How to think about fundraising
So, a big chapter in your company’s life—and your life—is approaching. You just finished organizing your pitch and are ready to approach Venture Capitals (VCs) or Angel Investors, through warm or cold introductions. Maybe you have already secured a SAFE or some other type of funding. This article will help you understand what’s ahead, how to improve the process, and how to tilt the odds to your favor.
Timing
Let’s take a step back and understand where you need to be. Arguably, the sweet spot would be when you have found a genuine problem, understand the solution, have a proven business model and are certain that you and your great co-founders have figured out a way to facilitate and realize the solution. This is the minimum requirement. It would be great if you could demonstrate your solution. Not all teams will need a prototype, some of them will, and some will also need to show that they can acquire customers.
The risk we are trying to mitigate with timing is “burning” the team and the project due to the desire to move quickly. It is best not to face a investors without having the ability to impress. Further, a bad meeting can say something about the team’s capabilities. So, take time to prepare. You will be surprised how much practice can improve your capabilities in that department. Don’t play it by ear.
Destination Market
It is important to understand the market you will serve very well. This is one of the easiest (and most important) understandings you should have since Google can cover more than 60% of the process. Do not start a dialogue with VCs or Angels before you possess a deep understanding of the market. This means the players and competitors, market dynamics, challenges and opportunities. Respectable VCs are somewhat like expert generalists and, in many cases, a lot more. They will most probably not summon a meeting unless you are operating in a market they understand well. They will be very discouraged if they surprise you with market information that you aren’t familiar with. How will they know? They will. Trust me. Even if you are a great performer. Their day-to-day is based on reading entrepreneurs. Maneuvering the conversation to another topic will not suffice. I have heard many VC partners stating that this is one of the brightest red flags out there. The information is easy to find, and the founders should dedicate their time to it.
Team
Make sure you have a great team and that you are all aligned on the mission. VCs and Angels are like fortune tellers, and the team on the stage is one of their prominent tools to evaluate the future of your company. As mentioned before, make sure that you and your team have a deep knowledge of the market you are serving. VCs know very well that it is very hard to replace the team, and statistics have shown that it’s best that the founding team will take the company through the entire company’s life cycle.
It is recommended that at least one of you would be a player in the market you are about to serve. Think about the best scenario from an investor’s perspective. Your story will be told to the other VC partners or in the investment committee somewhat like this: “I met with the team again this week. They are very knowledgeable in what they are about to work on. They all just left the largest player in the market after 5-10 years leading the R&D team over there. They figured out a way to solve this submarket problem. We have been waiting for such a solution for many years. We must all get together soon.” Sounds good, eh? I recently encountered a story just like that. A prominent VC invested in a startup on very founder-favorable terms after understanding that the group of founders possesses all the skills and that the solution was unique. The team detected a genuine market problem, found a solution (or at least an assumed solution), and were in the best position to solve it. They eventually did.
So, we have a great team with a genuine problem and deep understanding of the market. Very good start.
Let’s say something about tradeoffs. In the 2021 and 2022 markets, you could have seen some instances where a very respectable VC invested in a company with very good and aligned founders but not-so-great understanding of the solution they were after. This funding was done with one significant understanding in mind: A competent and flexible team that is dedicated to working together can be quick enough to pivot (together) and pursue additional problems and solutions if the solution that they are after is not worth pursuing. This has happened and indeed can happen again in the future, but as there is an additional risk that the Investors needs to mitigate, this does not happen very often.
One last thing about being aligned but now from the other side of things. I was once invited to help a company approach investor, as they were desperately seeking funding. As with companies I am not familiar with, we scheduled a first meeting. The founders were very capable, and the idea, although it needed some tweaks, was not bad at all. Something else clouded the sentiment. The two founders were not coordinated, to say the least. This was evident throughout the meeting. It wasn’t pleasant to sit in front of them and hear the pitch. This will be a significant drawback when approaching investors.
Don’t be afraid to approach more than one VC or Angel at the same time. In fact, I encourage you to. I would suggest approaching batches of 3-5. Let me explain. First, you need to maximize your chances. That’s obvious. Next, you need to think about the ultimate scenario where you’ve progressed with one VC and are now receiving a Term Sheet (TS). You will not have any other TS to compare it to, and a TS, most of the time, has 30-45 days to be signed. Yes, you can extend the TS, but too many extensions will start to feel like you are wasting the investor’s time and that you are not fully dedicated to the process with them. If this is a prominent VC or Angel, they will not like it.
Pitching
Let’s say something about how to think about pitching. A lot can be learned from pitching to investors. You should think about pitching as a learning curve with the ultimate purpose of knowing exactly what investors would like to hear. You need to have rhythm and flow. With that in mind, and to improve and expediate this theoretical learning curve, I would suggest not sending just one of the founders to pitch investors. Send the CEO and, let’s say, the CTO (especially if you are building a company that is very tech-oriented). Now, while the CEO is presenting (by the way, it is important to investors to see the CEO, so don’t come without him), ask the CTO to glimpse at the crowd and see what makes them lose interest. Shifting their intention to something else, what sparks an interest, and, finally, what kind of questions they are asking. If, for example, they are mainly focused on the size of the market, bring the slide that shows the market size to the front. If competitors are their focus, good. Bring it to the front. Let’s take it out of the way before we dive into something else, and they will lose focus. Don’t think about the presentation as a story that needs to be told. You can go off topic if this is what your investors want. Good off-topic understanding will show your future investors that you are flexible enough, have deep knowledge of the matter at hand, and are willing to be influenced by his opinion. That’s very encouraging.
I once was invited to hear a pitch for a new company that wanted my help in finding investments. The greeting and chit chat were very pleasant, and the CEO started going through the presentation. After he started presenting, I had a question and he answered by saying that the next slide would provide the exact answer on this issue. He proceeded. I kept quiet. The answer never came. Two minutes later, I asked a fundamental question again. His answer was the same as before. My second question was not answered, either. He insisted on following the slides as prepared. This was a bright red flag for the reasons I explained above. Don’t fall in love with your work or with your arguments.
One other thing we need to discuss is that VCs talk to each other. This is a kind of competitive but friendly industry. You might browse around for a long time to find someone who will invest in your idea, feel that nothing is progressing, and then, when someone finally shows interest, many phone calls will come your way and you will need to fend off many of them. This is because VCs sometimes want to share the risk with others and sometimes just want to be friendly so that next time someone will be friendly with them. So, be strong and keep in mind that this can happen.
My final remark on that is that you are better with one or two big names than twenty unfamiliar names. The number of investors is of no significance. On the contrary, it is better to keep your CapTable lean so the technicalities will not kill the ability of the company to make decisions.
How Much?
Let’s dive deeper and understand numbers and what’s behind them. How much do we want to raise? I mainly refer here to initial investment in the company (pre seed/seed), but the notion can help in all rounds. The quick “as much as we can” answer can jeopardize the entire project. Asking for too much might cause misunderstanding on the investor’s side and, if granted, might be expensive as the first money invested in the company has the highest ticket price. Asking for less than what is needed can look unprofessional and might shorten the way for the next round. Keep in mind that going through fundraising is time-consuming and most probably causes deviation from company development.
What do I mean when I say highest ticket price? Well, the investors in the early stages are taking a lot of risk upon themselves. To mitigate those risks and compensate themselves, they ask for a higher equity portion (about 20-25%, depending on the company and market condition) and for more control over significant decisions the company will make in the future. Examples can vary from a demand to approve all C-suite personnel to veto rights in the board of directors’ meetings. This might seem meaningless in the haste of the investment but later can cause difficulties in raising the baby. We will discuss several other terms and conditions that are important to look for in the “Term Sheet” section.
So, what is the perfect answer to “how much to raise?” The short and ultimate answer to this question is, “until the moment when the company can sustain itself.” Meaning, from an accounting standpoint, a positive P&L (Profit and Loss). This makes a lot of sense, but life, or more precisely the company’s life circle, works a bit differently. Why? Because of the expected, the unexpected, and the way that VCs look at companies’ growth.
The second-best answer to this question will take into consideration a good enough runway for the company to be developed. Arguably, a decent runway will be 18-24 months. A runway of less than a year will force the founders to start and think about the next round too quickly. Put into the mix the understanding that not all ideas and companies are created and live equally and there is a need to distinguish among the industries. Hardware startups will probably need extra funding as their operations are relatively more expensive and the building process takes more time. Same goes for several companies in healthcare and heavy machinery.
Finally, to reach the fundraising target amount, there is a guidance for the minimum amount to be raised. It goes like this: The most significant expense the company will have in its first years (and probably throughout its life cycle) will be its employees. More precisely, the programmers and developers. They are the core of the business in its initial stages. Consider that in the US, programmers are priced at around 15,000-20,000 USD a month and in Israel around 40,000-50,000 NIS a month. Now, ask yourself how many you need. Let’s say that 4 to 6 programmers are a good range. So, take 5 (programmers) * 24 (runway in months) * 50,000 (salary in IL) and you get 6,000,000 NIS, which is about 1,650,000 USD. This is the minimum amount of funding you need for the next two years. I usually add additional monthly programmer salary (over a year) to account for rent, travel, service providers (lawyers and finance) and computer programs, which gives us another 1,200,000 NIS (330,000 USD). So, taking into consideration all the above, the minimum check should be somewhere around 2,000,000 USD for a 2-year period. Recent turbulence in the market, good or bad, pushes founders towards a 3- or 4-year runway, so an additional 1,000,000 USD for each is to be added.
You should remember that this is just a rule of thumb, hence specific company-projected expenses should always be considered. The way that you have reached the funding ask should also use your team when meeting with VCs. You should specify the amount you are after and the reasoning behind it. This can help you and the VC a lot in framing the funding discussion.
We discussed it briefly, but it is wise to mention it again. When you are thinking about the company’s trajectory and your end goal, fundraising should not be one of them. This is not a business success metric. Starting your company and contemplating the vision, your goals might be, for example: change the world for the better, improve the way businesses are operating, or simply become the largest and best player in the field. Obtaining as many funding rounds as possible or at the highest amount are goals that will take your company the quickest way to failure.
From Whom?
Let’s try to differentiate between being invested in by an Angel Investor or Venture Capital, which are the main players in the market. Then we’ll talk about how to point out the specific Angel or VC you should choose.
So, what are the differences between VCs and Angels (from now on I will use the term investor when I am referring to both)? First, let’s discuss technicalities. VCs operate like a company (although they are most likely partnerships) with the main purpose of investing the funds that they received from third parties (the limited partners) in startups, early-stage companies (which differ from startups) and emerging companies that have been deemed to have high growth potential. They aim for their company to go through an IPO or M&A in 7-10 years, as they have promised their limited partners.
An Angel Investor, on the other hand, is an individual, mostly, with significant wealth, likely from the high-tech industry, that invests in startups at their earliest stages. So, the big difference is the size of the organization and the fact that the funds are provided from different sources. That affects the number of companies that each investor can be involved with and the amount of time each can dedicate to advising on strategy and helping expend his community. Unlike most of the VCs personal, those Angels (or most of them) have experienced the trenches and came out with the upper hand, so they have a lot to contribute from that experience.
Huge VCs can sometimes be a little bit stiff, especially in the sense that they might have investment committees and are fixed on doing things their own way. You are not the only company in their portfolio. This might not be true these days as those huge VCs are smart and experienced groups of professionals and understand that to make this marriage work, they need to be quick and flexible.
One positive factor that I would like to touch on that is more prevalent in VCs, and the large ones specifically, is the connections that they will most probably introduce you to. One story that I use when founders consult me on that subject is about a great group of founders that decided to be invested in by a large VC, after dwelling on it for some time. Their solution was not entirely on point. The VC realized this but decided to focus on the founders themselves and their absolute knowledge of the market. To overcome the “on point” problem, the VC invited them for 2-day face-to-face meetings with all the big names in the industry. When asked about it after their big exit, they said that this was a pivotal moment in their company’s life that helped them to eventually become one of the biggest names in the industry and very profitable to the VCs. This does not mean that Angels will not be able to provide connections, but brand names mean something and are very relevant, specifically in the US.
As mentioned above, the investor you pick can have a lot of positive influence on the company. They can steer the company in the right direction. So, how will you know if this investor is the one who will be there for you, regardless of if it is a VC or Angel Investor? Just ask. Sniff around. It is very easy these days to visit the portfolio page of the VC or Angel (the Angel might not have a site, so LinkedIn or Google might do the trick) and pick some companies to get in touch with. Ask them about the investment, the process, and if they are pleased with the continuing relationship. If you find one of your competitors on their portfolio page, I wouldn’t suggest approaching them. VCs usually don’t invest in competing companies.
Another common way to be fundraised that I would like to mention briefly is through the balance sheet of a large enterprise, public or private. Those will invest, most times, when there is some kind of long-term or short-term value to their core business. Hence, later stages are more suitable for those as they would like to see, in most cases, income and other financial KPIs before they invest.
One final investment tool that I would like to mention is a syndicate, which is basically the gathering or consolidation of several Angel Investors with the purpose of investing together. I prefer not to dwell on it as a good understanding of the differences between VC and Angels Investors will teach you almost all you need to consider when planning a funding round.
Term Sheet
So, you are at a perfect place to fundraise and have picked the right VC or Angel, that are willing to invest, and verbal negotiations have reached the stage where paperwork is in order. Let’s understand what’s ahead.
The Term Sheet (TS) will be the first legal, and in some sense biding, document you will see before entering an equity transaction. Just to note, don’t expect to see one when you are about to be invested using SAFE or CLA. Those two are relatively simple and quick investment tools (although some SAFEs and CLA’s can be very complicated and tricky to understand) and will not require preliminary documents.
Term Sheets and Memorandum of Understanding (MOU) are basically the same thing. Some say that there are some differences between them, mainly from a legal standpoint, but that is not always the case (or even most of the time). One important rule in interpreting a legal document relates to its content and form and the fact that you should not be confused by its shape or title. Same goes for TS. You need to read it all before concluding on its purpose.
So, a TS has entered your mailbox. Now what? Go through it, very carefully. Allow me to make a bold statement: It is more important to negotiate the TS carefully than the actual binding definitive agreement. The negotiations on the definitive agreement sum up differences from the TS and other legal terms and conditions that are “best industry practice” and are not “best industry practice.” So, take a moment to go over the terms carefully. More than a moment.
At that point in time, mainly if you are a first timer, there is an investor knowledge gap you need to mitigate. Your investor has probably seen many TS and binding definitive agreements while this is the first for you. Moreover, the funds they are investing are your lifeline for the next twenty-four months , and so there is a knowledge gap and pressure from the other side. What to do? Firstly, show it to your lawyer, who will probably help you on the legal side of things and some of the commercial aspects. He has most probably seen many of those in the past. It’s important to mention that if you are using a lawyer who is not very familiar with the legal aspects of startups/high-tech companies, this is a good time (and excuse) to replace law firms. Move to a law firm that has a professional practice dealing with startups/high-tech companies.
After getting your lawyer’s perspective on the TS, or in parallel, you can also show it to your community and friends. Ask for their opinion. If you think asking for their opinion on the entire TS will be a lengthy process (for them), ask them about specific sections that you think are not normal and can affect your long-term growth or exit strategy. Keep in mind that you need to think about the long-term ramifications of the equity deal ahead and not only the short-term pieces.
It’s important to note that there are some clauses and conditions that are not industry best practice. This means that they easily negotiate and will not result in the VC taking a step back from the entire deal. For the untrained eye, it won’t be easy to identify, but for someone with experience, it will, and it will be easy to take out when discussed with the investor.
It is also important to understand that the timing can have significant implication on the terms stipulated on the TS. Technology and the global slowdown will result in VCs beefing up their terms with the purpose of getting more control over the company’s operations, decision-making, and exit strategy. This might be in the form of additional veto rights and the desire to place more VC-related personnel in the company. This needs to be taken into consideration.
Let’s look at some TS clauses that will impact the founders’ ability to steer the company to their desired trajectory. These are just examples, and the notion should be taken under consideration:
· VC sets the board composition.
· Broad has veto rights on exit event type and timing.
· VC could approve or revoke a company’s budget.
· Investor director’s approval is required for operational decisions, hiring/firing executives and pivoting the business.
Those are clauses that need thorough review, so take the time to review them properly.
Founders need to understand that there are additional implications for a bad TS and final binding definitive agreement that is drafted in the early stages. This contract will most probably continue to be the starting point of future funding rounds negotiations. This was already agreed to in the past, so it is easy to push forward.
Final remark on the TS. Don’t be hesitant to review a longer-than-normal TS, let’s say more than 2 pages. This might indicate a desire to lower the expectation gap when the definitive agreement is to be written and avoid misunderstandings.
Valuation
Let’s clear something very quickly. The value of startups in their early stages is very far from the value that is learned in accounting and economics schools. There is no revenue or free cash flow to base our calculation on. With that in mind, Fair Market Value is defined as the price at which assets would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. So, the value agreed between the seller and the buyer is the fair value of the company.
This brings us to the not-so-obvious conclusion that the value of an early-stage company will be firstly determined by the founders, and if they succeed in convincing their investors that this value is a true representation of the company, this will be the value of the company until it is determined again in the next fundraising round.
So, what are the cards in your hands to convince investors that the value that you think is a true representation of your value? Well, as mentioned, great founders, a great growing market, great technology, and of course, personal charm. Not something to take lightly.
One other important tool you can use are comparable companies. Ask around and try to understand in which value your competitors or companies with similar nature are raising.
Another way to set your value is by reverse calculating the amount you would like to raise (as mentioned and calculated above). Let’s say that you want to raise 4,000,000 USD and are willing to say goodbye to about 25% of your equity (20-25% percent is the normal investor cut in early stages). That means that your value will be about 16,000,000 USD. If you succeed in negotiation and 20% is agreed, the value will be somewhere in the 20,000,000 USD. And so on and so forth.
There is one last thing that needs to be mentioned. Don’t aim for the sky when it comes to value. This value will need to be supported by merit and will be used in the next funding round as a value starting point. Down rounds are coming with negative industry sentiment, and it is advised not to be there.
Best of luck