Fundraising and governance

Typically when raising money at the build stage, the item that entrepreneurs focus on most is valuation. Makes sense. Usually by the time you get to build phase, the number of dollars is high enough and the valuation low enough that it matters (unlike a friends and family round, or a Series F). One item that is often overlooked at the company’s peril is governance.

Governance put simply is the list of rights, or lack thereof, that investors get. Usually when you raise preferred stock, which is how build rounds work, you have to give up certain rights. No longer can you decide to raise more money or sell the company without agreement from each block of investors. I have seen companies where the “block” of investors is exactly 1 person, meaning that this single person’s consent is required for any significant transaction to go forward. No bueno.

I also have seen companies where current investors have very few rights compared to a small number of insiders who effectively control both the ownership and day-to-day management of the company. Convenient for them and helpful when it’s time to make quick decisions, but less helpful from the standpoint of attracting new investors who will want some protection.

This also comes up when writing convertible notes. A convertible note isn’t equity yet, so it doesn’t have typical rights of preferred stock. Convertible note investors need reassurance that when it does convert, it will do so and grant their block certain rights that are on par with existing investors (just get more than 1 investor in this block).

Finally, I also have seen blocks where if you don’t get a particular investor to assent to an action, it’s very difficult to construct the necessary margin. This can happen when you have 1 or 2 large investors and then a large group of very small ones.

My advice to CEOs with whom I work is to think almost as carefully about this as they do about valuation. For sure you want to keep as much of the company as you can, but you want to make sure you can still run that company and make it possible to attract future investors to it if you need to.

 

It’s strategic

A sentence that usually sets off alarm bells for CFO’s is “It’s strategic”.  This is usually code for a decision that seems to make no economic sense, but is so important to the business, the company “has to” do it anyway.  Examples of this include, but are not limited to (1) an acquisition that the numbers don’t really justify, (2) launching a new product line that’s not correlated with the current one, (3) geographic expansion to a far corner of the world, (4) overpaying for a certain employee, and (5) going all-in on a particular trade show exhibit or booth construction.

Mainly, I have 2 issues with this approach.

First of all, most things that management teams call “strategic” are actually tactical.  M&A is a tactic.  It should get you into a market segment, a geography, a product category, and be tied to a broader strategy.  In theory, your company will have done a build/buy/partner analysis against that strategy and decided that M&A is the tactic that best gets you there.  Even in build stage companies, where deals are often opportunistic buys of smaller or faltering competitors, it’s only a tactic.  If you’re chasing a deal because it’s “strategic”, something has gone awry already.

Second and maybe more importantly, a major decision that cannot be grounded in numbers of any kind is almost certainly going to go badly.  For example: an acquisition that is dilutive on its face should get to being accretive because it helps you raise prices, lower costs, increase sales volume, cut G&A, something that has an economic return.  This return should be based an assumption that an investor can see clearly and question, including seeing the sensitivity analysis around it.  After all, it is their capital or stock you are proposing to use.

If an acquisition does none of these ‘strategic’ things, and is still dilutive except with heroic assumptions, it doesn’t make sense.  Full stop.

Trade shows are trickier.  I shiver a bit when I hear that a particularly splashy trade show presence for a build-stage company is necessary because I know from experience that nine times out of 10, it leads to heartache and lost ROI.  I shiver even more when I hear that it’s for “brand building”.  Brand building is a very expensive game.  And, if we’re spending a lot to build our brand at a trade-show, I would advocate that this needs to be part of a broader strategy including customer service, how we package and deliver our products, fit and finish, you name it.  You can’t overspend at CES and make these other things go away.

As CFO, you have to keep your eye on what matters.  In my experience, something that is truly strategic will show up in the numbers.