How we help Founders protect their Equity

As a VC I am constantly discussing funding strategies with Entrepreneurs.

While I might have seen hundreds of funding rounds during my career an experienced founder might have seen 5–10 and in most cases even less, particularly in the early stage. Therefore I feel I have to be very careful not to use this information asymmetry to my selfish advantage.

There is also an inherent conflict of interest between founders, VCs and the ecosystem in general:

• As a VC, particularly if I have sufficient reserves to “follow my money”, I am interested in frequent, increasingly large funding rounds that generate book value for the fund and accelerate the path to liquidity.
• On the other hand, Founders might not be interested in too much funding as this dilutes their ownership. But at the same time, extreme behaviour to avoid funding might slow down the company’s growth to a point where it becomes dangerous for the business.
• Moreover, large companies generate ecosystems around them and transform the economy for the better. Making companies grow, even at cost of dilution for the shareholders is a way to give back to society as the equity funding gets to be invested at very high ROIs and the whole ecosystem benefits.

I believe it is my duty as a VC to help Founders build large companies and protect their Equity by giving advice and talking openly about the conflicts of interest inherent in our business.

Here is a list of principles we use at Nauta that help protects Founder’s equity:

1. Focus on Capital Efficiency

Capital Efficiency is the cornerstone of our investment thesis and of the process we use to select investments. But it is actually more than that. It is the pillar of our approach to help Founders build large, long-term sustainable businesses and own as much as possible of those great businesses.

As capital efficient investors we understand that inefficient growth does not create value but actually destroys it. We focus on helping companies understand the ROI of their acquisition channels and never put unhealthy pressure to “grow at any cost”.

We are particularly careful with performance marketing as it can generate a growth trap that only benefits the Ad platforms.

2. Get the right funding at the right time

Focus on using the money that you already have raised wisely before raising more:

• 1 USD in your bank account adds 1 USD to the Enterprise Value
• 1 USD in your ARR adds 10–20 USD to the Enterprise Value

Capital efficient SaaS companies can convert 1 USD in the bank account into 0,3–0,5 USD of new ARR. This means that 1 USD in cash can be used to create 3–10 USD in value for the company at the next funding round ((0,3–0,5)x(10–20)=3–10).

Fundraising with too much cash in the bank or accepting pre-emptive offers from VCs to raise earlier than planned is usually a bad idea.

Funding is very tempting and VCs can be very seductive but the ideal time to raise a round is when:

1. The company has generated as much value as possible with the available cash and
2. There is a clear plan to execute on a set of well-understood growth opportunities in the coming 18 months

3. Build optionality during fundraising

One of the most feared competitors of VCs is the bridge to break even.

As a founder, make sure that you reach the fundraising phase in a position that gives you options. Usually, these can be: 1) raise a round (sometimes in different sizes), 2) extend your runway with a small bridge or venture debt to raise again in a few months or 3) reach break even (maybe also with a small bridge).

Note that this optionality can be created much easier if the cash flows are improving during fundraising. In the graph below you can see a schematic example of the (operating) cash flow evolution of a company between two funding rounds.

A schematic example of the operating cash flows of a company between two funding rounds. If cash flows improve during fundraising multiple options are available.

Each fundraising is followed by an investing phase in which spending increases and cash flows get deeply negative (downhill phase) as a result of the delay between input and output in the business.

It is important to tune the growth plan to get to improving cash flows by the time the company goes into fundraising again. This gives you the option to pass on term sheets that do not meet your expectations and to stop fundraising and try it later if you do not receive positive feedback from the market.

4. Focus on shortening the cash cycle

At Nauta we like to focus on subscription businesses because they are much more capital efficient. Note that this part is specific to those businesses.

• Focus on Time to Recover CAC instead of CLTV/CAC: For early-stage companies that have a very high cost of capital, minimizing Time to Recover CAC will make the company cash efficient at a time where each dollar in funding is extremely expensive. Later in the journey, when companies mature their cost of capital goes down and so maximizing CLTV/CAC makes much more sense.
• Get customers to pay upfront: In most SaaS businesses you can get your customers to pay 12-month licenses in advance. In SME and consumer SaaS, you need to offer reasonable discounts to get your customers to pay upfront but it works. In Enterprise Software businesses 12 months upfront payments are standard and necessary because of the budgeting processes in large corporations. In these cases, startups can actually get multi-year contracts paid upfront in exchange to keep the price unchanged (thanks SAP, Oracle and Co. for educating the market ;-))

Evolution of the MRR and Cash Inflows of a SaaS company that is able to generate a significant portion of upfront payments. Note that the cash inflows are always higher than the MRR.

5. Work on non-dilutive funding

There is a number of non-dilutive funding options available to early-stage companies. We help our portfolio companies establish relationships with banks, debt funds and government offices that can provide this type of funding. These partners see us as an anchor investor that generates trust and that usually helps.

• Bank loans: Try to develop commercial relationships with banks early on. At the beginning, the loans will be small and the application process might seem painful but later on, these efforts will pay off greatly. Remember that VC money has a cost of capital of 20–40% p.a. while bank loans cost much much less.
• Grants and public loans: Particularly relevant for the earlier stage companies. Spending time applying for grants and soft loans is a great investment!
• Venture Debt: Getting to know Venture Debt funds and their strategies can be very helpful. The management teams at those funds are extremely knowledgeable of technology businesses and by definition have seen many businesses use debt to grow. Besides funding, getting their perspective on the business can be a valuable input.

I hope this helps explain some of our principles that help entrepreneurs protect their Equity. Do not hesitate to reach out if you have questions or comments.

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About myself: I’m VC @ Nauta Capital. I’d love to blog more often but I only do it when I’m not doing DD or helping our portfolio ;-) email: guillem.sague@nautacapital.com