Subsequent Rounds of Funding
Posted on 10. Jul, 2010 by editor in Business News
Innovation is sometimes characterised as a journey from research to commercialisation or from concept to cash. Along this route the business hopefully moves from being a net consumer of cash to a net generator. However, most new businesses cost more to build than they can generate in immediate customer revenues. Therefore, repeated access to finance is sometimes essential to underwrite the early stages of cash burn and growth.
This series has so far focused on raising an initial round of equity funding and many of the same issues will arise when considering a further round of funding, particularly from a new investor. However, existing investors present a new dynamic and there will be other factors to consider.
REASONS FOR SUBSEQUENT ROUNDS OF FUNDING
Essentially, there are many variants on the following two main themes: The Business Plan always envisaged further rounds of funding would be needed as the business develops and grows. The initial round of funding might have been obtained to reach a key milestone, such as the completion of an R&D; the development of a working prototype; or the bringing of the product or service to market.
Upon the achievement of the appropriate milestone, further investment is often necessary to exploit the potential of the opportunity. The business has failed to meet its performance objectives within the requisite timescales. Long term financial viability and sustainability can only be achieved by passing the business’s break-even point, reaching and maintaining profitability and ensuring positive cash-flows. The initial round of investment may not have been sufficient to fulfil these objectives, but there may be valid reasons why they can still be achieved over a slightly longer timescale with some further investment.
COMMUNICATION
Start the process of raising further investment early, not when the company is desperate for the money. Negotiating equity stakes when the company finances are critical puts it at a distinct disadvantage, even if the existing investors are capable of financing the further requirement. Additionally, if further new investors are required then this will often be just as time consuming as the original funding round. As it is probable that the existing investors will have had some representation at board level, it is unlikely that any request for further finance will come as a surprise, particularly if it was always planned from the outset. However, the investors will always be keen to determine whether the finance is needed for the positive reasons or for the negative reasons.
VALUATION
On the positive side, the existing investors now share a common purpose with the founders in ensuring that the company raises sufficient finance to fulfil their joint ambitions. The investors will often use their own network of connections to bring on board potential new investors. In an ideal world, further funding rounds are done on the back of significant progress which should in theory result in increasing valuations. A higher valuation is in itself often regarded as one of the acid tests of progress and successive increases are key milestones on the path to a successful exit. On the negative side, the investors need to understand the reasons for any failure before they reinvest.
If the failure can be rectified by, for instance, an enhancement in the product or service or perhaps an addition or change in the management team then it is likely the investors will want to protect their original investment by following on, albeit that it may become a “down round” (a lower valuation is put on the company than in the previous round). In this scenario, the founders and earlier investors could have their shareholding disproportionately diluted. If the failure is more fundamental then the investors will be anxious to ensure that they do not throw good money after bad, but even then they may work with the company to syndicate the risk if there is still some prospect of a successful, if deferred, exit.
SUMMARY
In summary, early preparation and communication are key. As always, competing bids to invest from different most favourable deal for the company and its shareholders. In this respect, retaining fully committed existing investors throughout the journey sends out the best possible message.
