Update: June 2024

by | Jun 2024 | Updates

Hi everyone – exciting progress at DQ since our last update (brief details below), but the focus of this letter is something else. It’s a topic we’ve mentioned before, and it’s something we can’t stop thinking about: a brand new and fairer approach to early-stage investing.

In short, we need your input.

What’s the plan?

We’re suggesting a better way of structuring early funding rounds. The goal is to create a mechanic that lets a wider variety of companies raise capital from private investors (not just those claiming to be a future “unicorn”), and recognises the fact that, today, angel investors often get a raw deal. What we’re suggesting seems fairer, simpler and more logical than what’s used currently (SAFE agreements, convertible notes, ASAs and equity rounds), and stems from our belief that founders could access funding faster and more easily if they increased their investors’ odds of success.

As angels, we will use this ourselves. More importantly though, it could provide a much-needed boost to hundreds, if not thousands of early-stage startups. This challenge, however, is too big – and too important – for DQ to tackle alone.

What’s not working

Traditionally, founders have resisted sweetening the deal for investors because doing so would mean dropping their company’s valuation. This works against the founder’s own best interests. So, predominantly, they benchmark their raise against similar, often over-priced funding rounds (themselves based on optimistic projections), then complain when they can’t raise money.

Usually, in early-stage investing too little thought is given to the most likely outcomes (i.e. failure or a mediocre return); instead, all focus is on the desired outcome. In the vast majority of cases, of course, such deals lead to disappointment, and sometimes interests between founders and backers become misaligned.

This is just how the game is played. It may be perfectly acceptable for VCs, who understand the power law. It’s not so great for angels and founders, however. As investors in 100 companies, we’ve witnessed this first hand.

What’s the suggestion?

We believe founders could raise money more easily if they were to use terms that catered to all possible eventualities, not only the best and worst-case scenarios. Such terms would need to consider not just opportunity, but also probability, risk, and the founder’s ambition and belief. We explain how below.

What’s the timeline?

To make this a reality, we’re crowdsourcing feedback. We need your opinion on what we’re proposing. Once we’ve stress-tested the idea – hopefully within the next few weeks – we’ll ask our lawyers to create and share a document template. We’ll make this freely available for you, and others, to download. The goal? To give angels and founders a simpler, more sensible way of doing business together. Read on to find out what we’re proposing and why we think this could have significant, long-lasting impact.

Background: “rational startups”

It’s been hard to miss the recent surge in anti-VC sentiment. This happens seemingly every time the economy hits a speed bump. Startups that haven’t delivered on the hype, despite raising large rounds at eye-watering valuations (see 2021), are held aloft as examples of VC hubris and dysfunction. Meanwhile, terms like ‘bootstrap’ become the new words-du-jour.

We startup folk can certainly be opinionated (especially when there are LinkedIn likes to be had). And yet we all know that venture capital plays an important role. The real problem, in fact, is that VC is a victim of its own success. Survivor bias means we tend to read only about the best outcomes. This gives the false impression that all startups succeed, and that money is readily available to anyone with a good idea. This is obviously not true.

Avoiding the VC trap

The truth is the vast majority of businesses are not, and never will be, suitable for VC investment. Most founders would be better off avoiding it completely. Not only would they save wasted time (both theirs and the VCs’), but also they’d avoid the possible poisoned chalice of an inexperienced VC mis-allocating capital in their direction (thus inadvertently leading them down a high-risk path they never intended to take).

Advocating the “rational startup” movement

Having been operating and investing in the startup world for 20+ years, our thesis at DQventures is that most founders should build towards multi-million-dollar outcomes. Forget chasing unicorns and, in most cases, forget VCs. A startup’s chances of success increase dramatically when they try to build sustainably. Never “grow at all costs”. Founders who fund their business with a combination of “one-and-done” investment rounds, revenue, grants and debt have greater optionality than those who go the venture route. This may provide a lower chance of an outsized return, perhaps, but it also creates a higher likelihood of… a return.

At DQventures we call these businesses “rational startups”. We expect the majority of our portfolio companies to follow this path. We actively encourage them to do so. De-risk at every opportunity, run lean and get to default alive as quickly as possible. Meanwhile, fund growth with non-dilutive capital, look after your employees and give anyone who invests a realistic chance of a 10x return.

As for venture funding, while we’ll never stand in the way of a VC raise (especially when the metrics line up), we’re quick to point out that VC money comes with non-trivial expectations and pressure. Our commitment is to help founders avoid unnecessary risks that might lead to burnout or failure. Venture capital is one such risk.

Fair Equity For All (FEFA)

(We realise this working title is problematic and reminiscent of a disgraced footballing body, but we’ll stick with it until someone suggests a better alternative!)

What FEFA is trying to achieve is as follows:

  1. FEFA should speed up the fundraising process and avoid uncomfortable debates about valuation. It’s impossible to value early-stage companies accurately, so why not remove it completely?
  2. It should align the interests of founders and early investors, no matter what the outcome is or how much money is raised.
    • Founders should not make life-changing returns while their investors lose money. This can happen when the initial valuation is too high.
    • Founders should never resent the quantum of returns their investors are making. This can happen when the initial valuation is too low.
    • The terms should incentivise founders to deliver a good outcome for investors, no matter what. Penalising founders too heavily for smaller exits, for example, might lead them to give up completely.
  3. It should allow founders and early investors to have a good outcome without going down the venture route.

What does FEFA need to provide?

The criteria so far:

  1. If founders fail to deliver a significant return on investors’ capital (e.g. friends and family invest $250K; 5 years later the company sells for $250K), investors should take home a disproportionately high share of distributions. This minimises their downside risk. There should be no objection from the founder because it won’t happen anyway, right?
  2. Founders, by contrast, should take home a disproportionately high share of returns if the company delivers a higher return on investors’ capital (e.g. angels invest $250K. 10 years later the company lists and generates $500m for all those with founder shares). There should be no objection from investors here because they will still make a higher-than-expected return.
  3. In achieving the above, founders should retain control and avoid dilution. There are two things that both founders and later-stage investors take exception to: founders with insufficient skin in the game, and cleaning up cap tables.
  4. Investors should avoid unwanted administration. Most angel investors (probably) and people who participate in friends-and-family rounds (definitely) lack time for, interest in, or knowledge about corporate governance. So why should founders waste time chasing their signatures? Can’t we invent a way for these investors to participate without creating unnecessary admin?
  5. Two things should be avoided: complexity and multiple share classes. We need an equitable way for founders and investors to close funding rounds without a law degree and without falling foul of liquidation preferences.

Is it feasible to achieve the above via a simple contractual agreement, which allows investors to participate in company distributions (including proceeds from a sale, IPO or dividend) but without holding shares in the company itself?

Ratchet

Rather than investors receiving a share of company distributions, we think it’s better that early investors receive a share of founder proceeds. This aligns both parties’ interests, without unnecessary admin, without untidy cap tables, and without impacting later-stage funding rounds.

To give both founders and investors an advantage, we suggest a simple ratchet. This works because of how differently founders and funders look at the same deal:

Investors (should) know that the companies they fund are more likely to fail than succeed. Meanwhile, every founder believes they are the exception, meaning they are more likely to succeed than fail.

What’s needed, then, is a mechanism that rewards the founder disproportionately for being right, and costs the founder disproportionately for being wrong. In other words, if there’s a tiny return, the investor should keep most of it; if there’s a giant return, it’s the founder who should benefit.

Financial model

We propose the following structure. It satisfies – we think – all of the conditions mentioned above. What have we missed?

Please have a play with it and let us know what you think.

N.B. The early investors receive a share of the “Founder Share” distributions, not of all shareholder distributions (which obviously wouldn’t work for later investors).

What we’re saying is the following:

  1. Founders issue themselves 100% of company shares. These are “Founder Shares”.
  2. Early investors sign a FEFA, entitling them to a share of all Founder Share distributions.
  3. Other investors (like VCs) may come in later, investing in a typical equity round, receiving newly issued “Ordinary Shares”.
  4. Early investors receive a share of Founder Share distributions but not Ordinary Share distributions.

Returns calculator

Editable fields

Investment Amount:
Total Founder Share Distributions:(Dividends and/or Share Sale Proceeds)

Return parameters

Returns Founder share Investor share
First 100% 10% 90%
100 to 200% 40% 60%
200% to 500% 70% 30%
500% to 1000% 85% 15%
>1000% 90% 10%

Projected returns

Total Founder share Investor share
Value of first 100%
Value of 100% to 200%
Value of 200% to 500%
Value of 500% to 1000%
Value of >1000%

Total returns / ROI

Total Founder share Investor share
Total returns:
Share of distributions:
Total ROI %:

N.B. This is an agreement between early investors and founders. It dictates how founder share distributions are divided, and allows founders to retain 100% ownership of the shares. Later-stage investors, if there are any, would receive new “ordinary” shares, just as they do currently. They would not be party to this agreement.

Instrument

We haven’t yet settled on an investment instrument, but we’re leaning towards some kind of convertible debt. This could have the following advantages:

  1. Gives investors an automatic liquidation preference in the event of a company shutdown.
  2. Allows founders to retain 100% equity ownership.
  3. Liquidation events can trigger the conversion of investor debt to a portion of founder shares. This keeps early investors off the cap table, reduces complexity and admin, increases founder control and avoids unnecessary capital gains tax issues.
  4. Provides a structure with which later-stage investors are at least somewhat familiar.
  5. Provides enough flexibility to contain the ratchet-based distributions policy.
  6. Should be a relatively simple document, which is quick and easy to execute.
  7. Still enables us to include key clauses that protect the investor (e.g. an equivalent to drag-and-tag, a cap on salaries and reserved matters).

How can you help?

We want to hear from you. Please help us by answering the following poll:

Thank you

That’s the end of the section on FEFA. We appreciate you reading this far. As mentioned, we’d love to hear from you. Please email us, or you can find us on LinkedIn via the links at the bottom of this post. With support from investors and founders in our network, we believe this is an opportunity to improve the very fundamentals of early-stage investing. Please get in touch.

DQ business report

Notable progress

Here at DQ, despite a lull in inbound applications since the last update, we’ve signed three new ventures. We’re continually tightening our approach, making sure we only start companies and support founders in which we have full conviction.

Our continued expansion, despite more rigour in the applications process, has resulted from a marked increase in referrals. These have brought 5 more solid aspiring founders into our pipeline. Our target of signing 12 new ventures in 2024, therefore, still feels intact.

Thanks to several new initiatives, including FEFA, a media opportunity for one of our Australia-based startups, and some impressive growth from Duellix in Singapore, we expect this momentum to continue. DQ’s share of voice in the global startup ecosystem continues to increase.

Key metrics

Metric

Total

Change (last quarter)

Number of ventures

17

+3

Inbound founder enquiries

22

-28

Revenue-generating companies

7

Companies with full-time founder(s)

6

Companies part-way through programme

7

+3

Did not pass validation phase

5

+1

Portfolio’s approx. value 

$16,250,000

N/A*

* N.B. We changed the way we value portfolio companies, assigning a $0 value to any company that hasn’t received external price validation (i.e. this includes, for example, Duellix, which is profitable, turning over tens of thousands each month and growing at 30% MoM).

Final comments

Thanks for sticking with these updates and continuing to support us. If you have any feedback on the FEFA idea and structure, please let us know.

Best wishes,

James, Arjun and Oliver

Kickstart your business without quitting your day job

DQventures is the only venture investor worldwide to support aspiring founders who cannot afford to give up full-time employment.

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