Ask the VC is a blog written by some savvy guys who are all VCs, including Brad Feld from Foundry Group. Today's post deals with a real case where a founder gave up ten percent of his company to get an advisor on board with connections to VCs. I recently saw a case where a founder paid 30 percent for a 90 day bridge loan involving warrants (120% per annum). While obviously both founders were stareing a death spiral in the face, or at least I hope they were, why do so many startup entrepreneurs overpay for capital. There are several reasons:
- There are a lot of unscrupulous advisors out there who will overcharge; that's why you do background checks and get multiple proposals
- Entrepreneurs do not consult their advisors and attorneys; mentoring reduces the risk in startups partly because it stops you from doing stupid things and anybody can afford a five minute call to an attorney/accountant/mentor to ask what market fees are
- Entrepreneurs do not know how to calculate the value of the equity, warrants and options they are giving up; if you do not know how to calculate the value of these instruments you should not be trading them like baseball cards
- High stress makes for poor decision making; plan ahead
A couple of guidelines to avoid overpaying to raise capital:
- Loan sharks charge 4-8 percent per month. If the interest rate you are paying approaches these levels (after imputing the cost of any equity you are giving up), then you can be sure you are overpaying
- The highest fees I have ever seen to successfully raise equity was for a company with eight years of losses. The fees were 10 percent in cash and 10 percent warrant coverage (1 warrant for every 10 shares sold). I would like to point out that these fees were 100 percent contingent on the capital being raised and there was no upfront fee.
- Upfront fees to raise capital range from 0-$25,000 and the arranger should be putting some real effort into improving the business plan and/or financial model. Fees may vary based on the city where you are located but not by too much. Anybody short of a well known investment bank does not get a six figure upfront fee. (Remember that these fees are for early stage companies and not for a $100 million private equity deal.)
The more you need the capital, the more likely you are to make a mistake. Start the capital raising process early and do not overpay.
A thank you to loyal reader, Kendall, for pointing out the Ask the VC post.