Neil Rimer – Founders shouldn’t make these mistakes in early investment stages
On October 16th the Wall Street Journal Germany published an open letter to the German Startup Community by Neil Rimer, co-founder and partner at Index Ventures (invested in Facebook, Skype, Path, Soundcloud and many more). In his letter Rimer highlights that the major mistake German Startups currently make is giving up too much equity.
Rimer points out that despite a maturing European Startup community and increasing access to mentors, managers, experienced lawyers and investors, founders still make major mistakes in early investment stages. The major problem is giving up too much in the very first investment round. Usually these people are angel investors or family offices that, despite giving money, do not have much more to offer – particularly for fast growing, highly scalable startups. These investments are done without creating a formal option pool, making future investments unnecessarily difficult. As a result Rimer sees all too often Startups where founders have only 40% equity left after their first investment round, and one Angel Investor having the rest while there is not even a product on the market. This causes problems in later financing rounds, as it makes structuring the investment much more difficult.
Rimer recommends an option pool of 15 to 25 percent
Rimer writes that the foremost goal should be to create a financial structure that allows the Startup to grow, attract and keep great employees, and to raise in future investment round without having to waste time on endless negotiations to meet every individual’s interest.
Index Ventures tries to get about 20% equity of a Startup in a Series A investment round. Since the Startup is still growing Rimer recommends an option pool of 15 to 25 percent (!), as this enables the managers and founders to keep a healthy level of equity over future funding rounds. Of course angel investors should get equity, but definitely not more than 20%. This is particularly important if the Series A round is comprised of a syndicate of venture funds, which can take up to about 40% of equity.
Rimer points to another issue with early investors, the right to participate in later funding rounds. For angel investors this is particularly interesting if they want to keep a significant equity at a later stage, but makes investment much more difficult for VCs and founders alike. The easiest solution is, obviously, that the angel sells the shares to the investing venture firm. However, that is money which cannot be invested into the growth of the Startup, which should be the very reason to raise money in the first place.
He sees the source of the problem partially in the angel investors approach to financing startups but mainly in naïve entrepreneurs (particularly first timers) which shows that they are not able to judge if a deal is good or bad, and wrong priorities, as they could have consulted experienced (financial) advisors.
Rimer closes with a piece of advice:
- Founders should only take enough seed funding so they can validate their concept and go for a second round once it is successfully validated.
- Founders should be careful when choosing an angel and they should think about future funding rounds.
- Founders shouldn’t take every strategic investment/ VC they can get for seed funding – if at all. They should carefully assess if the strategic investor/ VC can be a valuable partner. Particularly in large organizations a Startup can become an insignificant investment without any importance to the rest of the conglomerate.
Several people in Germany have pointed out that he is right but that founders have no other choice but make deals as the cost of starting something in Europe are very high. In addition getting to a second round is extremely difficult, and so is raising money in general, because of the risk involved and the financial situation in Europe. Furthermore, most German angel investors are from, what is in Germany called Mittelstand (SMEs), which are very often family run and rather risk averse. Germany is very famous for having various SME’s that are hidden champions. These SME’s are very often based on the premise not to spend more than they earn and to prefer to avoid external investments. They therefore grow at smaller pace however tend to be rather sustainable ventures and family owned for generations. This nevertheless leads to the problem that there is often not enough investment that contradicts their behaviour and founders have to swallow the next best deal, in order to be able to get the product to a stage where they can go for a Series A round. This might sound somewhat familiar to people living in this part of the world.
Rimer’s view offers some interesting insights for the local and potential regional Startup scenes. Of course Thailand is at a completely different stage in the Startup ecosystem maturity curve but there are some similarities as well. Bangkok, like Berlin, is the hub for the local Startup communities, while the rest of the country is trying to catch up (particularly Chiang Mai, but there are IT clusters around the country and HUBBA is for example expanding to Hua Hin). There is not much local angel investment, despite a huge amount of people that could potentially invest. There is also not much experience with fast growing Tech-Startups on their side and the (investment) culture has a tendency to be rather risk averse/ conservative as well.
In Germany however there is some knowledge about investment and exits. This even dates back to the first dot com bubble, when the Samwer brothers started to build the foundations for their Rocket Internet empire and sold the ebay clone Alando to ebay. It is not only limited to Rocket though. Services likes Xing (German LinkedIn, IPO, and now mainly part of Hubert Burda Media) or studiVZ (former German Facebook clone) had successful exits and there have been several big investments into Startups like like Soundcloud, ResearchGate or Babbel.
In comparison there is not much knowledge about different investment rounds among local Startups, as there have so far only few Startups been raising money. It comes therefore as no surprise that several local Startups have pointed out that they don’t know how to raise, what a good term sheet looks like – or how to even get to that point.
Thailand has a two big advantage over Germany and the US. First, that the cost of living is very low and second, being in a fast growing market full of opportunities and problems to solve. That allows for proper bootstrapping. It is much easier to a) find a problem and b) not rely on seed funding that takes up large amounts of equity. However, cheap unfortunately seems to translate into the perception of low valuations. Internationally that matters, but in an early stage shouldn’t the question be: How much money does the Startup need to validate the concept and is this possible without external investment? If so, why take funding at that stage at all?
A Startup, or everyone for that matter, has to adapt to the environment it is working in. If the rules of the game are “limited access to reasonable funding”, Rimer’s advice would probably be: Raise as late as possible and as little as necessary – at least in early stages. Fortunately, doing so is not difficult as in the west. Maybe these circumstances can be a strength of the local Startup community.
Pictures by Ivo Näpflin