In an environment bristling with rising uncertainty, early-stage founders and investors must maneuver an increasingly dynamic environment where dreams meet dollars.
What an investor wants is not always aligned with what founders expect, especially in how they appeal to investors. There is a gap between what investors expect and what founders believe when it comes to funding, and it’s often attributed to disparity in goals and perspectives. Investors are primarily focused on maximizing returns on their investment and also managing risks, while founders are emotionally attached to many of their ideas and prioritize growth and innovation of their companies.
This gap often leads to misalignment. Founders may not always have a complete understanding of investors’ decision-making criteria or processes. Regardless of their own confidence in being able to develop a unique value to the market, it may not conform to the elements for which they’re being judged.
In this time of inflation, we witness rising uncertainty, along with rising interest rates, and conditions that increase the cost of capital, which may, in turn, result in down rounds for startups. And this ultimately influences a shift towards safer investments for many within the investment community. So, while the environment plays a key role in determining whether a company is funded, there are many other factors as well. In this technological landscape that ebbs and flows with the availability of investment dollars, understanding the nuances of early-stage investing is more critical than ever.
To gauge the current lens of tech investor confidence, I met with seasoned investors Karen Grant and David Wright, who have brought decades of experience in startup investing to the table.
Both help shed light on the myths and realities of startup investing and offer sage advice for early-stage founders.
The Current Landscape of Startup Investing: Proceed with Caution
“Investor returns in the VC industry have not always paid up for the risks involved in private investments,” notes David Wright, an equity analyst with extensive experience in supporting technology-enhanced high-growth companies. He highlights the complex relationship between interest rates and valuation multiples. “When interest rates go up, valuation multiples come down. The glory days of the VC era are behind us,” he asserts.
Over the last 40 years, VC fund performance has been marked by highs and lows, with the mid to late nineties being the standout period. During this time, interest rates were high, creating favorable conditions for VC investments. However, the average returns from VC investments have consistently hovered around 9%, comparable to public markets. However, Wright also highlighted the median return, a more telling metric, that stands at a mere 1.8%, indicating that only a handful of VCs have achieved substantial returns, while the majority have largely underperformed.
“Today’s startup investing landscape faces headwinds,” Wright continues. “Interest rates have just recently spiked, pushing down valuation multiples. This makes it difficult for investors to secure excess returns, even if a company’s valuation increases over time.”
Karen Grant, an industry veteran involved in early stage investing since the 1990s, echoes Wright’s sentiments about the cautious approach investors are taking within the current climate. Grant emphasizes that investors are scrutinizing opportunities more meticulously, driven by a desire for better returns. Founders, on the other hand, are seeking funding earlier than ever, often relying on external sources to kickstart their entrepreneurial endeavors. She reveals,
“And so, you’ve got this perfect storm where you’ve still got founders who are trying to raise money and they’re doing it earlier and earlier. So, they’re being taught that they should be funding their entrepreneurial initiatives with other people’s money. Furthermore, there are investors who, much like venture capitalists, have yet to witness the anticipated returns, and this has prompted them to exercise increased caution.”
Grant refrains from labeling investors as risk-averse but notes that they are less inclined to take leaps of faith.
Unveiling the Nuances of Pre-Seed Investing
Grant has strong views against investing in the pre-seed stage. Pre-seed investments, according to Grant, are characterized by minimal infrastructure within a startup. Karen declares, “They may have an idea, but their IP isn’t protected, they lack product-market fit, and the team may or may not have any experience.”
Wright elaborates on why VC involvement in pre-seed investments is rare. “The valuations are usually too small for VCs,” he points out. Venture capitalists typically look for larger opportunities, with minimum investments of several million dollars, making pre-seed investments unattractive. Wright explains, “So normally a VC probably has a large pool of money. So, if they have 100 million dollars, their minimum investment is going to be about two and a half million dollars. If a company is only worth five million dollars, they’re not looking to sell half the company. So normally it’s angels that are in the pre-seed area if they’re involved.”
“Pre-seed is where the company is basically an idea,” Grant adds, “and professional investors rarely enter this stage.”
Grant further highlights that pre-seed investments are primarily driven by individuals who have personal relationships with the founders. These individuals are willing to take a chance on the founders themselves, not just the business idea. This stage represents a conceptual phase where the company is in its infancy, with minimal data, proof of concept or market viability.
Wright and Grant concur that angel investors are more likely to participate in pre-seed investments. “Angel investors are willing to invest based on the potential of a business idea and the capabilities of the founding team,” David notes, emphasizing the role of strangers in this stage.
Grant adds an interesting trend that’s developed in pre-seed investing—quasi-governmental investment funds and sidecar funds. These funds often invest alongside angel investors, leveraging their specialized knowledge and resources to support early-stage entrepreneurs. While they may not be focused on valuation, they play a crucial role in nurturing startups and fostering economic development:
“They are doing quasi-economic development efforts to help these entrepreneurs get into the marketplace. They’ll come in very early, they’ll take that gamble, and they’ll be prepared to take some losses, but they’re there to help fuel the economy as well as make a return on their investment.”
Changing Times: From Traditional Investing to the New Norm
For Grant, she’s witnessed a notable shift in investor attitudes and strategies over the past 15-20 years. She noted how average investment cheque sizes had dwindled down to $25,000 or even less, with a growing emphasis on encouraging smaller investments adding:
“So, it’s almost a spray and pray strategy where I’ve got to throw in $5,000 into 25 different companies and hopefully, I’ll get a return on at least a few.”
Grant pointed out that these passive investment strategies do little to benefit the founder. When investors merely contribute capital without getting actively involved in the companies they invest in, the startups miss out on valuable industry knowledge and mentorship to help them not just survive, but also thrive. This “dumb money,” as Grant termed it, might lead to inefficient resource utilization and missed growth opportunities for startups.
Wright remarked, “Two notable changes have occurred over time. If you, [as an investor], invest $25,000 in a company and lose it, then put in another $25,000 and lose it again, how many chances will you give? If the sector fails to deliver decent returns, people will eventually walk away.” While there’s always a new group with money entering the scene, if the sector doesn’t expand, they won’t return.
He continued, “Another significant change is interest rates. A decade ago, we had negative rates, where the government guaranteed a $100 investment would yield only $95 in five years. This made it seem like a reasonable risk, as there was no cost involved. However, today, with a 5% opportunity cost, I can get a 5% cash return on my bank account. So, if I’m going to risk my money, it better offer a better return than that. I might be better off doing nothing, considering the opportunity cost that now exists but didn’t ten years ago.”
Grant interjected, “David and I have both managed angel groups and if I had a nickel for every time that one of our members has said, ‘I’ve invested in seven companies and I’m not going to invest anymore until I get a return’ – I would be rich!” She emphasized that investors have been gradually exiting the scene, with historical levels of returns becoming less common lately. She added, “They either age out; they actually hit a point in their lives where it just doesn’t make sense to make new investments that may take ten years before they see the return… or they’ve put in all of their play money and now they’re waiting for their investments to mature.”
Myth or Fact? Funding Guarantees Success
Grant responded by highlighting how some founders, after securing funding, may overspend on hiring without a clear strategy, recalling, “I’ve witnessed numerous occasions where a company secures funding and then proceeds to hire friends who may not necessarily be the best fit for the job. It’s as if they lose sight of the fact that investors expect not only the return of their capital but also a return on their investment. This misalignment is a common issue.”
Grant stated the importance of aligning funding with sales and revenue growth, creating increased value for the company. She illustrated, “Founders tend to forget that the primary purpose of raising funds is to boost sales, which ultimately increases the company’s value and enables them to provide returns to their investors. She expressed concern that some founders celebrate fundraising as an accomplishment in and of itself, instead of focusing on milestones, “They’re focusing on the wrong thing…They should be celebrating every time they break a million in their revenue stream.”
The minute a startup receives funding, the work really begins. Founders should expect the phone from investors to ring off the hook. Aligning with investor expectations becomes a harsh reality for founders. Wright emphasized that raising capital transforms a startup from a mere idea into a full-fledged business. Investors expect startups to use the funds wisely to reach milestones, grow their customer base, achieve profitability, or at least positive cash flow. He cautioned against spreading investments too thin across multiple markets, stressing the importance of focusing on one market at a time.
“Founders may have ample funds and believe they can pursue opportunities in five different marketplaces simultaneously. However, this often leads to a situation where they fail to achieve positive cash flow in any of these markets, so they eventually run out of money. You’re giving them enough rope to potentially hang themselves.” He offered a more prudent scenario where founders, who may be financially constrained, would be forced to focus the company on one market at a time, achieve positive cash flow in that market, and then use the funds to iterate on the next market. Wright added, “If opportunities arise, raise additional funds to expand into new markets sequentially. The key is to do it methodically, one step at a time, because the expectation is not just to secure investment but also to deliver performance and a meaningful return.”
Unlocking the Power of Bootstrapping to Build Investor Confidence
Despite the clear advantages of funding, the idea of bootstrapping your startup, relying on your own capital and resources, can be daunting, however Grant offers a different view, “There used to be an old saying, the best source of capital is sales because it does two things: it keeps your staff fed and watered and it adds value to the company at the same time. So, it’s a beautiful double whammy you’re establishing yourself.”
Wright concurred and added that successfully establishing a presence in a market with a product or service and meeting all sales targets can be particularly effective. By doing so, prospective investors can watch the company’s performance over time. This builds confidence in the founder’s ability to forecast, execute plans, achieve milestones, and enhance the company’s value while being under scrutiny. Later, approaching investors for funding becomes a smoother process as founders have demonstrated their reliability through bootstrapping and achieving success, even in a limited market. As Grant reveals, “It starts lowering that company’s risk profile with the investor.”
Wright exemplifies this scenario where a hypothetical Ontario-based company finds itself in a situation where it intends to expand into the Quebec market, requiring a substantial investment of one million dollars. Initially, the company relies on internal resources, generating the necessary funds from its existing Ontario operations. As it successfully penetrates the Quebec market and grows, its revenue increases to two million dollars, providing the means to explore opportunities in Western markets. Eventually, when the company’s revenue reaches five million dollars, it contemplates entering the US market.
However, a sudden realization emerges during the Quebec expansion phase: a competitor is aggressively advancing in the US market, necessitating an immediate entry to capture a foothold. At this juncture, the company recognizes that relying solely on bootstrapping and internal resources won’t facilitate the rapid entry required to compete effectively in the US. Wright signals, “That’s where you would say, ‘bootstrapping is not going to get me where I need to go, because if I then go out west and build my company, by the time I get to the US, two years from now, there’s going to be much more competition.’ So that’s where you turn to external funds and raise external capital to be able to go into the US. market right away and boost your valuation.”
Equity Dilution and the Emotional Reverberations for Founders
When founders choose to seek funding to fuel their business growth, they inevitably encounter the concept of dilution, which can significantly impact their ownership stake in the company. This is the tug of war between the emotional and rational that entrepreneurs grapple with when raising capital.
Wright defines the essence of dilution as the decrease in a founder’s ownership stake in a company when new equity is issued. This typically occurs during funding rounds when investors purchase shares. To illustrate this concept, Wright paints a scenario where an entrepreneur initially owns 100% of their company while bootstrapping it. As the need for additional capital arises, they decide to sell 10% of the company, for a million dollars. Consequently, their ownership stake reduces to 90%, but they have successfully injected funds to grow the company. This decision is based on the expectation that the million-dollar infusion will double the company’s valuation, thereby increasing the founder’s net worth.
As per Wright, this decision is based on the expectation that the million-dollar infusion will double the company’s valuation, thereby increasing the founder’s net worth. He adds, “Now your company is worth 20 million dollars. You own 90%, which means you’ve gone from 9 million to 18 million. So even though you don’t own 100%, you’ve still expanded your own net worth. And that’s why you take on the dilution as long as you can expand the value of the company.”
Grant emphasizes that founders often underestimate the potential upside of accepting dilution. Instead, they may focus on maintaining the highest possible ownership percentage, even when the company’s valuation is relatively modest. She notes that while founders’ concerns about losing control are valid, they should consider the broader picture. For instance, a founder who initially owns 100% of a four million dollar company and sells 35% during the first funding round might, at first glance, seem to have sacrificed too much control. However, this perspective overlooks the potential for exponential growth. By raising the necessary capital, the founder can propel the company’s valuation to $20 million, making that 35% stake far more valuable than retaining 100% ownership in a stagnant venture.
She adds, “So it’s a very interesting thing, and it’s more emotional than logical. If you can get the founders to go through the logic and actually run the numbers, they start to see and relax about selling off more of their company, it makes more sense. And then if you develop a level of sophistication, you realize that, in fact, you don’t have to have an exit event to pay off these investors. The companies can buy back those shares from the investors at a reasonable return for the investors and they can end up owning all the shares of the company if they want to.”
While Wright acknowledges this is an unconventional exit, it is a potential strategy, however he underscores the challenge it presents to entrepreneurs, particularly those anticipating multiple funding rounds, each contributing to a gradual dilution of ownership. In reference to Grant’s use case where a founder initially cedes 35% of their company at a four-million-dollar valuation, resulting in a 65% ownership stake, this founder may engage in another funding round at a 10-million-dollar valuation, surrendering an additional 25% ownership, diminishing their stake even further. He remarks, “So to some extent, you do need to plan out how much capital do you need at each stage and what’s that going to cost you. Typically, companies issue roughly around 20% of the company during fundraising rounds. So, you’ve got to plan out that if you are receiving one million dollars today and if that’s 20% of the company, how many more times can you do that?
Both Wright and Grant emphasize the importance of planning for multiple funding rounds and recognizing that dilution is part of the journey. Founders must assess how much capital they need at each stage and understand the implications of each funding round on their ownership stake. Wright concludes, “What they [founders] have to digest is that they don’t need 100% of the company to control the company.” Founders can control the company effectively with less than 50% ownership, especially if they are the visionary behind the venture. Investors typically seek entrepreneurs to lead and run the company and are uninterested in taking over operational control themselves. As a result, founders should focus on achieving a balance between retaining enough ownership to feel motivated and ensuring that their valuation remains attractive to investors.
When it comes to the ideal percentage of equity to release during funding rounds, there is no universal rule. Market conditions, the company’s performance, and a variety of external factors can influence this decision. Wright indicates that entrepreneurs should remain flexible and responsive to these dynamics, rather than fixating on a specific percentage.
Myth or Fact? Investors invest in Market Opportunities
We are squarely in another hype cycle. The current generative AI hype cycle bears some resemblance to the cryptocurrency bubble of the previous year. And the startup and investment community have experienced the rise and fall of companies who have received excessive funding for ventures developed within each of these verticals. I broached the question, is investment primarily market-driven or founder-driven?
“It’s not just one or the other; it’s a bit of both, as absolutes rarely apply in these scenarios,” says Grant. She adds having a stellar team is crucial, but without a viable product, what can they bring to market? Conversely, even an exceptional product can falter with a poorly executed strategy. The winning formula lies in the synergy between a capable team, ideally with experience in product commercialization, and the ability to manage quality assurance and other essential aspects of bringing a product to market. Success isn’t just about generating revenue but also achieving long-term profitability.
Karen also notes that some investors prioritize the team’s competence over the technology itself. While technology matters, a superior team can maximize a product’s potential and uncover new opportunities along the way.
“Investing revolves around concepts, which encompass both the product idea and the team responsible for execution,” highlights Wright. He draws attention to the ultimate goal in this process: “It’s not about the entry; it’s about the exit. What will my return be in the end?” In making an investment decision, Wright gets excited about a concept and scrutinizes the team’s capability to execute and realize the concept’s potential over time.
In cases where the early-stage team may not meet all criteria, Wright remains open to leveraging his connections to strengthen the team. The primary focus, however, remains on the team’s capacity to execute the idea, ultimately leading to returns for all stakeholders who took calculated risks. Wright sums it up: “It’s all about executing on this idea to ensure a profitable outcome, ensuring that we not only recover our investment but also gain a substantial return for the risks we’ve undertaken.”
Tread Carefully and Align Goals
Our current economic environment clearly marks a time where founder investment success hinges on a delicate balance of factors. Founders must recognize the value of strategic dilution, viewing it as a means to accelerate growth and capture opportunities. Simultaneously, bootstrapping remains a powerful approach to establish a foundation and demonstrate viability in the early stages.
Investors, on the other hand, should continue to prioritize both the concept and the team, understanding that execution is the linchpin of a successful exit. Whether it’s pre-seed investment, bootstrapping, or subsequent funding rounds, the ability to execute effectively remains paramount.
It’s the nuanced journey between innovative founders and astute investors that propels the entrepreneurial journey forward to drive innovation, growth, and prosperity. Being aware of and aligning the goals in the process will foster an ecosystem where groundbreaking ideas flourish, and returns are not only realized but exceeded.
Karen Grant has been involved in early-stage investing since the 1990s after a twelve-year career at IBM. She has launched four angel investor groups. She’s operated a business incubator and a commercialization center for the University of Toronto and has been a founder, investor, and director for a number of technology companies.
David Wright has spent his career supporting technology-enhanced high-growth companies, and he provides capital markets, corporate finance, and valuation advisory services through Cassio Capital Advisors. Wright is also currently a mentor for a few of Ontario’s regional innovation centers, and was an equity research analyst, investment banker, and executive director of an angel network.
Hessie Jones – Innovations Manager at Altitude Accelerator
This article originally appeared on Forbes