Navigating the investment terrain

When navigating investment as a startup, it is often easy to worry about funding and if an investor is willing to give you money, then there can be a temptation to give away too much or not fully understand the type of contract you are entering.

Here, Startups Magazine takes a look at the different types of investment available, who those investments are suited to, and warning flags to look out for.

Types of investment and timing

Securing the right investment at the right time is important for any startup. The types of investment available include venture capital, angel investors, corporate venture arms, and family offices, and are each suited to different stages of a company's growth.

  • Venture Capital (VC) is often pursued for significant growth and scaling, and it is usually suitable for startups with proven traction and those poised for rapid expansion.
  • Angel Investors provide funds during early stages and are ideal for startups needing capital to transition from concept to early business operations.
  • Corporate Venture Arms invest in startups that align strategically with their parent companies. They come into play when a startup’s technology complements the larger corporation’s offerings.
  • Family Offices offer a more personal investment touch and may be suitable for startups with a strong emphasis on values aligned with the investors.

Sergey Toporov, Partner at entrepreneur-friendly VC firm, Leta Capital, share’s his thoughts on the key indicators that a startup is ready to seek external investment: “A good company with a lot of ideas should always be on the lookout for additional investment to accelerate the business. So, it should be instantly ready for that from the process side. But if we’re talking about ‘readiness’ in terms of a good momentum to raise, it depends on the stage (pre-seed, seed, early growth, etc.). In a nutshell. I believe, the best indicator that a startup is ready to seek external investment is when the founders or management team have a clear vision of the current bottlenecks in their business and a strategic plan for how additional funding can address these issues. The best momentums can be following:

  1. Early stage: You have a great idea and strong people around that can help you to build it. Investors love a dedicated and capable team that can execute the vision. You can go and raise money to build an MVP.
  2. Product-Market fit: You've got a product or service that people actually want and are using. So now you need resources to build a business model around it.
  3. Scalability: Ideally, you're making some money or at least have a strong and growing user base. There's a clear path for growing the business, and you know how to scale it up. Go to investors with the numbers like ‘we put $1 and can take $5 from it in X years’

“The exact metrics, expectations on indicators, really depends on the area and type of the business. From the VC side, and I can talk only for our approach at Leta, it’s very important for us to see (1) a really motivated team and (2) early traction in revenue with the positive unit economy, that proves that the team can build a business, not just a product.”

So, a startup should look to seek investment when they have a clear plan for growth, a solid team, and when external capital can significantly boost their trajectory more than organic growth alone.

Warning flags in investment contracts

As a startup founder, it is important that you scrutinise investment contracts for terms that could pose risks, especially if your business might be considered a high-risk investment.

Red flags include:

  • High equity stakes: agreements that demand a disproportionately high share of equity can be detrimental. Startups should retain sufficient control over their business.
  • Rigid terms: contracts that do not allow flexibility in operations or future fundraising can stifle growth.
  • Excessive investor control: terms that give investors too much control over daily operations can hinder the founders’ ability to lead effectively.

Sergey offers advice on some of the less obvious ‘red flags’ to look out for: “Always check Liquidation Preferences and Anti-Dilution Clauses. These are powerful tools for negotiating economic terms that can help balance expectations. However, they can also undermine motivation and jeopardise the future of the company if not managed carefully. These clauses are not inherently bad, but understanding how they work and how to balance the risk and opportunity for both yourself and your investors is crucial.

“Exit provisions: Understand exit provisions like drag-along rights or forced exits. We had a story when one of our portfolio companies had rejected the investment offer because a potential investor wanted to have a right to force the acquisition at the 5x+ valuation. It seems minor thing, but sometimes such things can play a low-down trick.”

Navigating contracts

Understanding and navigating investment contracts is critical, and it is always a good idea as a startup to:

  • Seek legal advice: always consult with a legal professional to understand the implications of any investment term sheet.
  • Understand investor expectations: be aware of what investors expect in return for their investment, including financial returns, reporting requirements, and operational influence.
  • Negotiate terms: don’t hesitate to negotiate terms that better suit the startup's long-term vision and operational style.

Sergey offers some advice on term negotiation and control for a startup: “First of all, as entrepreneurs, you must remind yourselves that it is your business, and as startup founders, you are the ones ultimately responsible for it. So, if you are talking to Venture Capital investors (different types of investors have different approaches), I’m sure we also understand it and our goal isn’t to take the control. Our goal is to be part of a great story that can bring us an enormous return. If we’re on the same page.

“Here are some strategies to keep in mind:

  • Understand valuation and dilution: Know how valuation affects ownership and dilution. Aim for a fair valuation that doesn’t dilute you too much but keeps an opportunity for your investors to reach their financial goals in realistic scenarios.
  • Protect voting rights: Make sure you keep enough voting rights to control major decisions in the ordinary course of the business, that doesn’t touch rights of your shareholders.
  • Avoid overly restrictive covenants: Watch out for terms that limit your ability to run the business flexibly.

“The key point in these negotiations is to demonstrate that you are willing to take on the burden and risks yourself, but you need the freedom to steer the business without seeking approval for every minor decision. Otherwise, it isn’t a startup, it’s an enterprise.”

Resources for startups

There are a plethora of resources that a startup can access to aid their investment journey:

  • Educational materials: books, webinars, and courses on finance and startup management provide foundational knowledge.
  • Networking events: engaging with potential investors and other entrepreneurs at events can offer insights and opportunities.
  • Online platforms: websites and forums dedicated to startup funding can provide guidance and connect startups with potential investors.
  • Advisory services: some financial advisory firms offer free initial consultations that can be invaluable for navigating the investment landscape.

Once a startup has secured investment, Sergey offers some guidance on managing investor relationships: “It's very simple. Make investor relations (IR) a regular and transparent process. Establish a reporting system where you present both positive signals and challenges, including problems and bottlenecks. Incorporate a regular 'Ask Investors' section. We all know the classic investor phrase: 'Please let me know if I can be of any help.' Give your investors the chance to actually be helpful, or at least feel like they are. My advice to founders is to manage these requests proactively. Clearly set your expectations from investors to avoid situations where shareholders interfere more than they add value. Sometimes, having investors cheer from the sidelines can be more valuable than active involvement.”

So as a startup, it is advisable that you approach the investment process with a clear understanding of the types of investment available, the right timing for seeking investment, and the potential pitfalls in investment contracts.

By making use of all available resources and maintaining a strategic approach to investor relations, startups can secure the funding they need while retaining control and direction over their business.