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Overfunding is great – right?

Scale-ups seeking equity finance should always overfund. Or should they?

Customers are keener than ever to invest in the brands they love, which means that we are seeing records levels of scale-ups getting overfunded, which is great. Right?

Well, yes and no. While your instinct might say that of course it’s a good thing to have too much cash, it isn’t always the case. Scale-ups should make sure they have asked themselves certain questions before agreeing to accept funding beyond their initial target. Here are the three we think are the most important:

How much of my equity am I prepared to release?

The number one reason not to overfund is the dilution of shares. Say you’re seeking £300k. You’ve agreed this with your board, you’ve declared how you’ll use the funds and you know exactly what percentage of your scale-up’s equity you’re prepared to part with. You reach your target and yet the money keeps coming in, so what to do? Do you accept the investment or, if not, why not? As an example, a start-up has two founders, each owning 50% of their business and, as a group, 100%. When the founders raise capital, they understand that their percentage of ownership will be decreased, all of which is agreed upon in the key investment data document. However, if they decide to overfund, this dilution continues to increase, meaning that overall ownership and control by the original shareholders is – by default – further reduced. A great way to see if dilution can work – or not – for your scale-up, is to download Capshare’s Equity Dilution Calculator here.

Do I need these extra funds now?

Unless you know exactly what to spend these funds on and how they’ll help your company to expand, overfunding and excessive dilution can lead to a situation where a scale-up has issued more equity than its assets are worth, known as over-capitalisation. This can be a fatal mistake for any company, as this results in having to pay more in interest and dividend payments than can be sustained in the long-term. This creates a trajectory of decrease in share value, unhappy investors and an uncertain future. In cases such as this, one solution would be to buy back the shares – an anti-dilution solution, so to speak – which, in itself, is the antithesis of the concept of overfunding in the first place. Ultimately, too much money, at a time when it’s not needed or at too early a funding round, leads to idle funds and an over-inflated valuation; over-capitalisation is a cautionary tale when thinking about whether to keep accepting the cash or not.

Have I retained enough equity for future funding rounds?

As a start-up, your equity is your most prized asset and should be treated as such; the general rule of thumb is to release no more than between 10 – 20% to seed or early stage investors. Typically, a company will seek funding through five or six rounds, so premature excitement at any overfunding may create a case of such over-dilution that you may not have anything to offer in the future. Obviously – without a crystal ball – it’s impossible for a founder to predict just how much will be needed further down the growth phase, so this is a dilemma that has to be carefully evaluated when taking too much money in an earlier round. It’s crucial to remember too that the earlier the stage of the funding round, the lower the valuation of the company and the less proven the business model. So, investing in a seed or series A round is a bigger risk than for those who fund you in later stages; this means bigger returns. The more you give away at the beginning of your company’s growth phase, the less you’ll have for those who invest when you’re well established – and they’ll cost you more, so you’ll need to be meticulously prepared for these eventualities.

 

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Overfunding is great – right?

By Envestors31 May 2019