Is Investment Right for Early Stage Businesses? (Posted by Shell LiveWIRE Winner, Ben Smith)
27 July, 2016
The start-up and investment world is changing. The number of Initial Public Offerings (IPOs) has dropped, but the amount of venture capital funding has risen dramatically.
This rapid increase is particularly highlighted by the number of start-ups which have gained the status of ‘unicorn’ – those with a valuation of at least $1bn. The term was coined to demonstrate the rarity of such a feat, but it is now common. The number of unicorns has risen by 483% since 2011. But what’s driving this dramatic rise?
The media have played an important role. It’s difficult to avoid the term unicorn: an obsession which seems to have started in the United States, but is sneaking over to the UK. Add this to the popularity of shows like ‘The Apprentice’ in which gaining investment is seen as a trophy and has been glamorised, then you can begin to see why public perception may be changing.
Whilst it is encouraging that this growth means that the investment market is fertile, with availability of capital high, there are a number of downsides. For some, building a unicorn is seen as the holy grail, but what effect does this have on the way in which someone runs their business?
First, we need to be clear that building a business which has a high valuation at which investors are willing to invest is very different from building a business which generates large annual profits or has had a big exit. Sense dictates that one should lead to the other, but this is not always the case.
A high valuation is seen by some as a prize, an end goal, which no doubt massages an entrepreneur’s ego and sense of competition. As such, some founders prioritise user base and growth – aka vanity metrics – as opposed to sustainability and the creation of a profitable model. Although a large perceived market share may lead to a high valuation, it may ultimately impair the business’s long term health.
But what does it matter if you attract a high valuation? If you can’t back up your projections with performance, when you come to raise your next round (which you undoubtedly will as you’ve built your business on someone else’s money as opposed to your own revenue), you may find yourself in a difficult position with your original investor. If your next round is either flat (i.e. same valuation as the previous raise) or down (i.e. at a lower valuation that the previous), your original investor who took a big risk in funding you at your initial stage, is now being diluted heavily – and they won’t be pleased! If there were any antidilution clauses in place, which protect original investors in such cases, then the founder’s stock will be reduced (sometimes considerably). These antidilution clauses obviously motivate a company to raise new rounds at a higher valuation, but this can only be possible if a company has new investors interested, and you can begin to see the never-ending spiral you enter into.
Even if you don’t suffer at the hands of antidilution clauses or flat/down rounds, at some point your investor is going to want to see a return. It’s great to have millions of users, but not if you can’t monetise them. Typical free:paid conversion rates are up to 10% (on average around 5%). Let’s say that you have half a million free users, you’re attempting to monetise by charging £2 for a premium version and you’ve done incredibly well by having a 10% free:paid conversion rate. That only results in one-off revenue of £100,0000: great, but is it sustainable, particularly if you have a big team and are burning £30,000 per month? If you have investors breathing down your neck looking for a return – remember that you must answer to them as they own some of your company – you may begin to feel uneasy. External investment is not an excuse to take your foot off the pedal, rather you now have more people to appease.
This may paint a dark picture but it’s not all doom and gloom. Investment can be an incredible mechanism for accessing capital which will allow you to grow rapidly, but you need to go into it with the right mentality. Founders need to ensure that they take a more sustainable view of business growth; the obsession with attracting a high valuation should be followed by a greater obsession: maintaining momentum after investment has been taken.
What’s the answer? In my opinion, it is to rethink current assumptions around prioritising growth and relying on raising additional funding rounds above all else. Instead focus on building a profitable model, keeping burn rate under control and the path towards self-sufficiency. It boils down to the difference between raising money to survive and raising money to grow.
About Ben Smith (Programme Manager for UnLtd's Big Venture Challenge)
Ben Smith won a Shell LiveWIRE Award in 2014 for his business, Frumtious, a health-conscious natural food company. He is now Programme Manager for UnLtd's Big Venture Challenge investment raising programme. Ben and his team help social ventures to raise risk capital to scale their operations and social impact. Ben also sits on the board of Birmingham Town Hall Symphony Hall.
You can follow Ben on Twitter.