An investor’s perspective: A startup’s guide to fundraising

Last week, SM&B’s technology team hosted a breakfast panel discussion considering issues that early-stage tech companies should consider when raising funds.The discussion demystified the fund-raising process and highlighted what investors look for when deciding whether to invest.

The panel comprised Simon Moynagh of Icon Corporate Finance, Robert Davis of Calculus Capital and Ella Botham of Silicon Valley Bank, and was co-chaired by Simon Halberstam and David Martin, both SM&B Partners.

State of the market for investment in early-stage tech companies

The panel concurred with Simon Moynagh’s initial comments that the investment market is highly active and there is a lot of money on offer for early-stage tech companies. This has increased competition for institutional investors (such as VCs). This has not, however, reduced the quality threshold in terms of in which companies’ institutional investors will look to invest.

He also pointed out that the tightening of EIS and SEIS tax relief schemes which are available to investors who invest in technology companies have increased the investment appeal of technology companies (as opposed to asset-backed companies, which cannot offer investors the same tax reliefs).

Ella Botham also added that the investment rounds are increasing in value, with early-stage tech companies asking for, and securing, up to twice as much investment in comparison to previous years.

What do investors look for at each level of investment?

Ella Botham and Simon Moynagh both opined that investors will look for the following things at each level of early stage investment:

  • At seed level: a strong management team and a business idea with a defined market niche, which is scalable;
  • At Series A: not only a strong management team but also businesses which have started to generate revenue and there is early commercial evidence to show that significant growth can be achieved; and
  • At Series B: management teams which have a demonstrable plan in place for future growth and further commercialisation, with evidence/data-points that shows the business can now scale with further investment.

Robert Davis explained that at a later stage, tech companies must have developed a scalable product which already has traction in the market and generates around a million in revenue, annually.

The panel was unified in its opinion that a strong management team is essential.

How much money should early-stage tech companies raise?

The panel agreed with Robert Davis’s opinion that 2.5 years of ‘cash runway’ is a sensible amount of money to raise during early stage fund-raising rounds. This is enough money for at least one year of growth so that it can reach its short-term or goals or any inflection points needed to underpin the investment proposition in the next round, a year to raise funds for the next round (as for early-stage tech companies, raising funds takes up the lion’s share of the management team’s time and effort, and a half year buffer in case of any complications.

They all noted that early-stage tech companies must leave adequate time to raise funds.  Otherwise, they risk weakening their negotiation position and may be forced to accept unfair terms from institutional investors at the last hour.

What are the legal pitfalls to avoid when fundraising?

SM&B’s David Martin explained that transaction-readiness is key. Although it is tedious, early-stage tech companies should upload their documentation to a data room as early as possible. This will help smooth over the transaction process; help highlight any evidentiary gaps which may require some explanation; and show that the company has an organised management team.

Any trade-marks or other registrable intellectual property which has not been registered should be registered as soon as possible. Otherwise, the company risks losing investment opportunities or being undervalued.

It is sensible to seek advice during transactions. Advisers should be diligent, responsive and help to drive the transaction forward.

Business valuations

The panel agreed that business valuation is an art rather than a science, especially when it comes to early-stage tech companies. Simon Moynagh observed that valuations of any such companies are driven by the market more than hard evidence, especially where the company is not yet profitable. Institutional investors are often offering high valuations (which means they will invest more money for a smaller shareholding) but are securing their investment by requiring preferential shares be issued to them with certain conditions attached (such as a 2x liquidation preference for example).

Debt products available for start-ups

Venture debt is a type of debt-financing for early-stage tech companies. Ella Botham explained that venture debt should complement equity and not replace it. The amount of debt raised should be around 20%-30% of the equity raised during a fundraising round.

Venture debt is flexible and can be used by companies for any reason, but Ella Botham noted that its best use is to boost cash so that the company can reach its next inflection point or meet certain goals in order to increase its valuation.

Take away points

The market is rife with opportunities for early-stage tech companies. Investors are also willing to offer high valuations on companies based on limited evidence, subject to obtaining security using preferential shares with certain conditions attached to them. Nonetheless, early-stage tech companies are still expected to demonstrate a promising business with a realistic chance for growth and scalability, supported by evidence where available.

Companies need to be smart when fund-raising and most importantly leave enough time to secure investment before running out of ‘cash runway’. They should also consider complementing their equity with debt products.

Transaction-readiness is key if companies want to avoid any legal pitfalls that may arise when closing an investment deal.

For further information, please contact Simon Halberstam, head of the SM&B technology law group at simon.halberstam@smab.co.uk.