December 2016 marked ZEAL Investments’ (ZI) first investment, as we injected £1 million into the Free Postcode Lottery (FPL). This game-changing lottery start-up is exactly the type of disruptive business we are looking to help grow. It was an exciting, and engaging process that put our Director, James Oakes, on the other side of the investor/investee table for the first time.
Having co-founded Geonomics, a location-based digital start-up that raised over £20 million in funds, James knows all too well the challenges and complexities that hungry techpreneurs face when hunting for investment. This first-hand experience helped develop an existing relationship with FPL’s founder, Chris Holbrook, that resulted in a mutually beneficial investment. That said, investing in a start-up is never without its challenges. Here are some important lessons that we learned along the way.
Wood for the trees
At ZI, we believe that investing in a start-up is all about the relationship between investor and founder. It is much more than a business transaction, it is a vote of confidence in the entrepreneurial team. As an early investor, we want to be partners and contributors to the teams we invest in. We want to see them succeed because if they do, we do. One of our earliest lessons from the FPL deal is that proposing debt finance might send a signal that you are not looking for a genuine partnership.
The signalling difference between a debt finance deal and a pure equity deal is huge. Debt finance protects the downside for the investor in the event that things don’t work out whereas equity doesn’t have that protection. With equity, the investor is investing because they really believe in the potential of the start-up and the entrepreneurial team. This has the positive impact of aligning the interests of the investor and investee.
There will of course be times when investors will need to use debt finance, and convertible notes are a useful tool in very early-stage deals, but the advantages should be carefully weighed against the negative signalling effects. Get that judgement wrong and, for the sake of making you feel 1 percent better about the risk profile, you run the risk of losing the deal entirely – which really IS the biggest risk.
You want the other side to have good lawyers
Both the investor and the start-up need good lawyers. There’s a big misperception that the side with the better lawyer will get the best deal, because they will be able to pull one over on the other side. In practice, this is rubbish. It is crucial for both sides to have a great lawyer so that the right deal is struck quickly and painlessly. A bad lawyer in the mix only adds complexity, cost and can risk ruining the whole investment if contractual points are not explained well or understood. Good legal representation on both sides builds trust and makes sure the deal that you both want to do is the one that actually gets done.
Leave something on the table
It doesn’t pay for investors to get greedy. You need to remember that investing in a start-up is a marathon and not a sprint – The success or failure of the business rests squarely on the founders’ shoulders. While it can be tempting to try and grab as much business control as possible at the beginning, it is very healthy for the motivation of the team to leave a meaningful share on the table and not limit their options from the get go.
ZI, for example, opted for a 10 percent stake in FPL. We see big opportunities for growth and would have loved to have taken more, but it’s not our business. We agreed upon a small initial investment and signed on as a partner to provide strategic, data and general management support over and above any financial commitment. That way, FPL retains the ability to consider all options as the business grows and essentially, remains master of its own destiny. In the long-run this maximises the chance for FPL to be successful, and both sides win.
If you’re a disruptive digital start-up looking for an investor who gets your game, give our investment team a shout today.