Seven Rookie Mistakes Startups Make When Raising Money
1) Working with the Wrong Kind of Investors
There’s a saying in the startup world: “the first money that goes in determines how much money, if any money at all, comes in after.”
Regular startup investors are an incestuous lot, and they’re usually a pretty sophisticated group, too. If you look at the resumes of superstar VCs, it’s a humbling experience for many of us mere mortals. If your first investor is a big-named investor whom everyone recognizes and respects, you should have no problem finding more investors to write more big checks.
But the inverse is also true. If the first investor in your startup is someone that other investors don’t know, don’t like, or don’t trust, there’s a good chance that you will have forever foreclosed the possibility of finding more investors.
Maybe this isn’t a problem. To use a silly example, if your first investor is the Sultan of Brunei, and all the other investors in Silicon Valley or Boulder or Austin don’t like the Sultan of Brunei, you might still be able to grow and succeed. But that’s only true if the Sultan meets three criteria: 1) he wants to fund all of your future rounds, 2) he has enough money to fund all your future rounds, and 3) he is a reasonable person to work with from an investor-relations perspective.
The Sultan might meet all three criteria, but a lot of seed-round startup investors surely don’t. That’s why you need to make sure that smart investors are happy with what they see when they see your cap table.
2) Choosing the Wrong Type of Investment
I always have to bite my tongue when I hear a new startup tell me, “we want to raise X million dollars giving only away Y% of the company, and we want to do it in the next three months and blah-de-blah-de-blah-blah-blah.”
In my head, I’m always like, “Hold on there. Is this your first seed round? Are you sure that you want to use common equity on this? And are you sure the market’s going to bear a multi-million dollar common equity seed round for a company with no MVP yet?”
Regardless, part of what reaching out to investors is about is what economists call “signaling,” which is another way of saying that you’re communicating to investors that you know what you’re doing.
And if you don’t even know the range of investment vehicles most sophisticated investors consider at your stage of the process, you’re likely dead in the water.
So, the first step to consider when raising capital is thus the type of investment vehicle that makes sense for your business, the current market, and your investors. Get that right, and you will have signaled to investors that you understand the game that they’re playing.
Get it wrong, and you’ll signal that you can’t be trusted with their money.
3) Not Having the Business Set Up Right To Take in Investment
This should go without saying, but I’ll say it anyways. Before you take in investment, you need to be an organization in good standing in the jurisdiction of your choice, having followed the corporate law of that jurisdiction to date, with appropriate intellectual property protections in place.
If you’re not or if you haven’t, when you solicit investment, there’s a good chance you might be engaging in fraud.
Here’s a short, non-exhaustive list of silliness that I have seen:
- Companies selling investor stock before they’ve formalized founders’ documents.
- Companies using documents they found online governed by the rules of states that don’t apply to their company.
- LLCs printing off series seed investment documents from the internet and issuing preferred stock for an LLC (hint: only corporations have stock).
- Corporations issuing preferred stock when no such stock was authorized in the company’s charter documents.
- Companies representing that they had secured the intellectual property of the company when they had never executed IP assignment agreements with the founders.
And so on. Suffice it to say that if any investor were to ever find out about these shenanigans, they’d have a right to all their money back, and much more.
4) Not Knowing How to Answer the Questions Investors Typically Ask
Before investors write big checks, they usually want to know a few things about your business. If you want to get them to depart with their hard-earned money, you had better be able to answer each and every question to their satisfaction.
There are plenty of publicly available resources on this topic, but if your investors ask you questions about your business that you haven’t even considered, and it’s obvious you haven’t considered those questions, your chance of receiving investment from the investors are slim.
Before you go searching for investors, you had better know the industry, the marketplace, the competitive landscape, the go-to-market plan, and exactly how you plan to use any funds you might receive. You only get one chance at a first impression, as they say, and the startup world is surprisingly small. Go to investors without a solid sense of the business you’re entering, and you’d be amazed how small the world can get for you.
5) Looking for Investors Before Having Anything Worth Funding
If you read some mainstream media on the subject, you’d think that venture capitalists were a bunch of morons looking to throw millions of dollars at any 24-year-old who knows how to use a computer. But venture capitalists are most assuredly not morons, and most of them have very specific metrics that they use to disqualify most of the (many thousands of) companies vying for their attention.
For example, I had one venture capitalist tell me that he would seriously consider investing in any startup that had $100,000 in monthly revenue and meaningful growth by any metric.
Seems like a simple test. The startup gets to pick the metric by which they’re growing!
But as it so happens, the venture capitalist’s test weeds out 99.9% of all startups. I was only able to make a handful of referrals to this investor, because, well, so few startups meet those criteria.
Now, if that test weeds out your company, too, that’s fine. Because there are plenty of seed investors willing to take a risk on less-established companies.
But very few serious investors are willing to invest in pure narratives.
If you don’t have a minimum viable product or market traction or a track record of success, then the chances of you convincing a stranger to invest in your company are get-struck-by-lightning-three-times low. It’s just not going to happen, unfortunately.
If this applies to you, that’s ok! That’s the place where nearly every startup begins! But if this is you, the first step is to focus on setting up your company right (see above) and getting traction in the market.
Do that first, and then go look for investors. No sense spending all of your time fighting to get in front of busy people when you’re not ready to meet their standards.
Meet their standards first, and you’ll find the introductions later much easier to come by.
6) Not Seeking Out Professional Guidance on Securities Laws
If you use one else’s money to fund your business, you are entering into the hairy world of securities law. This is a world fraught with very real consequences, and not a place where amateurs should tread lightly.
Even if your only investor is your Uncle Larry – securities laws apply. Even if you’re only raising $2000 – securities laws apply.
If you’re entering into a contract to do business with someone, for the most part, the local, state, and federal government are fine with you picking whatever rules you want to apply to you.
If you’re using someone else’s money to fund your business, however, federal and state governments have a series of laws in place that require you to meet certain standards, do certain filings, and proceed in a very specific way.
If you’re not a professional who works in this field, you’re going to get it wrong.
Even most lawyers, if they are unfamiliar with this specific practice area, they get it very wrong, too. So to new startups that are worrying about all the hard things about starting a successful business, there are some situations where it’s NOT best to go it alone. This is one of them.
7) Using the Same Lawyers Investors Use
As I mentioned earlier, the startup community can be incestuous in a lot of ways. In some ways, it’s way too incestuous. One way that has a particularly negative effect on startups, in my opinion, is the way that many of the bigger law firms represent both venture capitalists and startups.
There are certain ethical restrictions that prohibit lawyers from representing both the startup and the venture capitalists on the same deal. Very few legitimate law firms are that shady.
But many law firms are comfortable representing certain venture capital firms on a regular basis, and then, on occasion, representing a startup that is on the other side of the table from that same VC firm.
This is problematic.
Think about this dynamic for a second. You’re a law firm, and let’s say each major venture capital raise generates about $25,000 worth of billings. With the startup, you’re only going to be working with them once, twice, maybe three or four times on a major capital raise. But the VC firms, you represent them dozens of times. Maybe even hundreds of times.
So with the startup, if you are in the top 1/100th of 1% of all startups, you’re worth maybe $100,000 in billings through your life as a startup to the law firm. But the VC firm is worth millions of dollars in billings to the firm!
Where is the law firm’s loyalty going to be on these deals? These folks know who butters their bread. And it ain’t the gung-ho startup facing an uphill battle for every subsequent round of funding.
If you’re reading this and you feel depressed, don’t be. The startup world is awesome, and there are more opportunities than ever before. And there are top quality law firms that make starting a business and raising capital easier than ever before.
Raising capital for a startup isn’t a mystery, but it is a challenge. If it’s something your business needs to do, make sure you have the tools, resources, and help needed to do it right.