Founders and entrepreneurs are by nature confident, optimistic and most likely very smart. They have a vision for the future and the skills to get there. They often show bravado and without much consideration roll up their sleeves and get dirty. This is sometimes admirable and necessary, but at times it can be misguided and short sighted, which in the long run may hurt the business more than it helps.
Whilst incredibly knowledgeable in their field of expertise, there are areas where founders and entrepreneurs may not have the experience or the time and personnel resources to close every gap in their business. This could apply to administrative matters such as legal contracts, managing a rental property, maintenance staff, etc, or it could be more strategic in nature like entering new markets, setting up off-shore structures, raising additional capital or partnering with strategic shareholders, or a myriad of others.
Focusing on one of these advisory roles, the capital raise process whereby building financial models, producing investor materials, negotiating with investors and setting coherent strategic narratives are not within the core skills in the founder’s armory. At the stage of angel or early seed funding, a one page spreadsheet, a nice logo and a cup of coffee may be enough to secure financing. However, as you progress to later rounds of capital, more professionalism is required, especially if founders want to raise capital from the right investors at the right price.
At the far end, with more mature and larger businesses, such capital raises could be managed in-house by a team of accountants, lawyers and brand or product strategists. However, you will find that despite these resources, these mature businesses would usually outsource this overall task to an investment bank or corporate advisor.
So for those in the middle, early- and late-stage startups, looking to raise larger amounts from institutions or VC’s, and without the internal skills or staff resources, it makes a lot of sense to appoint a professional advisor who will most likely make things go much smoother, saving precious founder time, limited financial resources, and the benefit from experience and focused expertise to guide them through the process.
What happens in Silicon Valley
It is common practice for firms in the US to hire advisors to run Series A (and later) funding rounds for them, including performing a valuation and producing the investment materials, as well as identifying strategic value adding investors. The reasons for this are plain: Founders’ time is better spent running the business; they do not necessarily have the financial experience to produce the necessary documents, particularly for items such as a valuation and building a robust financial model, and their networks may be limited.
These US advisory firms specialise in earlier stage tech businesses, as opposed to their Wall Street colleagues that deal with traditional mergers and capital raisings for more mature businesses. The lines between these firms start to blur when firms like Facebook list their shares on the stock exchange. At this point, traditional investment banks step in to assist with capital raises and initial public offerings (IPOs) / listings as the numbers involved can justify hiring expensive suits.
It’s hard to sell your own lemonade
One of the positive reasons for engaging an advisor is the relatively objective opinion and work product an experienced advisor gives its client, having been involved with many other similar businesses and therefore such advisor is best placed to value and market the sale of equity in a startup. A third party investor is far more likely to accept the valuation metrics produced by an advisor rather than the subjective opinion of a founder who owns the majority of the shares and has an inherent interest in driving up a valuation based more on emotion than objective reason.
Also, having an advisor provides a useful buffer between the founders and potential investors, so that any difficult or acrimonious negotiations that take place can be led by the advisor on the company’s behalf, thereby preserving the relationship of founders with their investors, which needs to endure for so long as they remain invested.
Valuations and financial models require certain skills and industry experience
Investment bankers and similar professionals spend years learning how to build financial models and produce valuations, and the skill needed to communicate effectively to investors. These are specialist skills. Founders of tech businesses tend to be product specialists who are not financially experienced. Even in the case where a startup has an accountant in the team, it is rare for that person to have the necessary experience to solely handle modelling and valuations. The art and science of valuations, and effective communication, comes from performing these tasks for many different businesses so that a wealth of knowledge is acquired which can then be applied appropriately into each new startup.
Deciding what revenue multiple and valuation methodology to use will have a significant impact on the ultimate valuation of each business, which determines how such valuation is received by the discerning investor. Our experience is that many startups overvalue their venture up-front which often is negatively received by VC investors. The risk of an inflated valuation early on, even if fully subscribed, is that the next round of financing may be at a reduced valuation, which often spells disaster for a startup. This is avoided with the steerage of a prudent advisor who looks at both the short-term and long-term interests and success of the client, noting down rounds are in no-one’s interest.
Founders should focus on the business
The management team should focus most of their efforts on running and growing their business. Capital raising can be an unhealthy and time-consuming exercise which is better outsourced to professionals. It is far more effective for founders to close those all-important client deals than being bogged down in legal and financial details of a capital raise. That said, at least on management shareholders will be required to provide the advisors with any required input.
Align advisors with your success
A founder generally has not much cash, and is hence raising capital. Paying fees for services is therefore one reason why founders often roll up their sleeves. Thus most, if not all, of the remuneration payable to an advisor should be structured as a success fee based on the total capital raised. This ranges in the single digit percentages and will align the interests of the advisor and company so that the advisor is always working towards a favourable result for the company.
Secondly, part of the role of the advisor is to present the narrative of the company as being great, the founder being great and the investment opportunity being great. Thus be weary of an advisor who does not wish to invest or has not previously invested in your business. Apart from questioning the motivation of the advisor, it sends a terrible message to a potential investor from which you may not recover.
Finally, being an entrepreneur is tough and the journey can be long and lonely, so just like the lightweight boxer who needs to go for the full fight, having someone like a coach, or in this case, an advisor, can be the difference between winning the bout or being knocked out along the way.