Things founders probably ought to know about venture capital.
As an entrepreneur, the places to learn how venture capital works are pretty scarce.
Accelerators are a good place. But getting into the accelerator often requires that you already know many of these things.
You might have a friend or mentor in the venture finance business.
But what if you don’t?
You could try to self-educate by reading a lot of articles. But, with a few notable VC blogger exceptions, most of the press around venture capital is written by people who are journalists (i.e., have never raised money nor made a startup investment).
As a result, these lessons are often learned by failing to raise money for your venture—pretty expensive tuition. The purpose of this list is to arm founders with information earlier in their journey as entrepreneurs.
There isn’t a formula that fits every company or every investor, but these concepts will give founders a better understanding and hopefully increase the probability that more great companies are successful raising the capital they need to ultimately change the world.
Download this article as a PDF e-book (coming soon) or just get The List
- Why VCs Say “No”
- The World of a VC
- Is the Founder Worthy?
- Is the Company Worthy?
- Pitching to Win
- Coming to Terms
- Valuation Voodoo
Why VCs say “No”
Which they seldom share.
Around 1 percent of companies seeking venture money get funded. If your company stinks or you have a black hole for a personality, it’s easy to see why a VC would turn you down.
But what if you’re a rock star with a great company?
There are lots of other reasons why your company isn’t a fit for any particular VC firm—which can be especially frustrating if it’s due to goings on inside the firm and therefore a mystery to you.
Here are some of the most common factors that don’t get shared.
#1. You aren’t swinging for the fences
VC investing is a risky proposition. Most startups don’t make it, therefore most VC investments turn out to be failures.
So, how does a VC make money?
Well, the few winning companies have to make up for a lot of losers.
Y-Combinator founder Paul Graham blogged,
“In startups… the distribution of outcomes follows a power law…. The big successes are so big they dwarf the rest. And since there are only a handful each year (the conventional wisdom is 15), investors treat ‘big success’ as if it were binary. Most are interested in you if you seem like you have a chance, however small, of being one of the 15 big successes, and otherwise not.”
VCs are trying to figure out which companies in their portfolio are going to be those all-important winners.
As for founders, you must at least be trying to win big. You’ve got to have big vision and big energy behind it.
In other words, if you aren’t swinging for the fences—VCs literally can’t afford to consider investing in your company. In that case, it’s super easy to calculate your probability of hitting a home run (and of getting VC investment).
#2. It’s hard making a living at the horse track
Venture investing is a lot like betting on horses. It’s not purely gambling. You can learn how to judge horseflesh and jockeys. And the right odds can set you up for a windfall.
But it’s hard to consistently pick winners; as I mentioned in Law #1 VCs lose more often than they win.
Startups by nature are riddled with flaws that could become fatal. That means there’s always a genuine reason NOT to invest. As a result, VCs are justifiably picky and there is always a legitimate reason to say, “No.”
You have to accept that this may not make sense to you.
#3 The cream didn’t rise fast enough
As I said, VCs are looking for big winners. Sometimes, the reason a VC says “No” is because it wasn’t obvious enough fast enough that your company might be one of these big winners, or that your company was first among the top 5 deals they are evaluating right now.
Remember, VCs screen a lot of deals, but invest in relatively few. If your company is the third best deal they’re reviewing, you may get a pass. You will likely not know who you are competing against or what the factors were that ultimately tipped the scales against you. Since there isn’t a lot you can do about that, your best bet is to stay focused on relentlessly building the best company you can.
If it takes too long or for some reason your company doesn’t rise to the top of the list, it’s likely the VC will pass.
#4 You lost momentum
So much of raising money is about timing.
Momentum matters in the VC community. A sense of inevitability around your company builds FOMO and signals to investors that yours is a train they need to be on.
Momentum matters both in your company’s pace for hitting milestones and in the critical mass of your relationship with prospective investors. Don’t be annoying, but don’t allow the pace of your contact and interaction to stall. That can be a difficult line to walk.
That means you have a lot of timing issues to navigate. What’s your timing in the market? What’s the timing of your company’s milestones? Where is the urgency? Where should it be?
At one company we were raising a Series A, and we started in an awkward phase where our ARR was on track to be 200% YOY plus we had just inked a key partnership deal that would double our revenue for the year. We were set to have a 400% growth year!
The problem? These revenues were tied to the academic calendar and wouldn’t materialize until that Fall, eight months later.
Key performance measures were in place. The work was done and nothing else was required on our part. But the timing was off for us to show the momentum we saw inside the company.
Ultimately, we used the Spring and Summer to plant seeds with prospective investors and painfully waited until Fall to kick our fundraising into high gear. This allowed us to paint an up-and-coming story with investors, which was borne out as the revenues we had secured materialized. We easily could have made the mistake of going out to raise without momentum which would have been injurious to the business and our fundraising prospects.
Bottom line is that VCs are human beings. Human beings sometimes behave like magpies and are quickly distracted by shiny new things. If your deal slips into the old news category, you have the much harder job of trying to breath life and excitement back into it in order to secure investment.
A VC Explains Why It Takes So Long for Startups to Raise Money, by Diane Fraiman of Voyager Capital. (An excellent article on why it sometimes takes longer to raise money than you think, and how to keep up the momentum.)
#5 No dry powder
The timing within the lifecycle of a VC fund affects how deals are evaluated.
A typical VC fund is created with a ten-year lifespan. The first half of the fund (both time and dollars) is for making new investments, while the latter half is for follow-on investing and pushing deals to exit in order to finalize returns to the fund’s investors as the fund draws to a close.
A new fund is raised each 2-4 years. Depending on the deal flow, VCs often don’t have a constant availability of capital to invest.
VCs may be asking, would this deal fit better in the new fund? Is this deal appropriate as the final deal in a fund that is nearly all deployed? Is the VC distracted by issues related to raising a new fund?
This means two things to founders. First, the lifecycle timing of a fund can affect the attractiveness of your deal to the fund. It’s important. Second, there’s only one way to discover anything about a particular VCs fund lifecycle dynamics. And that is to ask them.
In my experience it is uncommon for this information to be volunteered, but is generously offered when asked. VCs are constantly on the lookout for great deals, so they will not necessarily balk at taking a call or appointment with you even if they have no dry powder to make an investment.
Find out if the VC has dry powder.
#6 The Goldilocks principle
When a VC fund is created, it typically has a set of governing documents—a charter, an operating or partnership agreement—which spell out how the fund will operate. VCs typically focus on a fairly narrow band in terms of investment amount. A minimum or maximum investment size may be spelled out in the documents, such as no single investment will be over $5 million or 15% of the size of the fund.
As a result, VCs can’t have their deals too big or too small. Just like Goldilocks, the deal size needs to be just right.
#7 Industry alignment
Venture fund organizing documents or management philosophy may limit investment activity to certain industries. VC firms may choose to invest only in technology companies such as Graylock Partners famously does. Or it might be biotech, SaaS, medical device, real estate, manufacturing, etc.
The key is to know what sectors your VC is active in, so they don’t have to tell you, “No” and you can focus your energy on investors where you have industry alignment.
#8 You’re in the wrong place
VCs may limit their investing to certain geographies. You need to approach those who ARE investing in your area or move your company to a place where investors are active.
The highest concentration of VCs is on the coasts. Silicon Valley in Northern California has more VC activity than anyplace else in the world bar none. In the East, New York and Boston are the hubs. Some VCs in these areas will invest anywhere, while others like to stay close to home. If they have deal flow locally, why fly across the country for board meetings?
Less prominent communities still may have a strong startup ecosystem, such as Austin, TX or Salt Lake City, UT. It’s typical for those communities to have more local funding for early investments like Series Seed and Series A, while often companies must still turn toward the coasts when it’s time for a larger round.
Being in the wrong place is a reason VCs say, “No.”
#9 Portfolio construction
As a founder, a round of investment is a singular thing. You aren’t often raising multiple rounds at once.
This is not true for your investor. VCs invest a fund in a portfolio of companies. While invisible to you, the relationship between companies in the portfolio can be very important to the VC. They may already have invested in a competitor, in which case they are unlikely to fund you. They may be looking for synergies between portfolio companies where there is a mutual benefit. They may be looking for companies to shore up other dynamics between portfolio companies, such as exit horizon, access to talent or technology.
Portfolio fit is a common reason for a “No.”
#10 An ugly capital stack
Capital structure cleanup can add time, legal expense, and the potential for fights with existing shareholders who are unsupportive of corrective measures. Messiness, prospective hassle, and expense are turn-offs to investors.
Capital structure corrections are common, but given the choice between otherwise equal companies, one that requires correction and one that doesn’t, VCs are likely to avoid the hassle.
Cleaning a messy capital structure is something you may want to tackle before you approach investors. If an IPO is a potential exit, your capital stack may contain problems that need to be fixed before the price of your shares and the number of shares required for the public float are appropriate for a successful entry into the public markets.
The cleaner your cap stack, the more attractive you will be.
#11 Lack of social proof
VCs, like anyone else, are influenced by social proof. No investor wants to be the first kid in the pool. Intros from investors are best. Your next best bet for meeting new VCs is a warm introduction from the CEO of one of their portfolio companies. And also why you are far better off to have interest from at least one other investor when you start your conversations in earnest. Interest from the first prospective investor adds immeasurably to the comfort of those who follow.
Conversely, lack of social proof makes VCs afraid everyone else knows something they don’t and wonder why nobody else is interested.
#12 You’re missing a champion within
As you build a relationship with a VC firm, you are likely to meet multiple people serving various roles. It’s common for VCs to have an investment committee where partners sponsor prospective deals.
Throughout the process, you need to establish someone inside the firm to be your champion. That’s the person who is likely to go to bat for your company and win internal support for issuing a term sheet and shepherding your deal through the due diligence process to funding.
Find a champion and make sure that she never regrets sticking her neck out for your company.
#13 Know when to say “No” yourself
One of the hardest things for a founder is to turn down “bad” money. When you’ve pursued a long process with a VC, it can be super difficult to say “no” when the term sheet comes in.
You owe it to yourself to know when something is unreasonable or a deal breaker for you. It can be terrible to be tied to bad money.
There’s No Shame In a $100M Startup, by Eric Paley and Joseph Flaherty of TechCrunch
The world of a VC
Many founders have images of VCs as deified rich folk who maniacally force entrepreneurs through complex hoops before whimsically bestowing unlimited cash on a lucky few. The reality is that venture capital is a dynamic but risky and difficult business. This section outlines some of the key concerns and realities that VCs deal with, which may not be well understood by founders and which may impact fundraising success.
#14 One thing every investor believes
Entrepreneurs sometimes mistakenly view the role of investors as validating them and their company. They think investors are waiting around looking for causes to believe in or moral justification for handing over the cash and that they will invest if the founder can just convert the investor into a believer in their company.
But investors are just that, making an investment. And all types of investors make investments for the same reason—the same shared belief: that the value of their investment will go up.
Sounds simple, right? Investors may ultimately be swayed by a belief in the company and its founders, but not without first believing that they will see a return.
#15 Buy low, sell high
The business of venture capital generates returns by investing at early private valuations, then selling at later, often public, valuations which are higher. A stark difference between these investments and simply trying to time the public market, is that VCs can influence the outcome.
Their capital isn’t just a ho-hum stock purchase, it’s a value-changing event for the company, both now and in the future. After investing, VCs often nurture the value of their investment by providing important connections, advice, and board oversight for the young company.
Privy to intimate details and in a position to influence the outcome, venture capital is in many ways a legal form of insider trading.
#16 The power of liquidity
Why are public companies typically worth more than private ones? The answer is that they provide greater liquidity.
In a private company, you often have no market or ability to exit the deal. Your only chance for a return comes when the company sells or goes public. Your investment is illiquid. Contrast that with an investment in publicly traded stock. If things start going poorly for a public company, you can sell anytime.
The relationship between public and private valuations is a little upside-down for some companies at the moment. New York-based Union Square Ventures founder, Fred Wilson commented on CNBC in 2015,
Public markets are doing a good job of valuing technology companies, but the same cannot be said for private investors. The big problem: Start-ups can get much better valuations in the private market, so when they go public, their shares may end up trading below their last round of financing. Private markets need to be ratcheted back, but how that will happen remains to be seen…
#17 VC is the X-games of investing
Most startup companies fail, making startups an extremely risky asset class for investing.
I make the case in my post 4 Strategic Startup Risk Components for Investors that VCs need great fortitude to invest where the SBA says companies have a 50/50 chance of going out of business before their 5th birthday. If you wonder why your VC is picky to the point of paranoia, it’s because of VC is the X-games of investing.
One false move means a painful loss of capital. Only the very experienced or the dangerously inexperienced play here.
204 Startup Failure Postmortems, CB Insights
#18 Only 4 possible exits
VCs may not be able to predict the future, but there are really only four possible ways an investment can end up. In other words, each investment only has four potential exits. The company could IPO, it could be bought up via M&A, it could limp along throwing off cash, but never really growing to significant size, or it could crash and burn.
Only the first 2 of these are acceptable to VCs. They risk the last, in order to have a shot at the first.
#19 VC firms are often startups themselves
While its true that there are some legendary name brand mega-VCs, many firms in the industry are young and investing from relatively small and nascent funds. They are in effect, startups themselves.
It’s hard to build a successful VC firm. In the past 10 years, 20 percent of firms have gone away. As of 2015, there were 798 VC firms in the U.S. and not all of those are “active.” A 2015 article in Fortune suggests that there are less than 100 active VCs investing in technology and that there are many “zombie” VCs which are riding out their funds and no longer make new investments.
All of which serves to increase the performance pressure and the risk aversion among VCs.
#20 VCs don’t invest (much of) their own money
Most of the money VCs use to invest belongs to limited partners (LPs) who made an investment into the VC fund. These LPs are essentially investing in the VCs and hiring them to invest their money competently.
As a result, VCs typically do not invest from the fund the same as they would personally. They are often constrained by their fiduciary obligations to the investors in their fund. Which means they may have their hands tied no matter how much they like your company personally. Their obligations may limit their ability to invest.
#21 Money as inventory
All of that LP money is burning a hole in the VCs pocket. Quite literally the clock is ticking to generate returns on the LP investment. In the VC business, money is like inventory that must be turned if they are going to generate a profit.
All of this is to say that your VC may not view the dollars he is considering investing in your company at all the same as you are. It may be much less personal, he may feel urgency and constraint around terms that you aren’t even aware of.
#22 2/20 Rule
A VC firm typically makes money in two ways: a management fee on capital deployed and considered “under management” and based on the long-term success of the fund’s portfolio, where the VC will share in the upside of deals that reach a successful exit.
The typical scenario for these two channels is a management fee of 2% on capital under management, plus 20% in carried interest. Carried interest means that the first 20% of capital returned to the fund goes to the VC as the general partner. The remainder of returns are divided pro-rata between all investors based on how much they invested in the fund.
#23 Returns? Go big or go home
VCs must typically generate 100% plus internal rate of return (IRR) on each winning deal to make the economics of a fund work. Why?
They need to generate a minimum of 20–25% return to LPs across the fund’s portfolio despite losses. Otherwise, LPs would be better off investing in the much less risky S&P 500 (which returns around 10% for long-term investing).
Consider the task for giants like A16Z who raised $1.5B or Greylock Partners who raised $1B (both in 2016). These funds need to generate 20% plus compounded returns on over 1 billion dollars investing in startup companies. That’s around $300 million a year!
Data shows that in reality most VCs struggle to generate returns which beat the S&P 500. But those that do may generate 1,000’s of percent returns.
#24 VC occupies a tiny corner of finance
The VC business is relatively small in the world of finance. It’s influential (as I’ll argue later), but VCs are not the big dogs.
2016 saw $69.1 billion in venture capital investments according to the NVCA. By comparison about $1.27 trillion went into public investment-grade debt (corporate bonds rated BBB- and above).
Although the numbers have drifted up a bit since 2014, the year Marc Andreesen referred to in making the following statements, the sentiment still holds true.
“…Tech is really small. From a macro standpoint, tech is really tiny. So all of venture capital is $20 to 30 billion a year. All private tech investing right now is $50 billion a year, and there’s a lot of these bubble articles that talk about, ‘Oh, my God, $50 billion a year, how can you possibly put that much money into new companies?’
“So against that, the S&P 500, just the top 500 companies in the country, will give back $1 trillion in the next 12 months in the form of dividends and buybacks. And so, total private tech investing is 1/20th of just dividends and buybacks out of the S&P 500. Is 1/20th that too much, is that too little? It doesn’t feel like it’s too much.
“Just again put it in context. The big mutual funds like—my friend Will at Fidelity that does a lot of this… that’s a $120 billion fund. Right? It’s like the total amount across all of tech investment is less than that this year. And so it’s just a very, very, very small amount of money.”
#25 Most VC firms are slowly dying
Most VC firms don’t make money, but die a slow death. It’s a hard business. The few top firms generate the lion’s share of all returns in venture.
What does this mean for you as a founder? It means you may not understand the pressure that your VC is under, or how your interests may not be aligned. It means that you should be watchful for signs that your VC could fail or become a zombie, and consider what that means for your company.
#26 The VC power law
According to Paypal Founder and venture capitalist, Peter Thiel (and echoing Paul Graham),
The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined. This implies two very strange roles for VCs. First, only invest in companies that have the potential to return the value of the entire fund. … [Second], there can’t be any other rules. (Thiel, Peter. Zero to One p.86)
Marc Andreesen underscores this point in an interview with Y-Combinator’s Sam Altman where he said,
As an entrepreneur, your job is to build a company that has the potential to be the one deal in a VCs portfolio that outperforms all others combined, and then communicate that.
#27 Current Fund Success Opens Doors
About 2/3 of VC firms never raise more than one fund, and only 10 percent ever raise four or more funds. The biggest factor in raising another fund (i.e., staying in business) is the success of the previous funds.
When a VC looks at your deal, they are asking if this deal will be successful enough to keep them in business for another 10 years. Often they are betting on a particular angle or investment thesis in their investing to help them beat the odds.
Full Tilt Capital Progress Report: Our strategy may not be as crazy as you thought, by Anthony Pompliano of Full Tilt Capital
#28 Rock star entrepreneurs earn more than VCs
Since VCs typically give money to entrepreneurs, that implies that VCs have all the money, right?
Well, not so fast. According to Jason Lemkin from SaaStr answering the question, VCs vs. entrepreneurs, which cohort tend to earn more? (on Quora):
…A top founder takes much more risk, at least on paper, at least sort of. But can make a lot more than even the best VC of all time.
A pretty good VC probably makes more than a pretty good and successful founder.
A mediocre VC makes a lot, lot, lot, lot more than a mediocre founder and if lucky and has good partners, can make more than a pretty good and successful founder.
Takeaway: the really big money is in building an awesome company.
#29 Microeconomics leads macroeconomics
Many economists, journalists, and financiers are attempting to understand and forecast macroeconomic trends. But, they are almost always wrong, which means they are not providing useful info for how you guide your business.
Marc Andreesen on the unpredictability of macroeconomics.
“I’ve never met anybody who can predict anything macro. The Federal Reserve, all the big officials in Washington all thought the housing market was just fine in 2007.”
Despite there being almost nowhere to turn to understand the future of the macroeconomic picture, it’s helpful to understand that the macro picture is the sum of all the microeconomic factors at work in the economy.
If you want to understand the macro trends and how they might affect your business, the place to look is in the behavior of individual microeconomic systems. This is true of trends within venture capital as well. You’ve got to go granular to understand the global picture.
#30 Startups = transformative power
I argued that VC is pretty small in the big scheme of things, and that’s certainly true if we’re just talking dollars invested.
But those dollars are hugely and disproportionately influential.
In an insightful blog post entitled The Most Transformations Force in U.S. Society, Redpoing Ventures’s Tomaz Tunguz argued that startups are where change is happening. Startups are where entrepreneurs with inhuman appetites for risk are diving into solving the world’s big problems.
We see this in everything: food, transportation, healthcare, education, etc. Every part of our lives has the potential to eventually be improved by a startup. Is it any wonder that an incredibly smart and active cadre of VCs are enamored with trying to make these changes a reality?
The Most Transformational Force in US Society, by Tomaz Tunguz of Red Point Ventures
How Much Does Venture Capital Drive the U.S. Economy? Two scholars measure the economic impact of VC-funded companies, by Ilya A. Strebulaev and Will Gornall
Is the Founder Worthy
By worthy I mean investable (doesn’t pack the emotional punch of feeling examined and critiqued though, does it?). No component of evaluating a prospective investment will mean more that the founders. Here are some keys to how VCs evaluate founders.
#31 Execution risk
None of the 4 strategic components of risk (product, market, execution, and financial), is more critical than Execution Risk. At it’s heart, this is about a simple quesion: Can the CEO and the management team execute? The rest of this section is about coming at this same question from different angles.
To vet a founder and team’s ability to get the job done, consider:
Can they handle pressure… a lot of pressure? Is each member of the team world-class his or her role? What kind of experience do they bring to the company? Is their experience relevant to the current enterprise—are they working in the same field as their professional and educational backgrounds?
Will the founders look for people to fit the roles they need, not look for roles to fit the people they have? Do they value and show diversity in age, gender, and experience? Do they have the ability to be financially disciplined?
It’s rare that the skills for starting a company and the skills for running a large company live in the same person. What’s the longevity of the founders before a more seasoned team needs to be brought in? Does the company already have issues resulting from flaws in the decisions of the founders?
Does the senior management team have key relationships that will help the company grow? What evidence is there that demonstrates the priorities and judgment of the management team?
If you had to rate the founders in terms of the execution risk they represented, how would you?
#32 Strategy vs. execution
A mentor of mine once told me, “An ‘A’ execution of a ‘C’ strategy beats a ‘C’ execution of an ‘A’ strategy every time.” Since then, I’ve seen this play out time and again.
Execution beats strategy.
This is true for the same reason that great ideas on their own have little value. In fact great ideas are super common; they’re a dime a dozen. What’s truly valuable is the ability to execute on a great idea—the ability to rally a team and make stuff happen.
#33 Bet on the jockey
There’s an old saying among investors, “Bet on the jockey, not the horse.” The jockey is the founder. The horse is the company or product.
The reason it makes sense to bet on the jockey is because a great founder can turn a mediocre company or product around. A great product can NEVER turn a mediocre founder into a great one.
Leadership beats product.
Betting On the Jockey, Not the Horse, by Gary Vaynerchuk
#34 Are you a fanatic?
How deeply do you believe in your company? In Zero to One, Peter Thiel describes how he uses the interview question, “What do you believe which is true, that nobody agrees with?”
If your company vision contains only ideas that are generally accepted, you’re unlikely to have an original breakthrough. Fred Wilson once said, “I saw Bill Gurley say, ‘You can only make money by being right about something that most people think is wrong.’ His logic was that you can’t make money by being wrong. And you can’t make money by being right about something everyone else knows. So you have to be right about something that most people think is wrong.”
“The only way to generate outstanding returns is to be right and non-consensus. That’s hard to do because you only know you’re non-consensus when you make the investment. You don’t know if you’re right.
“Being willing to intelligently take this leap of faith is one of the main differences between the venture firms who consistently generate high returns—and everyone else.”
Makes sense, right? As a founder, you want to be the contrarian genius. But if everybody else thinks you’re crazy, it can be HARD to believe something despite their opposition. It’s a real-life test of the line from Rudyard Kipling’s poem If, “If you can trust yourself when all men doubt you, but make allowance for their doubting too.”
To do it, you have to be something of a fanatic.
#35 Don’t go it alone
There’s a theme among VCs that, while not always a deal-breaker, single founders are red flags. There is no way you can build a great company in isolation. You’re going to need a team of top-notch operators who believe in what you’re doing enough to follow your lead.
If you come to them alone, VCs have to ask why? Do you not understand that entrepreneurship is a team sport? Are you unable to find anyone who believes in your idea? If you can get someone on your team and understand why you should, why haven’t you already?
Your cofounder is the first recruit. In a way, he is your first investor even if he is only contributing sweat equity. His enthusiasm and commitment tells the VC something about the worthiness of your business idea and your capabilities as a founder.
#36 Recruiting is your resumé
Recruiting is an essential skill for entrepreneurs. You just cannot do this alone.
Part of betting on the jockey is betting on her ability to recruit a world class team. Your ability to recruit top talent (usually when you have no business doing so) is a key part of your fundraising resumé.
“About 80% of our investment decision is based on our belief in the entrepreneur. … A great company will only happen if the entrepreneur can build a great team. If a founder can’t attract great people, we’ll pass on the deal, no matter how great the idea is.”
The first internal folks you need to win over are not your financiers, but your senior team.
Does the CEO radiate the compelling vision of the company and inspire confidence? The vision shown by the CEO is what will be consistently reflected by employees to both customers and investors.
The Best Companies Don’t Have More Stars, They Cluster Them Together, by Michael Mankins in the Harvard Business Review
#37 Can you recruit “Originals”
Renowned management consultant Peter Drucker tells the story of GM Alfred P. Sloan, who after hearing his team report unquestioning support for one of his decisions said, “If we are all in agreement on the decision—then I propose we postpone further discussion of this matter until our next meeting to give ourselves time to develop disagreement and perhaps gain some understanding of what the decision is all about.”
According to Wharton professor Adam Grant, companies need homogeneity in their earliest days, but quickly transition to a point where diversity and originality become differentiators.
The question is, do you have the ability and desire to recruit people who will actively disagree with you? Will your ego prevent you from building the best company you can?
Adam Grant on Interviewing to Hire Trailblazers, Nonconformists, and Originals on First Round Review
Give and Take and Originals, by Adam Grant
#38 Are you all-in?
You’ve heard the saying that in a breakfast of bacon and eggs, the chicken is involved… but the pig is committed. Founders need to be committed. They need to be finishers. They need to have the hunger and drive to push when the winds are against them.
In his book, The Hard Thing About Hard Things, Ben Horowitz of Andreesen Horowitz wrote about The Struggle. Commitment is what gives you a chance at making it through The Struggle.
“…The Struggle is the land of broken promises and crushed dreams. The Struggle is a cold sweat. The Struggle is where your guts boil so much that you feel like you are going to spit blood.
“The Struggle is not failure, but it causes failure. Especially if you are weak. Always if you are weak.
“Most people are not strong enough.
“Every great entrepreneur from Steve Jobs to Mark Zuckerberg went through The Struggle and struggle they did, so you are not alone. But that does not mean that you will make it. You may not make it. That is why it is The Struggle.
“The Struggle is where greatness comes from.”
It’s hard to overstate the importance of commitment. Not just your gritty determination to see something through (which tarnishes if it becomes a stubbornness to make necessary changes), but the nature of commitment. Every time you say “yes” it means you are saying “no” to something else. Steve Jobs famously said, “innovation is saying no to 1,000 things.”
Ultimately your brand will reflect those things you commit to and those you sacrifice, which are two sides of the same coin.
A New Brand World: Eight Principles for Achieving Brand Leadership in the Twenty-First Century, by Scott Bedbury.
#39 You are your valuation
In the beginning—at the seed stage—your company has very few metrics upon which to base a valuation. Almost certainly the revenue or earnings multiples that will be the foundation of valuation at later stages aren’t there yet.
As a result, the true value of the company cannot be known. As a result, valuations at this stage tend to be arbitrarily based around what the company needs to get to its next stage. If the investor has confidence in the founder and team, then she will value the company at whatever it needs to be to invest what she thinks the company needs to get to the next round of financing.
The earlier your company, the less valuation is tied to fundamentals and the more it relies on the quality of the entrepreneur and team, and that’s you.
#40 Nobody likes to hear their baby is ugly
Sometimes it falls to a VC to tell you your baby is ugly.
Why isn’t this in the Company section you ask? Because how the founder reacts to criticism of the company she loves tells investors something about what it will be like to work with her in the future.
Is the founder humble enough to withstand criticism, to accept guidance and direction, to listen? VCs don’t typically need or want to run the show. But if you’re driving off a cliff, they want to know whether it will do any good to tell you so.
Is the Company Worthy
VCs are looking for companies that make success seem inevitable. What signs show that your company is one of them?
#41 Venture capital might be wrong for your company
VC is only one of many ways to finance a company and is most appropriate for a particular kind of company.
There are a lot of businesses that are otherwise awesome, which aren’t a fit for VC. They may not grow fast enough, or have the potential to grow large enough. But they may be strong, profitable companies for years.
One of my favorite VC alternatives is Indie VC. I’m a sucker for creative approaches to finance, especially within the vision of helping founders find a way to do great things.
Be sure you know VC is for you before you go after it.
#42 Product risk
Product risk is one of the Four Strategic Components of Risk. Is the product developed and ready for sale?
Historically there have been times when founders successfully sought funding for products that were no more than ideas, concepts, or maybe blueprints. Who knows if those halcyon days will ever return? I hope they don’t.
Companies built around products that are already ready for sale are less risky than those still trying to figure out what they are going to sell. Software startups often have continuously developing products, which sometimes puts them in the position of raising money while still trying to figure out the end product. They have a “product” developed, but not one that is ready for anyone to buy.
The important thing to understand is that this scenario is higher-risk.
Lowest-risk would be fully developed products with proven product development processes set to fill your sales channels as your current product(s) decline in their lifecycle. When it comes to product risk, high-risk equals NewCo with an unknown product, while low-risk equals Apple with years of new products already under development in their product pipeline.
Counterpoint: You Don’t Need a Prototype to Raise A Seed Round by Mike Hirshland
#43 Market risk
Market Risk is second of the Four Strategic Components of Risk.
In economic terms, market risk is demand risk and competitive risk. Do people want what you are selling? Do they prefer competitive products? How can you tell? One way is to ask, have you ever sold one?
A magic moment in the life of a company is when they close their first sale. That first dollar someone hands over because they find value in the product is a huge milestone.
Next, you want to know that you have a large and growing market for your product. This is often described as your Total Addressable Market (TAM).
Low risk is when the market is established and you’re selling hand over fist—when you’re making sales and you don’t even know why. As an early company, it’s evidence that early adopters are making sacrifices to get their hands on your product even with all of its flaws and that you have touched on a major nerve of demand.
Founders often overestimate the size of their market. Whatever you do, never start a conversation about your market with a stat like,“There are 3.6 million Internet users in the world.” Or only slightly better, “There are 126 million households in the U.S.” Those data point might be relevant if you are Proctor & Gamble, but as a startup you’ve got to show an understanding of the market in terms that are genuinely relevant to your business.
TAM-SAM-SOM is a way of trimming hunks of fat from your description of the market for your product.
TAM = Total Addressable Market (or Total Available Market). That is the total market you could capture at maximum scale.
SAM = Segmented Addressable Market (or Serviceable Available Market). The local market segment available to you.
SOM = Share of Market (or Serviceable Obtainable Market). This is what you can capture immediately or in the short-term.
(Note: As a marketer, I favor the STP approach when operating, but TAM is more familiar to venture investors.)
#45 Never run out of cash
The first rule of finance is never run out of cash.
One of the key lessons taught in business school is how a profitable company can go broke. It highlights your cash cycle and how just because you are unit profitable, doesn’t mean you get paid before you have to pay. This isn’t intuitive for many people.
Neither are the economics of scaling. You can only scale as fast as you can cycle your cash for growth (see Your Magic Ratio below).
A typical formula for calculating how much investment you should seek, is to look at your additional cash needs for 12-18 months, and then add 25% to that number. You need the discipline to shrewdly manage your cash and maintain an operating margin, so
- Your company doesn’t run out of money
- So you aren’t raising your next round from a position of desperation.
Both are recipes for failure. Nobody wants to invest in a company that will die without the investment.
#46 What is tech?
We live in a technology-enabled world. Software startups account for the highest number of VC-funded companies by category. So, what exactly is a technology?
Well, it’s more than circuits, code, nanotechnology, AI, VR, self-driving cars or software. It’s a bigger concept than that.
Military technology is a good way to break out of the software paradigm. Military tech has been developed for centuries, millennia even as one group sought advantage over the other. One of the oldest military technologies is the atlatl. The atlatl is basically a spear-thrower. The technology part is that by using the tool to effectively lengthen your arm, you could throw spears faster, farther and with more force. Pretty handy if you hunt with spears for a living.
And it’s old. The atlatl was being used be people 26,000 years before the wheel.
Fast forward and apply that same thinking to entrepreneurship: from Peter Thiel in Zero to One.
“… Searching for a new path might seem like hoping for a miracle. Actually, if American business is going to succeed, we are going to need hundreds, or even thousands, of miracles. …Humans are distinguished from other species by our ability to work miracles. We call these miracles technology.
“Technology is miraculous because it allows us to do more with less, ratcheting up our fundamental capabilities to a higher level. …We are the only ones that can invent new things and better ways of making them. Humans don’t decide what to build by making choices from some cosmic catalog of options given in advance; instead, by creating new technologies, we rewrite the plan of the world. (Thiel, Zero to One p.2)”
At the core, technology is nothing more or less than an idea. An idea, when executed, that makes things better than before.
Technology is simply an idea brought to life.
Technology is NOT What You Think, by Chad Jardine
#47 Projections are all created equal
Founders make projections about the future of their companies.
They have to.
Vision for the future is what inspires the startup ecosystem. Founders articulate these projections and issue pro forma and forward-looking statements. These are found in pitch decks, business plans, board meetings, and more. They typically project growth in revenues, customers, users, or market share.
Everyone projects growth. Nobody projects contraction and loss. Investors know and expect this.
#48 All projections are lies
See previous. Equally universal as all projections for the future pointing to perpetual growth, is the fact that they are all lies.
That is not to say that all founders are liars or that the exercise of building projections is foolish. Projections are rarely intentionally misleading. It’s just to admit that human beings are not generally great at predicting the future. Models contain flaws. The unexpected and unaccounted for arrives. Founders don’t posses a crystal ball about the future any more than investors do.
Bo Yaghmaie, Head of New York Business & Finance Group for Cooley, LLP wrote in The 7 Elements Investors Look for in Your Funding Pitch, “… Unless you are a later-stage company, the numbers in your projections typically don’t matter. Nonetheless, putting together a set of thoughtful projections on both the revenue and cost sides enhances your credibility with potential investors.”
Many companies ultimately do grow. But none of them hit their projections exactly on target.
Investors understand that they are in the business of probabilities, not certainties.
#49 Don’t say your projections are conservative
Even though they know that your projections inevitably point to growth and that the likelihood of you achieving them exactly as projected is zero, experienced investors will still be interested in your projections and the assumptions behind them.
They will also automatically discount them.
Many entrepreneurs say some variation of, “These projections are conservative.” They feel that showing their restraint will somehow win investors to their cause, convince them of their fiscal discipline, or comfort them that they have led with the worst-case scenario and the true future is bound to be more favorable.
This usually backfires. Because the investor is now discounting your self-discounted projections. You’d be lucky to get credit for any growth at all.
Guy Kawasaki writes about presenting financial projections to investors,
“… Don’t call your projections ‘conservative.’ We refer to this as Entrepreneur Lie #1. Investors want to see a bold plan that is well thought-out and realistic, if everything goes reasonably well. They don’t want to see a delusional plan. Your job is to show that you have tapped a team with the experience and insight to justify your bold optimism.”
Build the smartest projections you can. Aim not for optimism nor pessimism, but realism. Then understand that the deal still needs to work after your investor applies a heavy discount when they do their own analysis.
Creating an Enchanting Financial Forecast, by Guy Kawasaki
#50 Company beats pitch
Another line from Paul Graham about pitches is,
“Inexperienced founders make [this] mistake when trying to convince investors. They try to convince with their pitch. Most would be better off if they let their startup do the work—if they started by understanding why their startup is worth investing in, then simply explained this well to investors.”
What Paul G. is talking about here is that VCs see lots of companies pitched. He says after awhile, “they all just run together.” Investors who have been through this develop the ability to discern a story other than the one you are telling.
That story is made up of your personality and the key data points about your company. Your pitch on the other hand may have an agenda that investors want to see through.
In order to keep things consistent, make sure your company’s actual data is equally as persuasive as anything else you have to share.
#51 You need a monopoly and a moat
What’s your unfair advantage? What makes you able to beat out the competition?
Your task is to articulate reasons your company will not be copied, overrun by followers, out competed, etc. Is your business defensible? Do you have any IP protections like patents, trademarks, etc. that give you some legal ability to defend your position. These are seldom deal-winners, because VCs know the burden to defend patents is on the patent-holder, and you’re ability to defend depends not just on having a patent, but on having the money to pursue legal action (which you probably don’t if you are fundraising). Even still, it’s better to have them than not.
Whatever your situation, when raising capital you need to communicate how you will beat the competition and protect what you are building.
How to Change the World: Defensibility, by Guy Kawasaki
#52 Product/market fit
Marc Andreesen said in 2007, “The only thing that matters is getting to product/market fit.”
So, what is that?
Volumes have been written since, but the gist of them all is that you need customer validation of your product. Customers need to really want it. Startups sometimes raise money pre-product, sometimes raise money with only a trickle of revenue—so they haven’t really proven that there is a market of people who are over-the-moon crazy happy to pay for your product.
Paul Ahlstrom, Managing Director of Alta Ventures and author of Nail it Then Scale It: The entrepreneurs guide to creating and managing breakthrough innovation, says, “Entrepreneurs innovate, customers validate.”
In other words, you can’t depend on customers to come up with the answer, but without customers telling you your product or service is solving a problem for them, everything else about your business is suspect.
Ultimately, founders, investors, and all the other stakeholders get paid by the customer. So you need to know
- If you have any, and
- If they are excited to pay you for what you are making.
#53 Your magic ratio
It can be tough for startups to get a handle on their data. The magic ratio is a way to nail a couple of the critical metrics.
Customer Acquisition Cost (CAC) is how much you need to spend in advertising, marketing, or other efforts to acquire one new customer.
The Lifetime Value (LTV) of a customer is the average revenue a customer will generate over their entire relationship with your company, that includes the initial purchase and all subsequent repeat purchases. LTV = all time revenue per customer.
Contribution margin = price – costs. To make a profit, you must not pay more to acquire customers than they will ultimately pay you. LTV gives you the flexibility to see not just what you can spend to make one sale, but what you can spend to acquire the customer. Counterintuitively, this means you may lose money on the first, or even some of the subsequent sales, but you will ultimately profit by acquiring the customer. LTV is the present value of all future profits that customer will generate.
Here’s a graph of the relationship between CAC and LTV.
Calculating LTV and CAC for a SaaS startup, by David Skok
The Dangerous Seduction of the Lifetime Value (LTV) Formula, Bill Gurley
In Defense of the Lifetime Value (LTV) Formula, J.J. Colao
#54 Profits cover a multitude of sins
If your business is profitable, other warts matter much less.
Profits may be elusive in your startup. But don’t fall for the idea that they don’t matter. They are always the ultimate goal because they are the only long-term way for you to generate returns for shareholders.
Profitability delivers an assumption of competence around a market—we may not be able to infer how big it is, but we know there is one—unit economics, fiscal discipline and priorities, risk that the business will fail, and the ability to generate sustainable returns.
Criticisms of profitability from investors will likely arise around whether the company is focused enough on growth. High growth typically means high burn, which can suppress erstwhile profitable companies from showing more black ink on their financial statements. Sometimes growth is a justifiable tradeoff for profits.
Whichever focus you choose, you ought to be clear about which tradeoffs you are making and why. Communicating this to investors may bring you into or out of alignment with what they are looking for. You want there to be alignment before you take the investment.
At the end of the day, VCs have many companies they will invest in. Founders have only one. Remember that profits are the cheapest money you will ever raise. Those dollars have the fewest strings attached, the least amount of precious equity given up, the most happy customers as a result, and the terms are the best you can get.
As a founder, a profitable business is a better business.
Every investment has some waste, some inefficiency, some amount of dollars that don’t directly fuel growth in the company.
Painfully obvious ones are retiring of debts, or cleaning up problems from previous investors. Nobody likes seeing their investment going to pay for sins of the past. But even without the obvious, there are efficiency drags that prevent 100% of an investment from being used to fuel growth and returns.
Return on Invested Capital (ROIC) is a term used by investors to measure how much return their particular investment is generating. ROIC is calculated as:
Net Income – Dividends / Debt + Equity
If a company has a strong ROIC, then it is demonstrating efficient use of investor capital to fuel growth and performance. That’s a good thing to show when you are seeking additional investment.
More important is applying ROIC to reinvested profits. If you can generate a high ROIC through efficient operations and effective deployment of capital, you will get the most growth per dollar invested. But, when the invested dollars are company profits, you’ve got a mechanism for compounding your growth with the least amount of outside capital.
High ROIC on reinvested company profits will allow you to compound revenue and accelerate your growth like nothing else.
#56 Have you nailed culture?
Startup culture gets tons of press these days. Most of it is incorrect.
We get the idea when we use the word culture, that we are talking about food, art, entertainment, etc. The trappings of various human cultures—by trappings I mean the thin surface elements of culture that we experience as tourists, sort of shallowly.
But the hallmark feature of culture is not how it feels to go to work because of the foosball table or monthly cubiclelife budget. It’s the deep essence of how work gets done in a company. More importantly, it’s how work gets done when no one is watching.
And that’s where the power of culture is.
It’s in the ability for employees to know what to do without checking in with their manager.
This has an exponential effect in terms of a company’s productivity and competitive advantage.
One of the better pieces on culture is this video of a talk by Ben Horowitz about revolutions. According to Ben, “Culture eats strategy for lunch.”
Pitching to Win
As Guy Kawasaki says, “There is only one reason to pitch, and that’s to change the world.”
In his book Pitch Anything, Orin Klaff says, “A few minutes of pitching is the culmination of perhaps months of preparation. You get one shot and everything is riding on that.”
Here are some keys to nailing the VC pitch.
#57 VCs are people too
Never forget that on the other side of the table is a human being.
Make a human connection.
Sometimes it can be so tempting to put your best foot forward, that you don’t show vulnerability, don’t include the VC in your journey, and ironically make it more difficult for them to see you as you really are.
In The Naked Presenter, Garr Reynolds advocates for the power of presentations delivered with openness, vulnerability and authenticity
You never want to hoodwink someone into investing in your company. You want to court investors with all the honesty, transparency, and disclosure you can muster. Not only because it’s illegal to hide material facts from someone you are asking to invest, but because you need the relationship to be based on trust.
The Naked Presenter: delivering powerful presentation with or without slides., by Garr Reynolds
#58 The preeminence of trust
Nothing happens without trust from one person to another.
The value of trust as the enabling lubrication of business, finance and human interaction in general was extolled by Stephen M. R. Covey in his book, The Speed of Trust: The one thing that changes everything.
The same is true of investing. Ultimately, people invest in you because they trust you. That trust is not to be taken lightly. You must earn and defend it.
Why do they trust you? Their trust is earned through the interactions of your relationship with them. Initiating and building a relationship will give you an opportunity to earn and build trust.
Without trust, your chances of raising money dwindle dramatically.
#59 Fear and greed
It might seem out of place to follow a section on trust, with one about the ugly and selfish emotions of fear and greed. However, these universal emotions of investing are present in VC investing too.
Build trust. Give trust. But also don’t be naïve or foolish about the intent of investing (remember #14), which is to generate a return.
In an article decrying the ethics of Silicon Valley and startup culture, Erin Griffith wrote,
“Silicon Valley has always seen itself as the virtuous outlier, a place where altruistic nerds tolerate capitalism in order to make the world a better place. Suddenly the Valley looks as crooked and greedy as the rest of the business world.”
This is apparently news to Griffith. The point is that investors and founders have been, are now, and ever will be emotional human beings who try to inject rationality over the emotional roots of their decisions.
You can tell when VCs are getting fearful, because they stop figuring out how to take appropriate risks and try to skirt risk altogether. If your VC is asking for Series C performance as you try to raise your Seed round, that’s a bad sign.
Ignore this at your peril.
Embracing Experimentation in VC, by Roger Ehrenberg of IA Ventures
#60 The steps
In the mythology of raising venture capital, first-time founders often imagine The following two steps.
Step 1. Get lucky—or learn the trick to—contacting an investor.
Step 2. dazzle them with my in-person pitch, which they will find irresistible.
Epilogue: ride off into the sunset with investor’s money solving all my problems, move into the slightly larger home next door to Mark Zuckerberg, live happily ever after, the end.
In reality, it looks something like the following and you’ve got to be prepared at each step (also it’s kind of dumb to present this as a formula because any particular situation could vary, but it gives you a place to start).
Prepare your docs (executive summary, in person pitch deck, standalone pitch deck and financials)
Research and build a list of the investors you think will be a match. Sort them into A-list and B-list.
Find ways to get an introduction. The how of this is covered elsewhere on this page, but expect the intro to occur via email—this is more likely than an in-person intro.
Send a short email succinctly summarizing the opportunity your company represents. Include your executive summary attached as a PDF.
This email exchange is the first level of screening. You may be asked for supportive information or other questions about your company. If you pass the email screening, you will be invited to set up a screening phone call.
You’ll probably have 10-30 minutes. You can read my advice for this call here. There may be follow ups to this first call by phone. If you’re successful at this stage of screening, you will get an invitation to present in-person. It’s not uncommon for these invitation to be soft. That is, to take the form of “Well if you happen to be in Northern California over the next few weeks, why don’t you stop by.” (Tip: you will make it a point to be in No. Cal. at a convenient time.)
All of this happens before you meet a VC face to face.
Only then do you get a chance to pitch face to face. If that goes well, you may be invited to give your pitch again. (Could be that additional partners or investment committee members need to be looped in.)
There is likely to be some follow up via phone and email as the final layers of screening due diligence. If that is successful, you will be presented with a term sheet outlining the basics of the terms under which the VC is interested in making an investment.
If you accept the term sheet, you will move into more thorough legal and financial due diligence. This process can take anywhere from a couple of weeks to a couple of months.
If diligence goes well, you will have a close date where you will sign documents related to the investment. These will likely include the purchase of your company’s stock and modifications to your organizing documents accepting all the requisite terms.
And then some money will be wired to your company bank account. Then the real work starts.
The Fear of Missing Out.
I know this seems like such a manipulative cliché. And I just advocated for openness in your pitch.
Be that as it may, the psychology of FOMO is real. Investing is so risky that VCs often respond intuitively to competitive pressure. If they like your deal, then disclosing that you have other suitors does two things:
- Confirms that they are smart for thinking that your company is a good deal (otherwise nobody else would be interested).
- Introduces the idea that they might lose the opportunity to another VC.
VCs are competitive, smart, and do not like to lose.
For you, raising money is a sales process. You need to load up the top of your funnel. Don’t go to one firm alone. Build your list of well-matched investors and work that list like you would a list of sales prospects. By the time you are scheduling appointments you want to be scheduling them in batches.
Nothing creates more FOMO than closing a meeting with the VC you just pitched by telling them that you’ve got to get going to your next meeting with another investor.
#62 Do Your Research
Due diligence isn’t a one-way street.
I hear founders describe (and VCs lament) about this all the time.
The founder gets caught off guard for not having done his homework. The VC questions how serious or mature the founder is who comes looking for millions of dollars without having even reviewed the investor’s website.
Know the VCs and their firms before making contact.
Who are the partners? Who founded the firm? Who joined as a former founder? Who transferred from another firm? What is the makeup of their portfolio? Are they investing in your geography? Are they making investments at the amounts you are trying to raise? What do their portfolio exits look like? What does their Crunchbase profile look like?
You won’t learn everything there is to know. Some of the info online won’t even be correct. But doing your research shows that you care, shows that you are serious, and prepares you to ask questions about the firm in an intelligent way.
Getting Your Head in the Game for Fundraising, by Mark Suster of Upfront Ventures
#63 Warm intros are best
How do you get your company in front of VCs? The best way is to be introduced. This can be the trickiest part of seeking capital. The best introductions are from CEOs of a company in that VC’s portfolio.
It’s common for these introductions and initial screenings to take place over email. Remember the polite way for anyone to make an email intro is to get a double opt-in first. That is, they ask permission from both parties before making the intro. It’s not going to be hard to get your permission, but be patient if it takes some time to get it from the VC.
Once you are introduced, be prepared with a brief email explaining the highlights of your company. You should have an executive summary PDF available to attach.
(You may also be asked for your pitch deck. An executive summary is usually better as your first deliverable, but if you email a pitch deck, it should be designed as a standalone PDF that tells the story of your company—that means it may not be the deck you present from in person, where you are the main event and the deck is just a visual support.)
The Art of The Warm Introduction, by Jason Freedman
#64 Nobody likes a taker
So, you’re now researching the companies who got funded by the VCs on your A-list and B-list to build a list of CEOs who might be able to introduce you. Maybe there’s a world where busy people are only busy unless they have appointments for coffee with strangers.
Founders are generally sympathetic to other founders, but you need to reduce the cost of meeting with you, and you do that by creating some value for them. Steve Blank wrote a great article about this called How to Get Meetings With People Too Busy to See You. In it, he explains,
“… I now prioritize meetings with a new filter: Who is offering me something in return.
“No, not offering me money. Not for stock. But who is offering to teach me something I don’t know.
“… Don’t just ask for a potential customers time, instead offer to share what you’ve learned about a technology, market or industry.”
So, taking an approach like, “I’d really like to hear what you think and show you what we’ve learned about [insert your area of specialty]” is bound to get a better reception than a cold ask.
The Art of the Email Introduction: 10 Rules for Emailing Busy People, by Chris Fralic of First Round Capital
#65 Prep for rejection
Get mentally prepared to face rejection.
Even fully prepared, you’re going to hear a lot of “no.”
I loved that AirBnb founder Brian Chesky published 7 Rejections he received when the company sought its first funding, saying, “Next time you have an idea and it gets rejected, I want you to think of these emails.”
Don’t misunderstand. You don’t just need a thicker skin or to brace for bad news. More than that, prepare to face rejection the right way.
My friend, Jia Jiang (author of Rejection Proof: How I beat fear and became invincible through 100 days of rejection) gave an inspiring TED talk on facing rejection with the right attitude.
#66 There is no conspiracy
The author of The Art of War, Lao Tsu, is meant to have said, “People are not against you. They are just for themselves.”
When things don’t go right in your fundraising, it can be tempting to think others are out to get you or to take their decisions as a personal affront.
Do everything in your power to avoid this.
Disappointment, discouragement and frustration are real emotions. They are part of being a founder. Know that you need more grit to run your company that you do to get through these emotions.
This is going to be hard. Get ready.
#67 Wacky pitch power dynamic
Because VCs are always being asked for money, there is a messed up power dynamic.
Sometimes that makes them come off as uncaring, dispassionate, and generally like kings giving audience to peons. VCs, like founders, can be tempted to believe their own press releases.
So, as a founder how do you combat this power dynamic in your conversations?
If you have a good company, and you know why it is good, you can join this interaction with the confidence that your company is the true prize. Never assume you have license to be rude. But you don’t need to feel the psychological inequity that especially first-time founders can struggle with.
Consider this quote from Erik Ranalla in a 2015 ReCode article, “Especially in Silicon Valley, money is increasingly a commodity. The best entrepreneurs often have their choice of investors, with much greater access to capital from a broader selection of sources than ever before.”
Money is a commodity?
One VCs money spends pretty much the same as the next. But what about your company?
It’s one of a kind. For a VC, investing in your company is one transaction of many, but for your company it will be singular at this stage.
You have something potentially much more valuable to bring to the table than your investor.
#68 Know your pitch cold
There is a saying, “When the time for action arrives, the time for preparation is past.”
Make sure you are as prepared as possible before you get in front of investors (there’s no such thing as perfectly prepared, but don’t skimp here). Get your pitch down to 10 minutes. It will require some painful trimming.
Remember two things:
- Your investor will likely remember only 10% of what you say. Focus on what makes the most impact.
- Keep it short. Oren Klaff in Pitch Anything, makes the compelling point that if it only took 5 minutes for Watson and Crick to present their Nobel Prize-winning idea of DNA’s double-helix, the essence of all life on earth, then you ought to be able to pitch anything in 15-20 minutes.
Practice it a minimum of 100 times before you get in front of investors.
Then go to your B-list investors first and absorb feedback like a sponge. Mark Suster of Upfront Ventures calls this “taking a test drive” and adds that if you’ve raised money before you should get feedback on your pitch from existing investors. “Inevitably your first pitch or two you won’t be on your A-game.”
Then practice some more.
Having your core presentation nailed will reduce performance-killing stress and free your mind to think intelligently about the questions you are asked which fall outside of your script.
#69 Know your company cold
Be prepared for questions.
You will be asked about the company’s financing history, about your personal stake in it, about key people on the team. You will be asked about the company’s financial position and the economics of how you plan to make money.
Know your company inside and out. In many arenas “I don’t know” is a respectful acknowledgement of your limitations.
Here it can sink your deal.
It’s your responsibility to know.
That said, you may be asked a question from a particular angle that you are unprepared for. It’s okay to reframe and redirect questions in a way that you are better prepared to answer.
It’s not okay to ever mislead, cover up, or otherwise be dishonest.
#70 Your Story
Have a solid, concise and interesting story prepared for how your company came to be (usually this centers around the problem you solve for your customers) and how you are winning.
Include challenges you have overcome, things you have learned, and reinforcement that you are on the right track. Remember that when you tell stories, the audience accompanies you on the emotional journey. You want your audience to feel the peril of your challenges and celebrate the inevitability of your success along with you.
“Wait a minute,” I hear you saying. “Just a few minutes ago, you said my company was more important than my pitch. How does that jibe?”
I haven’t yet met Paul Graham. His blog is the writing of an insider genius but looks like he thinks WYSIWYG displays were just a fad. He packs it full of great substance, but couldn’t care less about design or presentation.
So, it’s no surprise that he’s more focused on the guts of the matter.
Paul G. has seen a ton of pitches, and I think he’s saying that he believes he can get a better story out of the unvarnished company details than he can out of a founder who is trying (and maybe failing) to tell the story.
You don’t want all story and no facts.
But, I think the evidence is clear that if you have solid fundamentals, a good story on top of that is more compelling, more memorable, and more effective than just a pile of stats.
No matter how your facts are laid out, they will be packaged in a context that cannot be objective. It’s foolhardy to hope to change the facts with your story, but it’s equally foolish to present the facts without one.
Takeaway: A good company is more effective than a bad pitch. A great pitch enhances a good company but doesn’t make up for a bad one.
Startup Best Practices 23—Leveraging the Illusion of Explanatory Depth in Interviews, by Tomaz Tunguz
#71 Every story need a villain
I loved how Andy Raskin broke down Elon Musk’s pitch for the Tesla Powerwall in an excellent analysis wherein he said, “… Musk does five things right that you should emulate in every pitch you ever make to anybody. And you should do them in this order:”
Number one? Name the enemy.
Why? Everyone is the hero of their own story, and every great story has a villain.
For investors to connect and remember your story, they need to identify with your struggle, your fight to make the world a better place. Describe the villain well enough, and they’ll want to go to war along with you. The industry you are trying to disrupt, the broken way things have always been done, that’s your villain.
(I think the other four things Musk does right are covered elsewhere.)
#72 VCs talk
VCs are a tight group. Even though they are competing for deals with each other, they know that they may also syndicate in a deal tomorrow with the same firms they are competing against today.
Use the golden rule and treat people like you would want to be treated. If you’re a hothead or prone to being disrespectful in the face of rejection, reign it in. It’s almost impossible to burn just one VC—your reputation will spread.
#73 Pitch decks
There is a lot of advice out there on building the perfect pitch deck. Most of it is pretty good, including this from me on Quora and some more from me. I like Guy Kawasaki’s 10-20-30 format quite a bit as well as this formula from Donna Griffit. Here’s a sample pitch deck from Sequoia (caveat) and 38 examples from successful companies.
Despite all of that advice, the key to getting this right isn’t the right number of slides or making sure you have all the right sections.
The key is that no matter what else you choose to add, you MUST include these two things:
- a compelling opportunity
- reason to believe
This is what all the advice is trying to tell you. You need to communicate an opportunity that makes the reader think this is the deal of a lifetime, something they will regret forever if they miss. Win this point and they will want the opportunity. Their emotions will be screaming at them to do the deal. If you miss this part the rest will not matter.
Then their rational mind—afraid of making a bad choice and looking dumb to their friends—will start asking questions. That’s when you need to follow with point after point that sets those fears aside and bestows on them undeniable reason to believe that your success is inevitable.
Most slide deck composition advice is designed to be a checklist so you don’t miss something here. But if you accomplish both objectives, missing a slide won’t matter.
Finally, most founders include too much in their slides. Prune ruthlessly down to your main point. 80% of what you say won’t be remembered anyway, so make sure that the 20% contains the key message you want to deliver.
An exercise I recommend to help with this is to try to include everything you need on one slide first. Then make every additional slide earn its place in your deck. If it isn’t essential, then it’s just diluting your message and your chances.
#74 Deck Frameworks
If you could still use some structure to tell you story in your pitch deck, here are two popular frameworks for focusing on the key points investors want to see:
The 6 Ts:
Traction—Creates a sense of fit and inevitability. For some investors, this is the number one characteristic they are looking for.
Team—For other investors, this is the most important
10x Potential—Can you blow the doors off this market?
Technology—What makes you special, defensible, and the right company to do this?
Terms—Can investors get into your deal under favorable terms?
Bonus Trends—What is happening from a macro perspective that is favorable to your company.
The 4 Ms:
Management—Team always makes the list as a high priority.
Model—What is magical about how you’ve built the business?
Market—Are there enough customers for us both to make a lot of money?
Momentum—How well have you shown you can execute?
Look at your company through the lens of one of these frameworks and you may find it easier to discover a compelling story to tell.
#75 Your Customer Acquisition Model
Here’s the thing. Real businesses are customer-funded, eventually.
Otherwise what you have is either a hobby or a slow death at your investors’ expense.
In order to be customer-funded, you need clarity around the process for how you acquire customers. This process is your Customer Acquisition Model (CAM). The entire customer journey, soup to nuts, from oblivious and unaware, to raving loyal repeat customer—can you articulate the steps?
Most companies can’t.
But here’s what it means if you can: You know who your customers are. You know where to find them. You know your CAC—what it costs to acquire each one of them. You know why they buy from you, what problem your company solves for them. And you probably have a good idea how many of them there are.
What does that mean to an investor? It means people are buying your product. It means you have a reasonable idea how many more of them you can acquire with the capital you receive through a new investment. And it starts to tell them whether there is any hope that your company can produce an acceptable exit.
That last one is important. What’s an acceptable exit?
VCs will (rightly) discount your appraisal of the market size and your potential in it. An exit of exit of $200–$600 million may generate an acceptable return, but factoring in the discount often means VCs want to see that you have a minimum potential of $1 billion.
If you’re shooting to dominate a $10 million market, there just isn’t enough there for you to generate the returns VCs need.
Humans are bad when it comes to large numbers. I’ve seen pitch after pitch where founders tout the size of the market they are going after. The investor nods politely and gives no indication that the founder just lost the deal.
The market, that is the Total Addressable Market (TAM), is too small to be of interest.
#76 Authentic honesty
Being honest is a challenge for some people.
Who knows why we’re tempted by exaggeration, seemingly innocent omissions, and little white lies?
But in a fundraising scenario, the stakes go up. The cost of a casual relationship with the truth is high. You could burn a relationship and even go to jail. (Remember, raising equity financing means you are engaged in the sale of securities. This is a heavily regulated activity, especially when it comes to what you told someone as an inducement to invest.)
In her Fast Company post, Seven VCs Tips For Surviving a Due Diligence Check in 2017, Beck Bamberger closes by saying,
5. BE RUTHLESSLY HONEST
Lastly, investors want plain honesty. “It’s the nature of startups: we will inevitably go through tough times together,” said Jennifer Carolan, a partner at Reach Capital. “As an institutional investor, I expect to be working closely with the founding team for years. It’s critical that we can trust one another and that the founder can be open about the problems so we can tackle them together.”
Eight years ago, Carolan led diligence on BetterLesson, founded by Alex Grodd. “He was very honest about himself, the early limitations of the product, and the tough market outlook,” she recalls. “He did not overpromise. Fast-forward to today, I still sit on his board and can say that his veracity and character are key reasons why the company has grown into a market leader.”
Takeaway: tell the truth.
#77 Stories in the statements
Founders come with various levels of financial aptitude. I don’t want to understate the value of rock-solid bookkeeping and financial accounting, but practically speaking CEOs don’t need advanced degrees in accounting to be successful. This is a hire-able skill. Managerial accounting is much more useful, which is less about building T-accounts and more about a basic knowledge of how to read financial statements and interpret what they mean.
In an early stage deal, your CFO (if you even have one) is not going to be talking through your financials with potential investors at first—a more thorough review of your financials will likely be part of the due diligence phase. Up front, you’ll probably be talking investors through your financials on a compressed time frame and in summary. As a result, you should focus on knowing the key data within your financial statements and the story they tell.
What do I mean by story? I mean the true nature and condition of the company. Financial statements are like the surface ripples that hint at your company’s actual condition beneath. Sometimes the ripples can be misread.
You should know what’s going on inside your company and how that’s driving what you see in the statements. This will offer more understanding and comfort to your investor than your ability to quickly put on the hat of a CPA.
#78 Keep the lines open
Most of the connections you make in your fundraising journey will not invest (see #64). Despite this, your first round of investment gives birth to your Investor Relations responsibilities. Prepare regular updates on your company. Communicate them to your current investors and those you met along the way.
Maintain regular communication with any investor who could potentially be involved in the next round of financing. They’ll appreciate you making it effortless to keep up with your company’s progress, and the connection will be much easier to reignite in the future if you’ve been keeping it warm.
The One Email Every Founder Should Know How to Write to Investors, by Clara Brenner
Coming to Terms
In this section I’ve laid out concepts tied to getting a deal done. Most of them impact valuation and capital structure.
Valuation can be one of the most subjective and elusive topics for young startup companies and disagreements about valuation kill a lot of deals.
#79 Financial risk.
The last in the Four Strategic Components of Risk is financial risk. Here the big question for investors is, “How do I get my money back?”
“Wait a minute,” you say. “I thought investors were all about the returns?”
While that’s true, the toughest thing for investors to swallow is not tepid returns. The toughest thing for investors, is to take a loss.
In fact, due to the sunk-cost bias, investors will often pour “good money after bad,” in order to avoid realizing the loss.
Losses make everybody feel stupid.
As a result, the perception of risk is greater when evaluating return of capital, than they are when evaluating return on capital.
The net effect of this is that you want investors to intuitively understand that this risk is low. The way you do that is by incorporating terms, (hopefully multiple terms or hedges), that create returns of capital for investors.
VC deals tend to be more standardized and include less room for creativity here, but Angels are wide open. You may include, for instance, a unit offering which carries a share of common stock and a share of preferred. You might attach terms to the preferred like distribution of a percentage of revenue until capital is returned, or sweeter conversion terms as the company hits certain milestones.
The goal is to allay financial risk with genuine and creative structures for getting investors their money back.
#80 Term sheets
If your VC likes what she sees and you’ve passed screening diligence, she will send you a term sheet to express serious interest.
Term sheets are not binding offers. Either of you could back out of the deal and owe nothing to the other.
Term sheets are a very useful method for working out the broad strokes of a deal. Negotiating through the major elements ensures you and your VC are on the same page before going to the time, effort and expense of lawyers drawing up the paperwork.
They are a framework for agreement on key terms and an important step in the process.
As your investor pool winnows down to those most likely to be a fit, you’ll be presented with term sheets outlining the basic terms under which a VC is willing to invest.
Signing a term sheet often requires you give exclusivity to the VC—be sure before you’re ready to box out your other suitors before you sign.
It’s wise to be open and transparent with anyone who has gone this far down the road with you. You’ve hopefully spent time building strong relationships with all of your potential investors. They have invested a lot too.
The relationship continues to have value even if you close with someone else. Treat it that way.
#82 Don’t sweat the dumb stuff.
Venture financings have their own tribal parlance (participating preferred, tag along/drag along, liquidation preferences, etc.) that is relevant to founders at two times.
- When you are negotiating over a term sheet
- when one of these mysterious provisions is exercised.
In his excellent book, Venture Deals: be smarter than your lawyer and venture capitalist, Brad Feld covers them each in detail. But perhaps more importantly than that, he gives the following advice:
“In general there are only two things that VCs really care about when making investments: economics and control. Economics refers to the return the investors will ultimately get in a liquidity event. … Control refers to the mechanisms that allow investors either to affirmatively exercise control over the business or to veto certain decisions… If you are negotiating a deal and investors are digging their heels in on a provision that doesn’t impact the economics or control, they are often blowing smoke…”
(Feld, Brad. Venture Deals, p. 32)
The reason I find this so refreshing is because it’s common for there to be agonizing and protracted negotiations over terms that are ultimately unimportant.
If you’re a founder, you may be in the midst of understanding unfamiliar legal terms without the benefit of experience to tell you what’s common and what’s not. Both sides typically have attorneys advising them whose job it is to make their clients aware of the risks in a deal.
All of this creates the opportunity for trust to get undermined and the deal to break down. Keeping your eye on what is important can inoculate you from much of that.
#83 The founder’s dilemma
In 2008, Noam Wasserman penned the HBR article (which he later turned into a book) entitled The Founder’s Dilemma. It’s a real description of where many founders struggle in their relationship with investors.
Raising money to grow the company, the founder typically ends up surrendering a lot of both control and ownership in the company. That can be very difficult.
Entrepreneurs are, by nature, control freaks. They have brought the company to its current state by sheer force of will.
Sometimes that same strength of personality that created the company starts holding the company back—oftentimes there comes a point when a company is ready to grow beyond its roots, but the CEO is not. It’s rare for a founder to have all the skills necessary to lead their company to it’s highest potential growth.
Entrepreneurs navigate many transitions. It’s a tough road.
So the simple truth is that a lot of CEOs get fired or otherwise transition out of the CEO job (maybe to take seats on the board or provide a consultative role) shortly after a company raises its first equity financing and hits the throttle on growth.
Terms of post-investment employment like how much you are paid and under what terms you can be fired, are often written up in an employment agreement and executed as part of the transaction.
Research Wasserman cites shows less than 25 percent of entrepreneurs are still CEO by the time their company makes its IPO.
As Wasserman stated,
“Most entrepreneurs want to make a lot of money and to run the show. New research shows that it’s tough to do both. If you don’t figure out which matters more to you, you could end up [doing neither].”
As with control of the company, entrepreneurs often struggle with the idea of parting with ownership. When the company started, the founder owned it all. It might not have been worth much, but the founder owned everything.
In order for the business to grow, and for the founder to raise financing, he or she needs to be willing to give up much of that ownership.
For entrepreneurs, this can be like giving up a child—they have nurtured the company this far with a lot of TLC mixed with personal sacrifice. Having their effort reduced to a dollar amount can be emotionally difficult if they do not have a vision of the financing as a stepping stone to an organization that will outgrow anything the founder could have produced on his or her own.
Ultimately founders can be rich or be king, but not both. It’s the choice between owning a slice of watermelon or the whole grape.
From CEO to Chairman: One Entrepreneurs Decision to Hand Over the Reins, Scott Johnson (previous CEO of Workfront, formerly AtTask)
What to do When You Get a $100M Offer for a “Billion Dollar” Startup?, Micah Rosenbloom, Managing Partner at Founder Collective
#84 Accredited investors and VC
Caveat: I’m not a lawyer and neither this, nor anything else on this site is legal advice
What’s an accredited investor?
Way back in the post-great-depression New Deal era, lawmakers regulated the sale of securities with the passage of the Securities Act (followed the next year with the Securities and Exchange Act, which created the SEC).
The Securities Act required that ANY sale of securities, private or public, requires registration. In layman’s terms, for you to sell one share of your company’s stock to your sister, you would have to do an IPO.
Which seems a little ridiculous. So there were some safe harbor exemptions written into the law. These exemptions allow the sale of securities without registration. Some of the key provisions are that the offering of securities is “non-public” and that rules are followed around “accredited investors.”
- Earned at least $200k ($300k together with a spouse) for the prior two years and expect to in the current year, OR
- Has a net worth over $1 million excluding the value of a primary residence.
(Some additional rules describe how companies can qualify as accredited investors.)
VC funds have their own legal agreements and compliance terms with their investors and the various components of a VC operation.
When a VC invests in your company, it typically relies on private offering exemptions in Sec. 4(2) of the Securities Act other than those requiring accredited investors. As a result, VCs may or may not be accredited.
#85 Your 35 investors
Certain rules under Reg D allow up to 35 non-accredited investors.
This is intended for close friends and family who don’t meet the criteria of accredited investors.
However, additional rules around disclosures, financial statements, etc., are required if you take investment in your company from non-accredited investors. Consult with a qualified securities attorney, but in general, you’ll save yourself a lot of potential headache if you stick to accredited investors only.
Crowdfunding is another exception. See that section below.
#86 Vesting schedules
Equity compensation is often used to recruit your senior management team.
This can be a great way to align key employees around the company’s success. Talent is hard and expensive to recruit, especially in competitive times. Founders don’t want to give up precious equity to employees who won’t stick with the company.
As a result, it’s common for employee options to vest over time.
Typically options will vest monthly over 4 years with a one year cliff. The cliff means none of the options vest until the employee has been with the company for one year. After that, each month a pro rata portion of the total options vests.
If you have followed a less customary approach to issuing stock to employees, VCs may require this vesting schedule (or something similar) be adopted for any issuance of options post-financing, and any options that don’t already have other terms specified.
It’s common for employees who have been with the company for some years prior to the VC investment to have vesting terms backdated.
#87 Cap tables
A capitalization table, cap table, cap stack, etc. is a record of all the owners of equity and potential equity (such as options and warrants) in your company. It includes when the equity was given, how much and what was paid.
Founders don’t need to be investment bankers to keep and manage their cap tables. But they should understand them.
Fred Wilson of Union Square Ventures has published an excellent blog post, complete with sample files. He offers insight into how a VC views cap tables.
Ultimately, startups need a cap table, it needs to be complete and up-to-date—and as the founder, you need to understand it.
The more shareholders you have, the more complex it can be. Every financing round adds a layer of shareholders and recalculates the equity percentage owned by each one.
At any time, you ought understand who owns what in your company, including your fully diluted equity position. In other words, if every option, warrant, note, preferred stock convertible share, combined unit, or anything else that will eventually become a share of stock were to do so, what does the picture look like?
Broken Cap Tables, by Henry Ward of eShares
The two acceptable exits are an acquisition or an IPO. These are typically where founders and early investors have an opportunity to get liquid (i.e., turn their shares into cash).
Acquisitions can be pretty straightforward, but if your company does an IPO, you want to understand overhang. Overhang is stock that could flood the market and drive down the price, which could ultimately impact how much you get when you sell your stock.
A common form of overhang is cheap stock belonging to the founders and early employees.
In an IPO, founders and control persons are typically locked up for 180 days. That means two important things for founders:
- You cannot sell your stock for at least six months following your IPO. (Selling as soon as you can is often not the most profitable time to sell anyway—so it can pay big to get smart about this).
- You need to manage the sale of founder stock at the six-month mark or your stock price is going to take a hit from the founder stock overhang hitting the market.
A perfect example of this is LinkedIn.
LinkedIn went public at $45 per share on May 19, 2011. By the next day, the stock had more than doubled in value at $94.25 per share, placing LinkedIn with a value of over $9 billion.
Over the next six months, they rode the market’s ups and downs, hovering fairly consistently around $80 per share. Then predictably in November, six months after the IPO, LinkedIn’s shares take a slide to below $60 per share—the lowest point since their IPO.
The company lost 25% of it’s value, almost overnight. Why?
Because the executive team didn’t manage their overhang. Early shareholders sold their stock into the market as soon as they were legally able to. The spike in volume was bigger than the demand, and the price fell.
#89 The miracle of preferred stock
VCs typically hold their equity in preferred stock. Why?
Here, the accounting folks raise their hands and dutifully describe how in a bankruptcy, claims on the company’s assets are prioritized: receivables first, then bondholders, then preferred stockholders, and lastly common stockholders. So, obviously VCs are simply looking for priority over common stockholders, right? Well, yes, but that’s only the tip of the iceberg.
The signature feature of preferred stock is not it’s seniority, but that it represents a contract. This means that preferred equity can be attached to contract terms that have far-reaching power and flexibility. The legal agreement for a VC investment means that the equity VCs receive is imbued with all the terms of the investment.
VC terms usually fall within a fairly standard set of parameters, well described by Brad Feld in Venture Deals. VCs are usually not looking for creative deal structure from founders. But a creative structure can be the difference between getting funded or not.
For example, maybe one side of an investment is hung up on a particular term—preferred stock can allow you to bring in an offsetting term that the other party may care less about. It may allow you to create hedges in the deal that increase investor comfort. Preferred stock does not inherently grant voting rights, but it can, even supermajority voting rights.
Creativity in terms is more common with private placements where entrepreneurs are building enticements into a common offering, but IMHO every founder (not just their lawyer) should understand just how much flexibility is possible with preferred stock.
The reason for this is that equity crowdfunding was illegal in the U.S. when these platforms launched. As a result, early investors were really donors to causes or to products they liked. And the funding in a lot of cases amounted to an expensive and risky pre-sale of an interesting product idea.
But that all changed with the Jumpstart Our Business Startups (JOBS) Act, passed by congress in 2012. Well, the notion that it would change came in 2012. The actual rules for Title III, which allows crowdfunding by non-accredited investors were enacted in October, 2015. With those rules, more companies jumped into the fray, like CrowdFunder. Indiegogo added equity to their platform as well.
All of which is to say that equity crowdfunding is still pretty new.
Crowdfunding generated about $34 billion in funding in 2015. But $25 billion of that was in the peer to peer lending space, and probably muddies the water. That still leaves around $9 billion, which is something.
Here are the basics:
- Companies may raise up to $1 million per 12 months.
- Investors can each invest the greater of up to $2,000 or 5% of their annual income or net worth (if both are less than $100,000).
- Or the greater of 10% of their annual income or net worth if either is over $100,000.
- No investor can purchase more than $100,000 of equity via crowdfunding in any 12 months.
- Qualifying companies must make certain disclosures based on which rules they are following for equity crowdfunding.
- Companies must use a registered broker-dealer or crowdfunding platform.
On the whole, crowdfunding is an interesting addition to the funding options available to startups. It is handicapped in its usefulness by the number of rules companies need to comply with as well as the cap on the amount of money raised.
There are also some unknowns around how crowdfunding micro-shareholders need to be treated. Simply honoring the rights of these shareholders may be more trouble than it’s worth for startup founders.
As SEC Votes On Title III Crowdfunding Regulations, Investment Platforms Are Divided On Impact, by Jonathan Shieber of TechCrunch
Regulation Crowdfunding: A small entity compliance guide for issuers, by the SEC
#91 Private placements and a PPM
In traditional venture capital, the investor sets the terms of the investment.
But a significant number of financings are done in the reverse. Companies issue terms in a Private Placement Memorandum and investors decide if the terms are acceptable or not.
An investor subscribes to the offering by making an investment in accordance with the offering terms.
For founders these deals require more financial savvy in deciding what terms to offer, some attorney’s fees (which can be steep depending on the financial position of the company), significant time commitments, and often the payment of commissions to FINRA-licensed broker-dealers who offer the financing to their network of accredited investors for whom they are acting as registered investment advisors (RIA).
On top of this, brokered private placements are often not offered nor invested in by VCs. In fact, they may actually serve to dampen any VC interest for many reasons.
In Venture Deals: be smarter than your lawyer and venture capitalist, Brad Feld describes his reaction,
“…we’ve seen plenty of early stage companies hire bankers and draft PPMs. To us, this is a waste of money and time. When we see an email from a banker sending us a PPM for an early stage company, we automatically know that investment opportunity isn’t for us and almost always toss it in the circular file. … we generally think this is a pretty weak approach for an early stage company.” (p.20)
That bias may be well-founded. But a significant amount of funding goes into early- and later-stage companies via private placements. As a founder, I believe you owe it to yourself to at least understand what they are so you can evaluate whether this option is for you.
Broker-dealers are regulated by FINRA and the SEC.
Preparing a Private Placement: structure, documentation, and regulation, by John S. Lore of Capital Fund Law Group
#92 Private secondary markets
Private company stock is illiquid. Sort of.
Investors in private companies are typically issued restricted stock—meaning it cannot be sold for at least one year, and usually comes with disclosures that there may never be a market in which it could be sold.
But, secondary markets for private company shares do exist (see SharesPost, Equidate, and Nasdaq Private Markets) where owners of shares in private companies can sell them to others, typically accredited investors.
These transactions typically need permission from the company.
Selling Private Company Shares, by Hans Swildens and Kunal Jain in TechCrunch
Ultimately, any time you evaluate an equity transaction it’s about valuation. What is this company you are building worth?
#93 Valuation Voodoo
Without the constant feedback loop of a public market, private valuation is always one part science, one part voodoo.
409A valuations are like this. These are an IRS driven approach for creating a basis for taxing employee stock options. They could be important in that regard and you should know what they are, but you should also know that they have no basis in investment negotiations around your business valuation and its impact on investment terms.
#94 Market cap, premoney & postmoney valuation
Market Capitalization or Market Cap is calculated by multiplying shares outstanding times the price per share.
Companies have authorized, issued, and outstanding shares. Authorized means how many shares the organizing documents allow to be created. This can change, but requires that the organizing documents be changed. Issued shares are those the company has created and given out. Sometimes issued shares can be repurchased by the company. When this happens, those shares are no longer considered outstanding.
Outstanding shares are those that matter for market cap. Your valuation will ultimately be determined by the number of shares your VC is willing to buy and at what price.
In both premoney and postmoney valuations, money means investment.
Both are also calculated using the price per share paid (or contemplated) for the investment.
Premoney valuation means the pre-investment market cap, or the price per share times the number of shares outstanding before investment.
Postmoney valuation means the post-investment market cap.
In a typical scenario, the VC buys newly issues shares, not existing shares owned by the founder. So, the investment will increase the number of shares outstanding.
For a good example of how this works through successive rounds of investment, check out The Founder’s Journey.
#95 True Valuation
In the world of valuing assets, three models prevail.
- market approach
- income approach
- asset approach.
Startup investments are almost always based on some version of the market approach. The rationale here is that ultimately the most accurate price for a company is the one someone is willing to pay.
How do you tell what the going rate is?
The market approach looks at comparables, that is, companies and investments with similar characteristics which have sold before. Ultimately the industry average multiple (see below) used as a valuation heuristic for companies in your category is nothing more than an average of many comparables.
The income approach values an entity or asset as the net present value of the free cash flows. The net takes the initial investment cost less the present value of future cash flows or discounted cash flows (DCF) which yields a net of the value of the investment.
This is common for real estate investments and companies that have predictable cash flows. Since cash in hyper-growth startups are often volatile or even negative in the early years, the income approach isn’t a great valuation method. (That said, the principles of value tied to regular cash flows are the essential heart of how SaaS companies create value.)
The asset approach values the company as the net of the fair market value (FMV) of its assets minus its liabilities. Startups are often short on assets and long on liabilities, especially for tech companies. Their assets are often things like IP, user base, and supply chain or customer contracts.
The difficulty in transferring this value to anyone else makes the assets themselves hard to value, so the whole assets minus liabilities thing gets pretty impossible. As companies mature and the volatility settles out, however, this may become a part of future M&A discussions or successive rounds. Whatever assets exist in the early days may also be attached as collateral in both debt and equity financings.
Startups Increasingly Turning to Debt Financing Despite Dangers, by Mikey Tom of Pitchbook
#96 Industry Avg. Multiple
No matter where it starts, your company will ultimately be average… that is, it will be valued in line with industry average multiples.
What does that mean?
Your company will be valued at a multiple of its revenue or earnings performance that represents the typical valuation for other companies in your industry. This is typically expressed as your P/E ratio (Price/Earnings) or perhaps as EV/EBITDA, or Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization. P/E is the common shorthand; EV/EBITDA is a way to account for P/E fluctuations if the company is issuing more shares of stock.
In the early days, your company might grow at hundreds of percent a year. Seed and even Series A valuations may be completely unhinged from the market overall.
But this will not last forever.
SaaS companies are currently valued at 5–7 times revenues. If you are building a SaaS company, this tells you that eventually the market will value your company at 5–7 times your sales.
This also tells you that if you want your company to be worth $1 billion, you need to get it to generate $200 million in revenue.
It is impossible to be a long-time outlier of this average, because your company is used as one of the data points in calculating the average.
The Narrowing of SaaS Valuations, by Tomaz Tunguz of Redpoint
#97 ARR & MRR = recurring revenue
Revenue shows your customers are paying you, a sign your company is creating value for someone.
Early valuations are often tied to annual trailing revenue. Typically 1–3x trailing revenue.
But things get a little more complicated for high-growth tech companies because they are growing so fast. You may have double-digit growth per month in some cases.
That means two things.
- An annual cycle isn’t granular enough to accurately value these companies. One year might see the revenue grow by hundreds of percent.
- As an investor, using the previous year’s revenue may be much too small, but waiting to see where revenue comes in at the end of the year may mean missing a sweet opportunity to invest.
To get around this, revenue can be measured in monthly terms or annual revenue extrapolated from the monthly revenue or monthly revenue growth rate. Volatile revenue is risky. How can you tell if it’s here today, but gone tomorrow? When this revenue is contracted to repeat in the future, that’s recurring revenue or the least risky type.
Monthly recurring revenue and annual recurring revenue are effective substitutes for trailing annual revenue.
#98 P/E ratios
Even better than revenue when it comes to valuation, are profits or earnings. Here you’re actually making money!
Public companies track price to earnings ratio (P/E ratio), which is the price per share of the company’s stock divided by the earnings per share.
At the time I’m writing this, Google has a P/E ratio of 26.68. This means investors buying Google’s stock are paying over 26 times more than Google earns in a year. Another way, assuming flat growth, investors are paying for 26 years of Google’s future earnings.
Google’s earnings multiple shows that people have faith in the company’s ability to generate earnings in the future, i.e., investors are paying based on future value rather than present value.
#99 Fundamentals are king
In the short term, valuations fluctuate.
In the long term, though, valuations are inextricably tied to your company’s fundamentals.
Fundamentals include the qualitative such as: Do you know who it is that you serve? Are you creating ridiculous value for them? Do you have a culture of delivering insane value?
And the quantitative: Are you consistently growing revenue? Are you profitable? Are you growing your earnings per share? Are your unit economics solid?
The closer you get to being public, the less speculative your valuation becomes.
Public companies measure this via the PEG ratio. That is your price to earnings (P/E) ratio divided by your growth rate in earnings per share (EPS). When this yields a number close to one, you could say that your valuation is correct and that your stock is fairly valued.
When your company is built on and consistently posts solid core fundamentals in clear and measurable ways, the fundraising dynamic shifts. As a founder, your confidence changes, and your negotiating position gets much stronger. Your rationale behind your valuation is solid and you know what terms match and when someone is trying to buy your stock at a discount.
Remember that ultimately your company fundamentals will bear out.
#100 The valuation formula
Conventional wisdom is, there’s no formula for your company’s valuation. While the sentiment is true—there’s as much art as science to valuation—there is a formula I’ve found to be very helpful.
In 2009, this valuation formula was published by William Sahlman in the Harvard Business Review. It’s an excellent way to rough in valuation parity between investors and entrepreneurs and introduces the concepts of multiples, exit horizons, and rates of return in context.
The formula yields an investment hurdle rate, or the point at which an investor has equity sufficient to generate desired returns. It can also help senior management teams understand what investors are looking for and be more objective about their company valuation. The formula is,
The terms of this formula are:
IRR = The desired internal rate of return
x = The investment horizon, the terminal value period, or the number of years to exit.
Investment = The amount invested.
Multiple = A factor used to determine company valuation at exit.
Exit Value = the estimated value of a company performance metric (a key stat like revenue or earnings) used with the multiplier to establish valuation at exit.
The numerator calculates the future value of the investment assuming it generates the desired IRR.
The denominator is the value of the company at the exit horizon.
The valuation formula isn’t ironclad; it’s simply a rule of thumb, a heuristic for estimating the value of a company at some point years into the future based on assumptions regarding things we cannot be certain about. It’s still a good thing to have in your toolkit.
As a founder, I wish I had been better versed in these concepts when I went out to raise money for my first company. I would have been smarter and more understanding of the investors across the table. I hope if you’ve read this far, you feel more prepared.
For my students and the awesome community of founders and investors around the country, I hope you find a nugget or two here that opens doors and helps you find success in your efforts to change the world.