The Key Challenges of Staged Financing

In many ways, investing is a trade-off. Investors put money in and ultimately hope to get something of greater value out. The challenge with this is that different investors have different expectations of what they’re going to get out of their investment. So how do you know who’s the right investor for each stage of your new venture? 

Explore the obstacles of staged financing with Dr Thomas Hellmann, Programme Director on the Oxford Entrepreneurship: Venture Finance Programme from Saïd Business School, University of Oxford.

Transcript

There are many milestones along the path to success and financing follows these business milestones. From an investor perspective, you can think of the financing of a start-up as a sequence of bets. What you’re doing in the first stage is you’re making a bet that the company is going to make it to the second stage.

You’re basically paying to see the next turn of the card. If it’s no good, the company fails and you don’t commit any more money to it. If, on the other hand, the card is good, meaning the company reaches the next stage, it hits the next milestone, you pay for the next bet.

Finding the right investors

The first challenge is to think about who the investors will be at each stage. So in fact, when you’re staging financing, you’re thinking about who are the right investors at this stage of the company? And so, very often, you find that in these early stages, the pre-seed and seed stages, most of the investors are not professional investors, but angels, so maybe crowdfunding or things like that. And then as we move forward, it becomes more and more professional investors, corporate investors, and so on. All the way to exit.

Old investors versus new investors

The next problem is going to be, if we have old investors and we have new investors, they’re going to have different preferences. So the simple principle that you should keep in mind is that all investors want the highest possible valuation.

They just think like the founder, they want their shares to be priced highly so that they retain more ownership. New investors want low prices because they’re buying in and they want to buy in low. That gets a bit more complicated if there’s an older investor who is also participating in the new round, and then they have some kind of a balancing role.

Valuation isn’t the only thing that investors are going to disagree upon. They might disagree on who should be on the board of directors. Very often the new investors want to add people to the board of directors, but it could get crowded.

The staged financing design process

Now, the questions that investors and entrepreneurs have to ask is, how do you design the stage financing process and specifically how much money do we give to the company now? How far will that money go? The language we often use is what kind of a runway does it give to the company? Meaning how long can the company operate and how many milestones can it achieve with the money that’s given? Sometimes investors want to give a long runway. Sometimes investors give a short runway.

Let’s think about this. From an investor perspective, you might say, well, we don’t want to give too much money, but would you really want to have an arrangement where the entrepreneur has to come back to the investor every month? That wouldn’t work. On the other hand,  the entrepreneur might say, give me enough money until I get cash flow positive so we don’t have to come back at all. But that doesn’t work from the investor perspective because they would be committing a lot of money knowing that the entrepreneur’s going to spend it no matter how successful or unsuccessful the venture is. So we’re going to have to come to some compromise. Now there’s a really interesting trade-off in how much money an investor gives to the company, because it’s a trade-off about what incentives do the entrepreneurs have.

Giving a short leash, giving only a small amount of money, puts a lot of pressure on the entrepreneur. And one investment philosophy is to say, this is great, we know that the investor has to perform. They’re going to be really focused on hitting their milestones. And if they don’t, well, we don’t want to refinance them.

That’s one model. There is a second model though, that says, hang on. If we give the entrepreneurs such a short leash they’re just going to go for the easy achievable milestones and they’re not going to build the most innovative, the most path-breaking company. So we need to actually give them more time to innovate, to take some big risks and to try something new.