It’s not so much swings and roundabouts but stacks and waterfalls that high-growth business owners need to be aware of when navigating the alphabet soup of early stage seed and funding rounds. On the face of it, the process appears quite straightforward. Start-up and early stage companies in need of capital to fund innovative product development and growth raise funds on the private markets by selling equity to investors. They generally move through a series of funding rounds, labelled A, B, C and so on, with each one usually raising more money than the last.
But it’s not quite as simple as that. There’s no such thing as a free lunch in the capital markets and each investment comes with its own terms and conditions.
“The first stage is the seed stage,” explains Deloitte partner James Toomey. “It does what it says. It seeds early stage growth when the business is still pretty small and almost certainly pre-profit. That’s typically a few million euro and can come from a variety of sources including angel investors, friends and family, and you could be bootstrapping the business yourself.
“Angel investors have become more important in recent years in helping get businesses off the ground. Enterprise Ireland will often come in with a chunk of capital in the seed round. Many companies will do a few seed stages to get going while they are trying to get traction in the market and developing products.”
Enterprise Ireland head of funding and scaling solutions Tom Early explains some of the complications that can arise after that.
“In the good old days you had the seed round to help you get to a minimum viable product and bit of sales traction, and then you went into A, then B, C and D rounds,” he says. “When investors come in, they try to get to the top of the stack or the waterfall. This is the way proceeds are distributed when a sale event occurs.”
For example, if a funder invests in preference shares in the A round, that will grant them certain participation and redemption rights. “If you have put in €1 million for a 10 per cent stake and if the company is subsequently sold for €20 million, you take €1 million off the top and 10 per cent of what is left,” Early explains.
Simple enough – but that’s when things can start to get a little tricky.
“In the B round you can have people coming in looking for preference over others,” says Early. “It can get really complicated. It comes down to negotiations. There is no one right answer and there are plenty of wrong ones.”
It all comes down to what is known as the term sheet, the agreement that dictates the rights of the investor when the company is eventually sold or when other investors come in. There are a number of aspects to these agreements; the economic aspects dictate the price of the shares, the percentage of the company the investor is getting and so on. And there is the control mechanism.
“Shareholders will want as much control as possible,” says Early. “Entrepreneurs need to push back on that. Investors’ bread and butter is understanding term sheets and negotiating them. If your hill to die on is the valuation of the company, you may think you are getting what you are looking for until you look at the terms and conditions the investor is putting on it. For example, if there is a down round which puts the company at a lower valuation than previously you can have terms which say that certain investors must be given more shares.”
“The devil is definitely in the detail,” says Toomey. “There is a whole hierarchy of shares that needs to be set out. The rights of shareholders need to be well understood by investors and founders. It’s very complex. Both sides need a lot of advice. It can be harder for smaller businesses to get advice but there are lots of state supports from organisations like Enterprise Ireland to help them.”
And there is no real end to the process, according to Toomey.
“A scaling business is always focusing on the runway of capital,” he says. “When does that run out? They are always looking at the next chunk of capital. When they get to a certain scale, they may look to take in private-equity investment. That can allow them to take some money off the table, having put all their resources into the business over the years. That de-risks it for them.
“The next phase could be a larger private-equity round, an exit to a trade player or even an IPO. The process keeps going on for quite a while.”
Knowing how to engage with investors throughout the process is critically important, according to Early.
“We help companies to prepare for that,” he says. “You need to make sure you are getting the right advice from the right people. Make sure the advisers you are dealing with have experience in the area. At Enterprise Ireland, all we want is to see companies grow and succeed internationally.”