Funding a (European) start-up
A lot can be read about Venture capital. Nowadays the role of the traditional Venture Capitalists is being questioned and this discussion is rather interesting. Some nice posts and articles about the role of the VC (VC2.0) can be read on the following pages:
- A VC rant with an opportunity and part 2 by Rick Segal on Jan 26 and Jan 29 respectively.
- How to reform the VC industry by Dave Winer on jan 28.
- The ventures we need by Robert Scoble on jan 28.
- On Venture Capital by Michael Arrington on jan 29.
- A New VC Model? by Mark Evans on Jan 29.
Probably there are a lot more out there, but these are the ones I’ve selected. It gives you a smell of what’s going on in the VC world (in the internet start-up sector).
I think this discussion is quite interesting but there is one problem: It’s all about VC in the US! As you might have noticed Fleck is based in Amsterdam, The Netherlands. When funding an internet start-up in Europe other rules apply.
The money is not the problem; there is plenty of it available in the Netherlands. A lot of Dutch investors are waiting to put their money at work again, but internet start-ups left them with a sour taste after the bubble burst in 2001. Although in the US the ‘groove’ is back again, with VC’s investing in new hot web2.0 start-ups, European investors are still hesitating to invest.
To raise initial capital for Fleck we have been talking to different VC’s and Angel investors, from the US and (mostly) from Europe and we’ve sensed a huge difference between European (Dutch) and American investors.
(1) In the States investors talk about initial investments with ‘an extra digit’, (2) they understand the market and (3) see opportunities (and always ask if we’re willing to move Fleck to Sand Hill Road).
Americans think BIGGER, FASTER and are willing to take more risk (the chance of success will increase as well).
Our goal was to raise just enough first-round capital in the Netherlands to build the company and its ‘juice’ and to be able to keep on developing (see also these interesting post of Joe Kraus and How to ride the fifth wave in Business2.0 by Michael V. Copeland).
As mentioned before, Dutch investors are still hesitating to invest in internet start-ups, knowing this, we decided not to raise ‘the whole nine yards’ at once at a very high pre-valuation, but to reduce the risk of the investors by raising less money (for a shorter period, for less %, at a lower pre-valuation). This way we can build the company (achieve our goals) and the investors are exposed to less risk (ok, their upside potential is reduced as well).
The ideal situation for an investor would be to decrease the downside risk and fully exploit upside potential. The problem seems that this would contradict the interests of the entrepreneur. So what is the solution?
I’ve been thinking about a solution that takes the interests of the investors (especially the Dutch investors) and of the entrepreneurs into account. Hear me out:
1. The start-up sells a small amount of its stock to the investor at a realistic valuation (through a convertible bond).
2. In addition the start-up sells an option to the investor to buy more stock in the future, so the investor can expand its stake in the start-up when successful.
The option to buy additional stock gives the investors the right to buy additional stock at a pre-defined valuation (higher than the initial valuation) within a specified time (expiration date). So the investor invests not only a certain amount in the convertible bond, but it pays a premium for the option as well. This way the start-up can raise some extra money, just enough to achieve its goals.
To decrease the downside of the option one can make it a convertible option. So before it expires it gives you the right to buy stock at a set price and if it is not exercised the initial fee paid to obtain the option converts into a loan.
If the start-up is flourishing, there is no need to do a second round of financing (the initial investor will exersize its option) so everyone can focus on the important stuff. Entrepreneurs happy, investors happy.
When things aren’t working out that well, the investor will not exersize its option (or even convert his bond) and the company has a liability to the investors, which it needs to pay off during business (and hopefully can).
I don’t know if this financial structure, which I call a Convertible-Bond Convertible-Call-Option combination (or in short: a Financial Fleck), is used to fund internet start-ups somewhere else in the world (the convertible call option seems quite unknown), but I think that it resolves the possible conflict of interest between the entrepreneur and investors and is very suitable to fund high potential internet start-ups (especially in countries where investors are not investing with US dollars).
I believe that this financial structure results in a win-win situation for both parties.
Isn’t that what everybody wants?
With a little help of our Fleck friends…. 
