A day-long series of mentoring sessions this past week on the subject of startup funding brought to top of mind some of the basics. “Safe” financings, which have the mathematical effects of convertible notes but are legally more like warrants, are in vogue on the West Coast in particular. My unscientific observation is that the farther east you go across the US, the less desirable Safes or convertible notes are to local angel and institutional seed-stage investors. They are still part of the mix in any market, but, as a general rule, it’s easier to sell an offering that matches the tastes of the investors close at hand. Carolina barbecue and Texas barbecue are quite different; hold the vinegar if you plan to open a BBQ truck in Austin. Your odds of success will increase considerably. Similarly, taking time to understand the “appetites” of investors on your local prospect list before you launch an offering is time well spent.
The core message in my view is that you as a founder want to manage your financing strategy in a logical progression. Every increment should be undertaken with a view to the next step, and the steps after that. Here are a number of points to consider:
Your first few dollars may come from grandma or your next door neighbor. That’s fine and not unexpected. You use that money to get to some milestone, which may be a thorough process of customer discovery, an MVP, some pilot users, or perhaps even a bit of revenue. You want to deploy this high-risk money invested on faith in you personally to de-risk the concept. When grandma’s bank account gets low, you will want by then to be at the point where your deal is compelling to a dispassionate angel investor. An important thing to remember here is to cover your tracks with careful legal work. If you take money from nonaccredited investors who are not active members of the team, you may poison your ability to do an offering to accredited investors in the next round. You may have an unwelcome introduction to the term “rescission rights.” You can probably assume that the people who gave you your pre-seed money will still believe in you when that next round comes along, but their personal circumstances may have changed based on family matters or even illnesses. While probably not deal killers, those situations could cause more heartburn and legal fees than you need at this stage in your nascent company.
Assuming your work to date has confirmed that you can and should proceed with your business, you may then want to do a more formal seed round. This could be a convertible note or a Safe instrument, both of which will punt the ticklish valuation question to the professional investors you might anticipate in a more formal Series A offering. Or, you can just calculate a value and see if you get takers. At this seed stage, you will probably do a Reg D offering to accredited investors only, again anticipating the need for an always buttoned-down legal trail in any financing progression. Whatever instrument you are selling, here’s where your spreadsheet genius is called into action. Each step in your process should be a step up in terms of predicted valuation and in the amount raised. And, each step needs to leave enough equity for subsequent rounds so that the management team can remain significant stakeholders. Practiced investors bet their money on founding teams, not on who’s in the deal. They will want the founders to dominate the cap table after this round. It’s not a control issue; that is generally handled in shareholder agreements and deal terms like vesting. Your spreadsheet should show how you accomplish the goal of a post-funding cap table that keeps the team fully in play.
An important warning here is that follow-on rounds will be very much hampered if you step outside the lines of doing discrete investment offerings and bring on board a bunch of shareholders on ad hoc deals. Trading stock for services is one way that often occurs. I’ve seen pre-A companies with too many shareholders and where nearly every ad hoc deal has different pricing and terms. Shares are often valued in those cases on something higher than the most recent round and with some guesswork as to what’s next, and that can change from month to month. When you are teeing up a new offering and show an eclectic history of accumulating shareholders, you are exhibiting warning signs to the better investors you’d like to chase. Having a really clean cap table where every investor came via an organized offering and many of them have some value to add beyond just their cash is a huge plus when you have achieved the inflection point where the big money will look at you.
Series A is generally the next step. Here’s where you get into more traditional Preferred Stock offerings that are priced. Here also is where you want to apply your spreadsheet skills, but more so on the waterfall chart than on the cap table. It’s that waterfall chart that reflects all the terms and conditions, particularly the preferences, that help venture investors make their return objectives while creating the illusion that they’ve given you the valuation you sought. They’ll remain mindful of keeping you in play for generous rewards on the upside, but they’ll also carefully hedge themselves on the downside if you don’t achieve the projected glory. Most eager founders will fight to the teeth over valuation but never really study the T’s & C’s that tilt heavily in favor of the investors. The only way to understand that is to create your own waterfall chart that shows which class of shareholders gets how much of the pie at any given exit valuation, assuming no further dilution. You may be surprised. I mentioned vesting above, and it is becoming routine for Series A investors to impose vesting requirements on shares already issued to founders. The sole objective of that in a hot market for technology talent is to make sure that if you or any of your founding team members leave on your own to pursue something else, you shares are surrendered back to the treasury. No one wants to see a meaningful chunk of the cap table held by someone who escaped early and didn’t finish the drill. These vesting periods are negotiated and may be 3-5 years, with some portion vested up front; they are not intended to create lifetime indentured servitude, but just to make sure you are around long enough to play your role in a happy outcome.
To emphasize what I wrote above, this Series A like every step in your progression should be a step up in terms of predicted valuation and in the amount raised. And, you always want to leave enough equity for subsequent rounds so that the management team can remain significant stakeholders.
What if you capture a strategic investor along the way? Strategic players are not normally valuation sensitive and will pay more for ownership than will a pure financial investor. You bring other value to them, and if they are large corporates, you current scale may be a rounding error for them anyway. All you need to do is find one champion with enough authority and budget to get your deal done. You may or may not even interact with corporate financial departments beyond the necessary legal documentation. There are downsides, however. As you try to maintain a steady progression and have a good reason to launch a round subsequent to a strategic investment, you’ll find that nobody will invest unless that strategic owner commits at least pro rata. You’ll also preclude any investment interest by its competitors; you may also wall off a big segment of your potential market; and, at exit time, you may find yourself with only one plausible buyer and no negotiating leverage. Tread carefully in this area; you can easily lose control of your tidy plans for your company and its funding.
A additional essay will be required to focus on questions like how much money you should be trying to raise. I have seen numerous plans in various settings this year where there’s a multi-billion dollar projection accompanied by an initial ask for only $500K. Those defy credibility and would generally fit the rule that it’s easier to raise larger sums than smaller amounts. You don’t want to give the impression you are raising just enough money to get yourself in trouble and nowhere nearly enough to accomplish the mission.
Every founder’s situation is unique. The generalities covered in this installment should provide some helpful guidance, but things will look very different when the startup has some things go wrong and doesn’t perform somewhat close to projections. My ultimate advice in that case would be to get some professional help from a board member, mentor or advisor who has seen that movie before.