Investments in a Nutshell: How to Make Your Business Even Stronger
Business projects in IT field have a great potential for out-of-the-box solutions to implement innovative ideas.
However many promising ideas have never been turned to life because of the lack of funding.
A straightforward problem solution is the business investments.
If the fundraising is your past point and you are advancing steadily - Umbrella IT would like to share with you some great lifehacks on how to find more investors for your business and use your resources even more effective.
Let’s run through the basics.
Investment process consists of 3 phases each of which pursues its own ways:
- Seed round
A company enters this round with a formed key team (A-team), detailed business plan, MVP (which is being transformed into the fully operational product during this round) and first sales channels.
MVP (Minimal Viable Product) is a working prototype with core functionality made for the primary market analysis and future full-scale development.
Seed investments are designed to develop technologies in the project and create a self-sustaining business.
An average amount of investment: $50-500 thou.
- Round А
Round A is a phase of active business growth and scaling in a competitive environment.
This round’s investments are focused on the complex development of business marketing and entry into a mass market.
An average amount of investment: $1-2 mln.
- Round B
Round B investments center on the higher profitability and entry into a global market.
Future investments on rounds B1, B2 … Bn or C-rounds are possible in cases when it’s necessary to increase production or to sell the company to a strategic investor.
Strategic investor is a large company working in the same field as an investment object that wants to become the startup’s majority shareholder.
An average amount of investment: $2+ mln.
NOTE: calculate the expenses carefully and take the optimum amount of money at every step.
A common mistake that was fatal for many startups is the overcosting of potential profit and the underrating of funding needs.
Contrary to a common misconception, a large share of the business given to an investor at the early stage is a serious stop-factor for the collaboration.
Let’s examine the case of irrational distribution of business shares on the seed round.
IT company X needs funding desperately. The founders have already spent $50 thou. for its MVP. Now they need $5,5 mln. for their MVP to be developed into a fully operating product and their marketing management to be effectively organized. At the start market capitalization of the company equals $1mln.
Investment: $300 thou.
Share price: $1.
Investors’ expectations: 75-100% per year.
Investors’ expectations mean an interest that the investors expect to get annually and on executing exit (more on exit later).
Exit is a point at which an investor or other shareholder sells his or her stake in the project.
In this particular case, the investors will get $450-600 thou. + dividends in 2 years, and $900-2,4 mln. + dividends in 4 years.
Company X saves 70% of their shares and gives 30% of it to the investors in order to get a required amount of money.
The seed round being finished the IT company X enters the round A to raise $250 thou. of investments in the marketing.
Investment: $250 thou.
Share price: $1.
Investors’ expectations: 50-75% per year.
After the seed round and round A the investors’ share of the business made up to 55% in total that is more than the founders’ share.
Such share distribution makes it difficult to raise investments in the next round and equally bad for both sides:
- Bad for the investors: an investor being a majority shareholder generate uncertainty on the startup’s team motivation and her engagement. It’s easy for the company’s founders who have less than 50% of shares to withdraw from the company leaving the investors high and dry.
- Bad for the founders: an investor at the early stage with a large share of business doesn’t have much experience in the field and doesn’t deliver value. However, his majority stake allows him to make or block business decisions.
Let’s examine another case, where the founders adopted a more reasonable investment strategy.
IT company Y needs funding. The founders have already spent $50 thou. for its MVP. Now they need $1,5 mln. for their MVP to be developed into a fully operating product and their marketing management to be effectively organized.
According to their business plan, the founders of the Y Company have 2 different choices:
- to execute exit strategy in 4 years and sell the company to Google for $30-50 mln.;
Exit is the main way to make a profit, having invested in a startup, and its major feature is the profitability.
In the first place, investors aren’t really interested in the startup’s progress and development as much in the possibility to execute their exit strategy on advantageous terms for themselves with maximum returns on investments.
- to cause an IPO in 7 years with the market capitalization of the company equal $200 mln.
IPO (Initial Public Offering) is the private company’s first sale of shares to the general public.
NOTE: A business plan that arranges the execution of exit at the precise moment is the perfect configuration to heighten the investors’ interest.
The company Y seals the deal with the investors and divide the required amount of money between two investment rounds: $500 thou. for the seed round and $1 mln. for the round A. At the start market capitalization of the company equals $10 mln.
Investment: $500 thou.
Share price: $1.
Investors’ expectations: 75-100% per year.
Company Y saves 95% of their shares and gives 5% of it to the investors in order to get a required amount of money.
At the start, the market capitalization of the company Y is worth $10 mln. the total number of shares is also 10 mln. with the share price of $1.
Investment: $1 mln.
Share price: $1.25.
Investors’ expectations: 50-75% per year.
At this stage, Y Company’s shares go up in price. Now Company sells 800 shares that are accounted for the 8% of their business in order to get a required amount of money.
After the seed round and round A the investors’ share of the business made up to 13% and the founders’ share of the business made up to 87% in total.
NOTE: share price appreciation indicates that the investment rounds were successful and the project is profitable.The key to success is selling shares at a higher price than at previous round. Each successful investment round proves your profitability and reputation and lowers the investors’ expectations and amount of money owing to the investors.
HOW TO CHOOSE THE RIGHT INVESTOR
- Right investor for each stage
Investors who have never invested in a business at a certain stage before could make your project fail.
At the pre-seed stage try to either invest in your business the personal savings or raise the money from FF-investors who you can really rely on. Pre-seed is a stage of organic growth.
FF-investors - Friends and Family Investors.
At the seed stage seek for a Super Angel or a seed investment fund.
Super Angel is a private investor (or a group of serial investors) with a certain reputation and business contacts who invest in a company at the early stage only focusing on technologies.
At the stage A and B, choose the professional venture funds which match your investment situation and has the expertise in your field.
It's worth noting, that some seed stage funds are involved in the investments at the advanced stages.
NOTE: up to several dozens of funds and super-angels can be engaged in a single deal. This is a common practiсe.
- Background of the investor
A company sells itself to an investor exactly the same as an investor does it to a company.
An Investor is an important business partner who should be chosen responsibly. After the initial review stage you should take into account several factors:
- Reputation and contacts;
- Leadership team and partners;
- Public or private fund;
- Financial capacity.
NOTE: surprisingly, financial capacity is a characteristic of secondary importance. Many investors are market majors with a deep understanding of the field, links to other investors, mentors and a customer base. Involvement in this network is a key to the prosperity of a company.
- Exit strategy
The unmatched company’s and investors’ sense of future exit strategy execution doesn’t leave a project a chance.
It makes sense to choose an investor with a long-term exit strategy at an early stage. Weigh carefully the terms and sums upon which the investor presumes.
- Toxicity of the investor
Links to a toxic investor may block the startup’s international expansion.
Toxicity of the investor means non-transparency of business processes, major investors concealment, suspicion of corruption and fraud, offshore practice and sanctions.
It’s difficult to estimate the fund’s toxicity value and, sometimes, even impossible without the professional help. However, neglect of this factor may raise flags and crumb the deal at best or damage to reputation and block the international expansion at worst.
HOW TO IMPRESS AN INVESTOR
Investment project selection is a rough five-stage procedure during which a number of relevant for the investors applicants is tanking.
You need to understand the investors’ intentions at each stage to make it into the final.
Let’s look at these stages closely.
- Phase 1. Initial Review
In the 1st phase, an executive summary is analysed, a pitch deck is presented and a cashflow forecast is made by executive team. In addition, the team specifies how they are going to dispose of their investments.
Identifying the potential of a project, investors begin with the estimation of the failure probability rather than success probability.
That’s not surprising: according to the Fortune magazine, 60% of startups fail. The investors’ main goal is to think through all the potential risks and cut the nonviable projects off from the very beginning.
This phase includes 100 applicants.
- Phase 2. Second Review
At this stage the number of the applicants goes down rapidly. Phase 2 involves more nuanced analysis. The investors question the business plan, evaluate growth prospects and USP.
USP (Unique Selling Proposition) is a short marketing message that sums the competitive strengths of the company up, defines its target audience, highlights the principal advantages of the product demand for it.
The main reason why this phase becomes last for so many startups is the lack of the strong A-Team.
This phase includes 15 applicants.
NOTE: A weak team = A weak project.
The team is not just a group of people with a promising idea. The team is a set of professional competences which the investors provide capital for.
For example, you want to create a digital health project. Before you go for the investments check whether you have a qualified M.D., a lawyer with major in medical law and a developer with a background in the medical facility. If you don’t have such a team6 you don’t have the basic competencies and be ready for the investors to answer with a plump “no”.
- Phase 3. Face-to-face Meeting
As the company enters the 3rd phase the assessment of its potential, involvement, and integrity is continued but now face-to-face.
Investors test the A-team asking hard-hitting questions: why should they invest at this precise point? What’s in this for the investors? When will the investors get the dividends?
The outcome of the meeting depends on the objective and subjective factors: self-representation, strategic thinking, professionalism, background, completed projects and even charisma.
In case of the favorable outcome, the company is offered to sign a term sheet.
Term Sheet is a document containing general agreements between the investors and company of financial and legal parameters of future investment.
A term sheet is not a legally binding document and, according to Forbes magazine, 50% of investment deals are canceled after the term sheet was signed.
This phase includes 7 applicants.
- Phase 4. Due Diligence
The 4th phase centers on the complex investment audit of the company that is known as due diligence.
Due Diligence is an audit procedure that includes independent an evaluation of the investment object and investment risks, a full review of company's operations, its financial condition and position on the market.
Any potential risk which resulted from the due diligence is a strong reason to back out of a term sheet.
Due Diligence procedure is worth $50-100 thou. and takes from 2 weeks to 1 year. Investors are ready to overspend time and money to decide against you only until they are dead sure in the project.
This phase includes 3 applicants.
- Phase 5. Final Negotiations
The 5th phase is a logical final of all the previous phases, the conclusion of the definite investment agreement.
This phase includes 1-2 applicants.
Fund-raising and building a business from scratch is a difficult task that has no unified manual.
Each specific case requires a personal approach on a risk-sensitive basis. Investment in the innovative project is a game of Russian roulette for both a founder and an investor.
The market is irrational, but we believe that our suggestions could help even an experienced entrepreneur to manage risks and boost figures.
Your project and Umbrella IT are a perfect match.