Columnist Yrjö Ojasaar (pictured) continues to analyze the biggest mistakes start-ups are often making.  This time he points out the typical financing related failures.

Assuming that VC money is for you

VC money is not the right financing tool for everyone. Your start-up may be profitable and growing, but if the company can’t rapidly scale, apply an innovative business model and the total addressable market is under $100 million, then VC money is probably not the appropriate growth vehicle for your business.

VC investment historically has flowed to the IT sector (mainly software and hardware) which has accounted for ca 60%, and healthcare (mainly pharmaceuticals and medical devices) ca 25% of all venture investments. These fields have shown to be able to yield unique concepts and products that were rapidly scaled internationally (the cost to manufacture and sell each additional copy of proprietary software or medication is near zero after initial big development costs). Clean/Greentech sector investments have also shown strong growth over the past 5 years.

A stern look in the mirror should fix this dilemma – founders, for obvious reasons, often have difficulty with assessing their company impartially. Entrepreneurs often overvalue their strategic chances for growth, ability to monetize their product/service and their advantage over the competition. Finally, most founders are not prepared to live the stressful life of high-stakes technology gambles, regular formal reporting, and trying to meet the hyper-growth expectations of VC investors. If you think you qualify, put your game-face on and start fundraising.

Assuming that a higher valuation is always a good thing

Insisting on an unrealistically high company valuation will usually come back to haunt the founders. In exchange for the high valuations VC’s will demand that their “standard” provisions be included in your SHA and SPA documentation (high liquidation preferences, participation rights, cumulative dividends, tranche payments and other risk allocation tools).

Overvaluation in the initial round may come to bite you in the next round as you pushed your projects buy-in price out of range (beyond the investment profile) for the smaller or less liquid funds (beyond the investment profile). So if you are located in the Baltics, your list of potential investors just got a whole lot shorter.

To maker things worse, if the company cannot then raise the next round with an even higher valuation, the founders will face drastic dilution due to the VC’s anti-dilution clauses in the agreements (including the infamous “full ratchet”). The founders that insisted on a $10 million pre-money valuation begin to realize that they may be just be expected to deliver a $50 million exit only 5 short years later. Of course undervaluing the company is also a sin – as you are basically stealing from yourself and your co-founders.

Doing your homework helps to get a realistic valuation: find out how the VCs have valued similar companies within the past few years and research the acquisitions pricing of M&A deals (Best free place to find this info is the SEC filings of the acquiring companies, as they are often listed and thus obligated to make disclosures) or if the company has significant revenues for over a period of years start looking at revenue multiples (How did the acquirers rate the target’s value in relation to revenues?).

Looking for financing only in your home town

Unless you are in a location like Silicon Valley, Boston, New York, Seattle, London, Paris or Stockholm your start-up will probably have trouble finding sufficient local financing even with a super team and a very cool prototype.

If you need to raise several multi-million dollar rounds from “smart money” funds, you pretty much have to fundraise in the top ten VC capitals.

Moreover, each VC has its own specialized investment region, if you are not in the region – you better be a short non-stop flight away (more reasons to think about the full implications of the future of the aptly named Lennart Meri Tallinn Airport).

To get financing from UK and US you should expect as a pre-condition for financing – establishing an entity with key IP and management in the VC’s region. I know – it’s not fair, but location does matter – the traditional investment meccas, in addition to VC money and experience, also have top-notch IP lawyers, accountants, scientists, universities, programmers and other professionals. Many start-up are getting wise to this, and have upgraded their game for international fundraising by refining their pitches, recruiting more broadly, establishing real corporate governance regimes, and getting professional about IP creation and protection. This dynamic may eventually start to pull all of the choice IP and technology toward those investment capitals, which in turn will require local VCs and angel investors to work extra hard to fund the better deals.

Read also other Yrjö’s columns on the mistakes start-ups are making from here