10 mistakes to avoid when raising capital in financing rounds
Raising capital is one of the most challenging tasks startups face. Moreover, although raising investment can be the boost needed to scale a business, the process of raising funds is full of obstacles, and there are certain mistakes that can be very costly, both for companies with little experience in the market and for those that already have a recognised reputation for their products or services. The funding process goes far beyond a simple presentation or pitch: it involves complex legal agreements, negotiations and a host of details that can become obstacles if not managed properly. Here are 10 mistakes to avoid when raising capital in financing rounds.
1. Not having the right vehicle in place when raising capital in financing rounds.
It is common to underestimate the importance of having the right legal structure in place from the outset, but it should not be forgotten that it is the framework within which the business will be presented to investors. Choosing the right legal form to set up or continue a business (public limited company, limited liability company, limited joint stock company, cooperative society, collective investment schemes, contractual joint venture…) is crucial to protect the founders, facilitate the entry of investors and avoid legal complications in the future.
There are different types of legal structures for a company, and each has its own characteristics, advantages and disadvantages in terms of legal liability, taxation, governance, and ability to attract investment.
For example, some corporate forms have restrictions on the issuance and transfer of share capital, which can be a significant obstacle to raising finance. If the company needs to convert to a public limited company to attract capital, the restructuring process can be costly and time-consuming.
Similarly, each legal structure has different tax implications, so that taxes on profits and the form of dividend distributions may vary according to the type of entity.
The legal structure is therefore the foundation on which the entire business is built, and choosing the right legal form from the outset will undoubtedly have a significant impact on the ability to attract investors, the ease of scaling up and the protection of the founders’ interests.
2. Negotiating deals without understanding the legal implications of raising capital in financing rounds.
During a financing round, entrepreneurs often focus on attracting investors and raising the funds needed to grow their business. However, in their eagerness to close a deal, many make the mistake of negotiating terms without fully understanding the legal implications of the contracts they are signing. This mistake can have serious and long-lasting consequences, from loss of control of the company to legal disputes that can jeopardise the viability of the business.
Investment agreements are not simple contracts; they are complex documents that set out the rules of the game for the relationship between the company and its investors. These agreements include a number of terms and clauses that can have a major impact on the future of the company.
Some of the most common terms are defined below:
- Pre- and post-money valuation: Define the value of the company before and after the investment. A common mistake is to accept a low valuation which, while it may seem like a quick option to raise funds, can lead to excessive dilution of the founders’ stake.
- Pre-emption rights: These rights give investors pre-emptive rights in various situations, such as the sale of the company or the issuance of new shares or equity. A poorly negotiated clause can leave founders without a voice in crucial strategic decisions.
- Anti-dilution clauses: These protect certain members or shareholders against the entry of third parties into the share capital or the increase in the shareholding of existing members, insofar as such an acquisition may lead to a reduction in the percentage shareholding of those concerned. Some anti-dilution formulas can be extremely detrimental to founders if not carefully negotiated, such as the ‘full ratchet’ clause (under this clause, if new shares are issued at a lower price than an investor paid in a previous round, the investor will be allowed to adjust its shareholding as if it had paid the lower price for all the shares it initially bought).
- Veto rights and control: Many investment agreements give investors veto rights over important decisions, such as issuing new shares or equity, taking on debt or selling the company. Without a proper balance, these rights can limit the autonomy of the founders to manage the business.
- Exit clauses and drag-along rights: These define the conditions under which investors can exit the investment or force the sale of the company. Poorly negotiated exit clauses can lead to a situation where the founders are forced to sell their company on unfavourable terms.
3. Unrealistic valuations when raising capital in financing rounds
The valuation of a company is a crucial aspect during any financing round, as it determines the price investors will pay for an equity stake in the business. However, one of the most common and potentially damaging mistakes entrepreneurs make is to set the valuation too high or too low. This mistake can have significant consequences, from loss of investor confidence to difficulty in raising additional funds in the future.
What does it mean to value unrealistically? It means assigning a value to the company that does not reflect its true financial situation, growth potential, business model, team or market conditions. There are two main ways in which a valuation can be unrealistic:
- Excessively high valuation: This occurs when founders set a valuation well above what would be justified by revenues, projected growth, market traction or product innovation. This type of valuation can create unreasonable expectations and discourage potential investors, as it implies higher risk and lower potential return on investment.
- Valuation too low: This occurs when the founders, for fear of not attracting investors, set a valuation below the true value of the company. This can lead to excessive dilution of the founders’ shareholding and the perception that the company is in trouble or lacks potential, which can also scare away more sophisticated investors.
4. Not having a strong team when raising capital in financing rounds
An inexperienced or uncommitted team can scare off investors. When someone decides to invest in a business, they are betting on both the idea and the team behind it. In this sense, it is crucial to have a multidisciplinary team, with complementary skills and relevant experience in the sector. It is key to listen to people with experience in the sector to assess whether it would be necessary to invest in hiring a specific professional who can add value to the company.
In addition, internal conflicts between co-founders or employees can arise at any time, especially when the business starts to grow. These conflicts can threaten a funding round if investors perceive instability. To avoid this, clear and solid contracts that define the roles, responsibilities and rights of each team member are essential.
5. Lack of preparation for due diligence when raising capital in financing rounds
The due diligence process is essential in any financing round, and consists of investors thoroughly reviewing all legal, tax and financial aspects of the company.
Lack of preparation for this process can raise doubts about the transparency and soundness of the business, generating mistrust, and may lead investors to consider scaling back, delaying, or even cancelling an investment. To avoid this, make sure you have all your documentation in order and are ready to answer any questions clearly and transparently.
6. Not having a clear and coherent business proposition when raising capital in financing rounds
One of the most common mistakes is not clearly articulating the company’s value proposition. An investor wants to quickly understand what problem your product or service solves, how it differs from the competition and why it is relevant to the market. If your value proposition is unclear or poorly defined, it will be difficult to capture the attention of investors.
Similarly, many entrepreneurs make the mistake of underestimating or overestimating the size of their target market. Claiming that your product has a ‘potential market of billions’ without supporting data may seem unrealistic.
Conversely, too narrow a view of the market may cause investors to question the scalability of the business. It is essential to conduct thorough market research and present realistic, data-driven projections.
Investors expect to see key metrics that demonstrate traction, such as user growth, revenue, and acquisition costs. Failure to present this data, or presenting it incompletely, raises doubts about the viability of the business.
7. Not knowing investors and their investment criteria when raising capital in financing rounds
Not all investors are suitable for your business. Each investor has their own investment criteria, areas of interest, stage of investment and return expectations. Approaching investors who are not aligned with your type of business or stage of business can be a waste of time and resources.
We recommend that you research investors beforehand to ensure that they are a good strategic fit or, if you prefer, you can have a professional who can do this analysis or is used to dealing with investors interested in your sector.
8. Failure to adequately protect intellectual property when raising capital in financing rounds
One of a company’s greatest assets is often its intellectual property: patents, trademarks, copyrights or trade secrets. It is not just that investors expect to be able to check that intellectual property is properly registered and protected, it goes further: without proper legal protection, these assets can be vulnerable to theft or litigation, and the mere dissemination of the information can generate damage that is difficult to resolve.
9. Not having a clear strategy for the use of funds when raising capital in financing rounds
Investors want to know exactly how the funds they contribute will be used. A common mistake is not having a well-defined strategy for the use of capital. It is important to specify how the money will be invested (whether in marketing, product development, staffing or expansion into new markets), that these investments are aligned with the business plan and, of course, to try to deliver on the intended use of the funds. This shows that you have a clear and focused plan for growth.
While it is essential to have a clear strategy for the use of funds, it is also important that this strategy is backed by a sound legal basis. For example, if you plan to expand your business into other markets, it is essential to understand local laws and regulations. A specialist lawyer can help you plan this expansion from a legal point of view, ensuring that every step you take is within the appropriate regulatory framework.
10. Failure to plan a legally sound exit strategy when raising capital in financing rounds
One of the most common mistakes when raising capital in financing rounds is not having a well-defined and legally sound exit strategy. Investors not only invest in startups for their growth potential, but also with the expectation of a significant return on their investment over a reasonable time horizon.
A clear, credible and well-structured exit strategy is key to attracting these investors, as it provides them with a concrete plan on how they will be able to recover their investment and generate returns.
An exit strategy is a plan that describes how investors will be able to convert their stake in the business into cash, usually by selling shares or units at a higher price than they bought them. The most common exit strategies are as follows:
- Acquisition by another company (M&A): The entity is bought by a larger company, which seeks to integrate its products, technology, talent or access to its customer base.
- Initial Public Offering (IPO): The company goes public, allowing investors to sell their shares in the public market.
- Secondary sale: Investors sell their stakes to other investors, usually during subsequent financing rounds or through a private process.
- Merger: The entity merges with another company to create a combined entity, which may provide an exit route for the original investors.
Ultimately, raising capital is a complex process that requires preparation, clarity and a well-defined strategy. Avoiding these common mistakes can significantly increase the chances of success in funding rounds, as investors are looking to invest in companies that not only have a great idea, but also the ability to execute and grow it sustainably. If you can demonstrate this, you will be in a much stronger position to attract the investment you need.
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