Fundraising decisions and how they can shape your destiny
By: Amir Farha
Tags: Strategy, Venture Capital, Startup, Funding, Growth

As a VC we spent the past 3 years raising our second fund and we learnt a lot in the process. Not only did we struggle and discover how difficult raising capital (at scale) is in the Middle East, but we realized that we need to constantly fundraise, despite whether we need money or not. We also witnessed the ecosystem go through rapid growth that resulted in more startups coming to market, bigger round sizes and a shorter time between rounds. This has led to a significant shortage of capital, a cash crunch, that has become and will continue to be a problem. While there are plenty of angels and seed funds that cater to the first couple of rounds of funding in the Middle East, companies that are raising > $10m rounds start to struggle. No regional VC can effectively lead those rounds, apart from perhaps Saudi Technology Ventures (STV) but they can’t do that many deals per year, and no family offices act as lead investors, period. As a result, we decided late last year to hire a person on our team, Firas Al Naji, that is dedicated to focus purely on fundraising and investor relations for BECO and our portfolio companies. He is helping us build closer ties with institutional Limited Partners (LPs) and family offices both regionally and globally, and support our companies by leveraging our international network of VCs to bring them into the ecosystem. This will allow us to continue to build that network as part of our responsibility to our founders, spending time meeting, educating and selling the regional story wherever we go.

While most of us (VCs) and startups struggle to raise capital at certain stages of growth; it is the strategy, decisions and process to how one tackles their fundraising that can ultimately determine the success and the magnitude thereof. Most founders will have to raise multiple rounds of funding throughout the life of their venture, spending months talking to investors at each round and then doing it over again a few months later for the next round, and so on. A very difficult existence.

Our experience over several years of investing in more than 25 early stage companies in MENA has given us insight into patterns that separate companies which are on a path to success with those that don’t quite make it. I’d like to pay attention to one of those patterns — the pattern of decision making by founders around fundraising rounds — as I feel that it is very relevant to the MENA ecosystem, given its nascent stage of development. It may sound obvious, but we feel that these decisions by founders can be a strong signal as to whether we choose to invest. Taking the time to really think about the strategy and consequences of decisions at those critical moments can determine whether you survive and thrive, or not make it, and I wanted to unpack some of the factors that should be considered in this process.

1. Fundraising Approach: Tying it in with the Growth Strategy

I have split a company’s fundraising strategy into 2 main buckets, those that are (A) burning capital to capture market share growth, and those that are (B) more conservatively seeking organic growth and profitability. Either approach works well in many cases and not so well in others:

A. Fundraising for market share and growth: founders often get excited when they are getting traction early on in their business. The challenge here is timing. This strategy works well when a company has a clear product-market fit and go-to-market strategy. Often enough though, founders believe that they have product-market fit and take the decision to go for market share without a clear distribution/go-to-market strategy, a lack of understanding of their customers and unproven unit economics. The decision as to going after market share vs. not, should be a calculated and clear option. The founder should be able to demonstrate evidence that they are getting real “sticky” and engaged customers, rapid revenue growth month-on-month (20%+), with a clear understanding of their cohorts and a baseline LTV:CAC framework (a ratio of at least 3). Those that raise on the back of heavy marketing spend to show growth or subsidizing economics for more growth, can find themselves in a vicious fundraising cycle in the future, which can result in capital drying up very quickly.

Careem is a great example of success in this approach since they proved out strong customer traction, revenue growth and a base line for their unit economics at Series A, and laid down the foundation of scaling internally. This allowed them to focus on market share and growth over there next rounds of funding, advancing at every round and ensuring value accretion and a strong return to investors.

If you are to succeed with the above approach then you inevitably spend most of your time fundraising, especially internationally, and so be prepared and really understand the commitment it will take. There are plenty of examples of failure in this approach, some regional (e.g. Bookwitty, MarkaVIP) and others internationally (e.g. Homejoy). These approaches are typically pursued by consumer-focused businesses, and ones where the defensibility is questionable at the core and where they need to drive first mover advantage and capture market share as fast as possible.

B. Fundraising for organic growth and profitability: while this is a slower fundraising strategy, it can have exciting results. When we encounter companies that are building typically software or B2B businesses, we find that organic growth matters. The challenge here is having patience. Building truly transformational products takes time. You often have to do things that don’t scale to eventually scale and so it is often the best choice for the entrepreneur to really spend time and effort figuring as much out as possible around the business (product, team, customer behavior etc) with the least amount of capital. Companies that have built strong moats around their product or offering can really benefit from this strategy and take advantage of the business model that they have. Some successful examples include Shedul (B2B) and Property Finder (B2B2C), both of whom have raised several rounds but have strong network effects, and/or switching costs that make them really exciting businesses that are capital efficient, with high profit potential.

For those that choose this option then it’s important for you to test different strategies as fast as possible to prove out concepts/models that can capture significantly large opportunities. The danger here is that this can become a lifestyle business where the founder has built a nicely growing company that is profitable but will never be able to capture a sizeable enough opportunity. Founders can fall into this trap and raise venture capital when they should have self-funded it or taken on angels. We like those that are curious and seeking to win a market, despite taking a slower approach.

To conclude on this, there is no right answer. While approach (A) has more risk because it focuses on growth vs profitability, it also can generate the fastest returns to investors and founders, and creates significant impact. We spend a lot of time trying to align with founders on their growth plans and how that will tie into their fundraising strategy. We ask questions pertaining to the ambition of the founder’s vision, their current growth rate, engagement metrics, and product roadmap. We look at competition and the intensity thereof, meaning that it may be a “race” and therefore focus on approach (A), or a white space, therefore potentially approach (B). We review comparable companies to understand how capital efficient they are (capital invested to Enterprise Value generated or Revenue). We look at unit economics, product and the defensibility/moats that can be built around it. Then we try and understand whether they have a clear fundraising strategy based on milestones that make sense and demonstrate de-risking at every stage of the business. These are all questions/areas that each founder should consider before choosing approach A or B. Aligning with an investor is crucial here; not only so that they are bought into the journey, but so that they can effectively support you in getting there. As investors, when we align with a founder, it can allow us to set up a clearer roadmap for us to add value, while also giving the founders the comfort to focus on the business.

2. Terms Matter: Valuation, Amount Raised and Dilution

I am generally not a stickler for valuation at the early stage. We see it as a binary outcome, and a very ambiguous number that can be argued in many ways. Every founder is on a journey, and the more robust the growth story, the more exciting it is to investors. Each founder needs to raise round(s) of funding as they grow, at hopefully increasing valuations with each round, building value for their shareholders and themselves. So, pricing does matter in the story of the startup and how investors will perceive it going forward. It’s not necessarily the actual amount, but instead showing your intentions whether you can set a reasonable price and deliver on milestones that allow you to increase that price at the next round. It also highlights how much you know about your business and what it will take to execute your plan by raising the right amount of capital and focusing on the key factors to de-risk and execute on it.

Unfortunately, founders are sometimes driven by unrealistic expectations or irrational exuberance where they may price the company at too high a valuation, or may give up too little equity ownership, or give up some specific terms for the sake of a higher price. Each of these outcomes, driven by pricing, can decide on whether a company achieves success or not. Typical rules of thumb you can follow include:

Each round that a founder raises should give up as little as 15% to 30% of the company. Anything less gives the impression that the founder is greedy, and anything more suggests that the founder may have too little skin in the game. If you project it forward and assume that a company goes through at least 5 rounds of funding, then the founder should end up with 15% to 20% of the business by the end of it. Some founders are too dilution-sensitive, others take the first offer that comes to them at onerous terms because the investor is taking advantage. We’ve seen both ends of the spectrum. Setting dilution gives a signal to the investor what type of founder you are, both in terms of values (win-win, sharing the spoils with others around you, or selfish/greedy) and your confidence level in the business.

Deciding the right amount to raise relative to the dilution is hugely impactful to you. I often see founders raise too little funding that will barely give them enough runway to the next round because they’re afraid of diluting too much. We often encourage founders that are testing many experiments to raise big enough rounds to have a bigger cash cushion while they get more reliable answers. This is especially the case with Seed, Series A and sometimes Series B rounds, where founders should raise for at least 18 months (if not 24 months). Having that cushion or not can make or break the business — always take it if you have the capital available, and that doesn’t necessarily mean that you dilute more. People often don’t realize that by raising a bigger round, you will effectively have more runway to get a higher valuation at the next round. Therefore, you can get an incrementally better pricing if you take more money, since it will get you to progress further.

Investors will often offer up certain terms to give founders valuations they need. These terms can be painful to the founder and set a precedent that is very difficult to recover from. Terms like earn-out structures or participating preferred liquidation preferences, are some of the terms that you need to be wary of. If founders are adamant on getting a price that they want, then earn-outs work to a certain extent. However, they can also mis-align interests between founder and investor. Participating preferred is dangerous because every future investor will have a participating preferred on the next round of funding, creating a layered waterfall that can drastically reduce the outcomes for common shareholders (founders, employees and early angels), which is not fair, and is often a demonstration of bad judgment by the founder. It’s a shortsighted approach as these decisions can destroy the chances of closing your next fundraise and can signal that the founder is egotistical or disloyal (especially to early investors).

The above terms are often misunderstood by founders, especially first-time founders, where they either give up too much equity for too little capital, over-raise just because they have significant demand, or under-raise because they’re stingy with their equity. The main message here is that each round of funding gives you another chance at bat, another lifeline. Each round is a make or break. So don’t sweat ownership too much, but make sure you have enough to keep you happy, and raise the right amount of capital for testing and de-risking. Over-raising can make you spend money inappropriately and if you don’t get to the right milestones then it’ll be very difficult for you to recover from it. Under-raising doesn’t give you enough time to show results and ask for a higher valuation or a larger round of funding. So you’ll often see bridge rounds at slight uplifts or even flat rounds, which is not a problem, but as a founder you may find yourself getting heavily diluted because of it. Founders that demonstrate that they have thought deeply about their fundraising amount and dilution (incorporating future rounds) gives us comfort that they have a good grasp of what’s required to get to the next round of funding.

3. Investor Selection: Choosing the Right Partner(s)

The MENA ecosystem is small and there are very few VCs that invest. Family Offices are entering the market, but they lack the knowledge of technology and early stage investing expertise. Angels exist and are doing a good job, but value-add is often limited. With these few alternatives, founders have very little choice about who to take money from, and so don’t spend enough time doing diligence on their own prospective investors as they should. There are various situations I’ve seen where founders have taken money from the wrong investors. Investors who have big egos, who make the founder’s life difficult with onerous requests that take time away from the business, or worse still, who have an active influence on the company decisions through board roles and preferential rights. These inevitably lead to problems down the line — whether at the next round of funding, or in the round after that, and they can drastically reduce your likelihood of success.

Pick your investors wisely. I strongly recommend doing reference checks on your investors by asking their investee companies about them. Are they supportive? Would you take their money again? What have they done that has really helped you grow apart from capital? Are they available/accessible? Once you choose your investor, they are with you for the duration of your business. That is an average of 7 to 11 years in the US and more likely 9 to 13 years in the Middle East. A very long time. Make sure you have chemistry with your investor, align on values and on the areas where they can help in advance.

You also want to diversify your cap table and ensure that you have enough pockets of capital to support you in your future rounds. For example, we invest at Seed and Series A, and follow-on at Series B. So founders raising Seed rounds will know that we have pockets to back them in their upcoming rounds. Try and get a mix of different investors at different stages of your growth so that they can cover you through the challenging rounds until you get to the goals you want. This means really building an investor criteria based on who they know, what companies have they invested in, what sectors, how big are their funds, how much do they allocate to one company and so forth. Profile your investor so that you can build a targeted investor list that will allow you to draft a clearer pitch and increase the likelihood of closing a round with them. Founders that have strong arguments on why they have these investors in the cap table and have a solid plan for who to target in future rounds of funding will inevitably have a greater chance to make it.

I’ve tried to summarize my learnings in a digestible way, with the hope that it can help entrepreneurs make better choices by putting it into context. I’m sure there are plenty more patterns to identify and areas to explore as more rounds get closed and more success stories get built in the Middle East. Until then, best of luck with your fundraise.