Fundraising for RegTechs

Fundraising for RegTechs looks at the specifics of financing companies in this sector. While all start-ups are different there are some basic aspects that apply to all of them and the sectors they operate in. Jochen Heussner looks at them for PlanetCompliance and tells you how to get the ball rolling.

One of the major reasons innovation is disrupting successfully the finance industry and related services is that automation can drive down costs significantly, especially with regard to head count. So in turn it is somewhat ironic that one of the main challenges for RegTechs are resources, both in terms of funding and team but you can’t go without either of the two.

I’ve worked with several startups and been through the fundraising process a number of times in one function or another, so I can tell you that it is very time consuming at best and gruesome at worst. Every startup is different and so are the sectors they work in. There are also large differences with regard to the financing needs and solutions, but there are some “basics” that everyone should know about before they get into the business or return to raising funds.

The good news first: RegTech is a very attractive sector for investments. The cost of compliance is ridiculously high and innovation can address this while create new opportunities at the same time. A recent reportpredicted that the spending on RegTech would reach $76bn by 2022, so it looks like a lot of money will be flowing into the sector.

The bad news is that start-ups regularly underestimate the strain on resources and the time and commitment it takes to raise funds. For RegTech firms sales cycles are particularly long and the period from contact to contract, i.e. the time from first contact and discussing a project to the approval and signing of agreements, can easily take between 12 to 18 months and sometimes even longer. Even the common method of delivering a Proof of Concept (POC) can be very cost and time consuming. Even for a start-up with a brilliant idea, a great product and team might find it challenging to make ends meet when bridging such stages without the right financial resources. That’s why it’s all the more important to approach the fundraising process with the right strategy and mindset, following a few golden rules.

Fortune favours the prepared mind

I admit that it wasn’t me who came up with this great quote (it was Louis Pasteur), but before you reach out to potential investors, you need to make sure though that you’ve got your properly prepared. Not only will it result in a serious setback if you don’t cover the core aspects and you need to go back to the drawing board during the fundraising process. There is a good chance that you will loose the potential investor(s) that have made you aware of a lack of preparation, as it could be perceived as a sign of unprofessionalism. In any case it is going to delay you and make you loose the important momentum, see also the importance of timing below.

Some time ago we already wrote about the key aspects investors look for in RegTech firms, but here are three elements you need to address:

The Financials

First of all, make sure you have all the financial information ready. This means the use of money in the past, the money you’re making and the projection of the future financial situation. It is one of the most common causes for a start-up to fail is running out of cash, often because they didn’t manage their resources properly or couldn’t raise sufficient funds in time.  Everyone knows that it isn’t always an exact science since many of the numbers are based on estimates. Still, you need to demonstrate that you have a very good take on it. Otherwise, it will taint the credibility of your company and your efforts to raise funds. After all, investors trust you with their money and if you give them the idea that you’re not going to handle it cautiously or have no real idea what to do with it, they are unlikely to make that investment in your firm. Also, not only do you need to know exactly how much you want to raise now (if something asks you how much you need you wouldn’t want to respond by asking them how much they can spare, right?) and what you use them for. You, too, ought to make sure you to include how much money and financing rounds it may take to get to an exit as it in the end the reason why someone invests in you firm. Thus explain what your long term goal is and how that will be achieved, e.g. are you aiming for a takeover or public listing, as well as how much equity there is and how it will be distributed.

The Product

RegTech solutions more than most other products needs to solve a problem. Many financial institutions complain that when they talk to RegTech firms they are often left with the feeling that they don’t understand the problem these organisations have to deal with (see the key challenge for RegTechs No. 2). Make it clear, which issue your solution tackles and how. Have a roadmap of milestones that shows past and future achievements you are likely to achieve in the near and mid-term with regard to product and business development.

The Team

And possibly the most important one, tell the story of the team behind the company. The idea or technology can be as good as it gets, execution is what matters and that’s done by the people that run the firm. So make sure you present the key team members, how long they know each other and what have they experienced together. For instance, have you already been some storms and came out in one piece on the other side? Examples of achievements are good indicators in respect of the likelihood that a team will be able to execute a plan.

Which instrument?

Still, you shouldn’t be reaching out to investors yet if you haven’t got the answer to the next question: which instrument or how do you want to raise these funds? Most start-ups primarily consider equity as their main option, but other ways like convertible notes or bonds are possibilities, too. What’s the difference? Glad you asked!

Equity

If someone invests in your company in exchange for equity, they become shareholders in the company. This can for example be done through a private placement or through equity crowdfunding.

The amount of shares they get depends on the size of the investment and the valuation of the company. Generally, the bigger the investment the bigger share of the company investors get. The valuation is rather difficult subject. First, there is pre-money valuation, which is the valuation of the company before the investor’s money is received or the last round’s valuation. Then, there is post-money valuation. This includes the financing received in the latest round. It’s important for the investor because the amount of equity they will receive will depend on the valuation of the company. This in turn depends on whether pre- or post-money valuation is used. And then there is the risk of equity dilution. This basically is the question of what happens with the shares an investor acquires in the current round if the company raises more funds in additional equity rounds in the future and new shares will be issued. These new shares will dilute existing investors’ shares but the new investors’ deals could also have better conditions, for example preferential rights to dividends.

Convertible Notes

Convertible notes are another popular fundraising instrument for start-ups and established firms alike. It is basically a loan from an investor that can converted into equity under specific circumstances, the so-called conversion event. It depends on the terms of the convertible note, but generally it happens when the company raises another round at a fixed discount on the valuation. The main upside of convertible notes is that they depend less on the correct valuation of a company, which can sometimes be difficult to agree on, especially for start-ups at an early stage.

Loans

Then there is, of course, the old-fashioned way of obtaining a loan. The problem is that it can be difficult to get one especially for start-ups as they have little security and given the risk traditional financial institutions often shy away from lending to firms or require higher interest payments. Interest is also an issue if a company is not generating enough cash flow for the repayment of the loan plus interest.

Bonds

And then there are also bonds that are available mostly to more established companies. Similar to a loan, a bond is a debt instrument that has a fixed interest rate and has to be paid back after a certain period of time. Like a loan they are for similar reasons re hard to come by and are less common but shouldn’t be entirely disregarded in your consideration about how to raise funds.

ICO

Lastly, there is the currently immensely popular fundraising model of Initial Coin Offerings or ICO. During an ICO a company issues a token or virtual currency in exchange for funding, often in the form of more established virtual currencies like Bitcoin or Ether. The company issues a form of business plan in the form of a whitepaper that sets out the objective of the project, how much financing is needed and how it will be used, and the details of the ICO process. These details include the duration of the ICO and which forms of payment are accepted. In exchange the investors receive the newly created coins. In most cases these coins do not give right to any share or influence in the company itself. It has especially in the last year been a very popular way of raising funds without giving too much (or anything) away, but the regulatory pressure has been increasing steadily as well as the costs of doing an ICO, so you should be carefully considering if it really is the right way for your firm instead of being blinded by the (erroneous) idea of obtaining financing fast and cheap.

 

Finding the right investor

In order to find the right investor, you need to define what the “right” investor means for your company. Not every investor is necessarily a good choice for your firm and though it may be tempting to take the money that has been offered to you instead of looking elsewhere, you want to make sure that the whole relationship doesn’t end in tears. It has to work on more levels than just the investor has money to spend and the RegTech needs it now. If the interests of both parties aren’t aligned it is likely to cause friction further down the line that can easily result in very stressful arguments and potentially costly lawsuits. Make sure that all the pieces of the puzzle fit: is the company at the right stage for the kind of investment the investors seeks to make? For instance, if there are different views about the time it may take to reach a certain point, the investor might not have the patience necessary for the execution of the business plan. Has the investor experience that is relevant for the industry or the particular firm he or she wants to invest in? If not, it might be difficult to understand specifics and problems that could occur along the line. At the same time, a RegTech firm should look beyond the money an investor has to offer. Finding an investor that contribute by making connections and introductions, help with certain issues a start-up encounters during its development and its strategy could be more valuable than the capital they bring in the long run. Having someone sharing the same ideas can lead to invaluable contributions and when (more likely than if) further money is needed at some point in the future this investor might be more willing to put more money into the firm.

The importance of timing

You are likely to need funds at every stage of your companies lifecycle, but if you ask people for money too early it will make things difficult for various reasons: a) you may have nothing or too little to show for, so investors either turn you down right away or refer you to a later stage in time, basically duplicating efforts; b) the less you have to show for, the more you will have to give up for in terms of equity and/or control – why else would someone trust you with their money if you lack credibility?

Equally, it is important to get started early enough: a) fund raising is a time consuming exercise and most entrepreneurs underestimate how long it takes to close a round; which in turn leads to b) you could run out of fuel because you missed the right moment.

That’s why it’s important to strike the right balance but if you consider things early and properly, you are on the right track.

Conclusion

Of course, these are the initial aspects of a complex and intense process, but they are also the core of any fundraising campaign. Preparation is often the element responsible for the success of fundraising campaigns. While there will be cases of lucky encounters that lead to the deal, the majority of cases doesn’t support its probability. Or to say it in other words: Luck is what happens when preparation meets opportunity.