation of a Minimum Viable Product that can be shown to potential customers.
The key point for the seed investor is that when that milestone is passed, the perceived value of the company will increase, often dramatically. The value to seed investors, therefore, is that since they invest before that clear proof of progress is reached, they are taking a more substantial risk than someone who invests afterwards and so they expect be rewarded for taking that risk.
If done well, this means that seed investors will provide support at a critical moment and then see a short-term appreciation in the value of their investment because it allows the company to demonstrate progress toward a viable product.
Note that it also means that seed investors will often be interested in having the company embark on another round of investment soon after that critical milestone is met. In this way the seed investor will be able to confirm the increase in the value of their investment by having the next round of investments specified at a new, and higher, valuation point.
After one – or more – rounds of seed funding, companies that have been successful at maturing their technical solutions into viable products – and which are developing viable business plans will usually embark on their first round of investment with what most people outside the investment community would think of as Venture Capitalist (or VC) funds. Inside the investment world, this round of investment is often referred to as “Series -A.”
To be of interest to this kind of investor, a business will normally have answered most of the questions about the viability of its technology and the value of its product. Rounds of investment forward from this point will be focused less on questions of whether there is a viable business model and more on questions of how to accelerate the growth of the business and be competitive in the market the business is entering. As such, investors who provide funding at this stage are usually interested in a business because they believe that its business model is sound, they see that the business has been successful at attracting customers and that it is generating at least some revenue from selling its product
It is important to note that while revenue is important at this stage, profits are less so. In fact, the situation that is attractive to Venture investors at this stage is to find a company that has been successful at developing a product for which there is clear demand the production of which the company has not yet mastered to the point where they are operating profitably.
This is particularly true when profitable operations appear to be a matter of economies of scale. Venture investors hope that by injecting capital at a strategic moment, they will catalyze the scaling up of the company both in terms of total revenue and in terms of profitability. Once again, the investor hopes that by choosing to take a risk on the company at a particular moment, they will see a fairly rapid increase in the value of the company is it’s growth accelerates.
As you can see, the interests and concerns of the various types of investors can vary significantly in their details. But there is one critical point that will always be true and which founders should understand before they embark on these discussions. And that is the fact that while talking to potential investors feels very much like a sales process, it is different in some significant ways.
You see It is a bit of a truism to those who work in sales that to be effective at making sales, you need to be good at establishing a relationship with your customer. The idea being that the more you understand about your customers real problem, and real constraints, the more effective you will be at proposing solutions. In effect, a good sales process is about developing a relationship which then generates the sales transactions which are really the object of the exercise
Raising investment, on the other hand, is actually the flip side of that coin. This is because the net result of a single investment deal is going to be a long-term relationship between the founder and their investors. So, while sales is about developing a relationship to generate transactions. Investment is about creating a transaction that generates a relationship.
BUT – and this the key point – most of the effort in developing an investment deal usually goes into specifying the details of the transaction. This is not surprising given that an investment transaction is a much very complicated legal construct. Some of the details can be subtle but also very important. It is also a fact, that such a transaction may literally be a life and death decision for the founder’s business.
It is not surprising, therefore, that discussions around the specific terms of the investment dominate discussions between investors and founders.
But, after the “deal is done” the founder and the investor will find themselves in a relationship that will almost certainly last years and may even last a decade or more. It’s also true that while some deals may solve a short-term issue for the business, the wrong kind of deal can be a blemish on the company’s balance sheet and make future funding both difficult and expensive.
I don’t think it is any surprise then to find that having a constructive relationship with investors that goes beyond the initial transaction can be the key to ultimate business success. And that likewise, it is not uncommon for relations with investors to be the source of significant difficulties for many businesses down the road.
Although such difficulties often get laid at the feet of investors, I am not sure that is a fair characterisation. The very nature of the relationship between founder and investor provides fertile ground for the growth of misunderstanding and miscommunications. After all, founders tend to view their company as more than simply an asset or source of employment. A lot of the founder’s identity is bound up in their company. For many, their company is an extension of themselves.
But, an investor, by the nature of their business cannot have that same perspective. The success of the investor’s business depends on treating every business they invest in as an asset. For many investors, especially “venture” style investors, their business makes money by selling those assets at a profit. And, critically, the value of each of those assets is pretty strictly defined by what it can be sold for to another willing party.
Thus, right from the start of the relationship the investor will want to talk about topics such as “capital market strategies” and the timing of “liquidity events” while the founder just wants to move on from the unwelcome task of having to raise money and back to their first love, developing their technology and running their business.
This difference in perspective is at the heart of a lot of unhappiness in Founder-Investor relationships.
The key point here is that a founder who needs investors AND who wants to avoid such unhappiness should spend some time thinking about how the business will be of value to their investors. No matter how much time, energy, and passion a founder has spent developing their business, once they have investors, it no longer belongs solely to them. In fact, the agreement with those investors almost certainly specifies that the founder has a LEGAL duty to manage the company in a way that protects the interests of the investors.
In other words, to have a constructive relationship with investors a founder must be prepared to manage and grow the business in a way that will increase that value for their investors as well as for themselves.
As you will have noted, one thing that all investors have in common is that they hope, or rather expect, to see the value of their investment grow. Most expect to see it grow substantially in a relatively short period of time. It is not uncommon for Series A investors to set a target of seeing their investment grow by a factor of 10 (so called 10X) in a period of five to ten years.
So, during the search for capital – and certainly after the initial rounds have been secured – the question of how to achieve such growth will become a, if not THE, critical question for founders. Obviously, there are many ways to approach that problem. Almost certainly those plans will involve another player in our drama – The Customer. Those customers might even be from The Government. But other players including bankers and other “institutional investors” may also make an appearance.
And so that will be where we will pick up in the next article when we’ll talk about strategies for growing a new business and the various ways to finance those strategies.
Editor’s note: This is the third article in a six part series focused on entrepreneurial space.