Perhaps you recently read about Intel buying a vision technology company in the autonomous driving space for $15 billion and thought, why? Maybe you’ve done all the things they tell you to do with your existing investment portfolio – diversify a bit, moderate the risk, and are still left wondering, what else? Possibly you overheard a colleague discussing how he recently connected a MedTech startup in his portfolio to a board member within a major hospital network, and it made you think, what could I be doing for innovation?
As venture capital and startup investing are becoming a more readily-available asset class to broader investor bases, understanding the basics of funding is essential to evaluating the right deals.
The purpose of this series is to provide investors (and even first-time entrepreneurs) with a perspective on the basic structure of venture-backed deals. Through an illustrative startup example, I describe some of the key concepts of the industry, from the perspective of the founder, for the benefit of the investor. Here’s how we’ll break it down:
- Part 1: Understand the basic valuation negotiation tools, capital raising strategies and how to select your best investors.
- Part 2: Learn about different types of shares, dilution, preemptive rights, the ‘power
law’, ESOP, debt vs equity considerations and anti-dilution protection.
- Part 3: Discover the ‘great beyond’ in a startup’s lifecycle: the exit.
Get ready for some other useful tidbits along the way… let’s get started.
The Hustle: How Does Startup Fundraising Work
In Part 1 of this series, I discuss the beginning of it all; what goes into the first round and what founders need to consider at this phase. Startup fundraising is a delicate process, and the various ways to structure a company with different shareholders is a foundational step. Ready to get some firsthand experience? Put on your entrepreneur hat: we’re going to explore the process from the startup’s point of view.
You’re finally ready to come out of stealth mode. With a hot idea in a piping market, you’re sure that ‘boot strapping’ (i.e., eating macaroni and doing your own accounts in QuickBooks) for the past year was worth it. You (let’s call you Fred) and your co-founder (let’s call her Fran) have now decided that the time is right to raise $750K of seed capital to take your company to the next level.
At this stage, things are pretty simple. The company has no debt, cash burn is predictable (but increasing) and you have already achieved two concept/product milestones. In terms of corporate structuring, you each hold 500,000 common shares in the company, equating to a 50% equal ownership. For now, these are the only two line-items on the cap table.
Setting the Cap Table
You’ve heard the term… put simply, a cap table serves as a list of every equity holder of the company, including founders, investors, employees, consultants, etc., along with the corresponding number of shares, by share class, per each equity holder.
For more, check out this very worthwhile read about ‘healthy’ cap tables by Kobi Samboursky of Glilot Capital Partners. Rona Segev from TLV Partners has also recently released her Cap Table 101 toolbox for keen entrepreneurs.
So, how much is your idea worth? (AKA, Pre-money Valuation)
The pre-money valuation refers to the valuation of a company prior to an investment. Although this series isn’t about valuations, suffice it to say that deal making all comes down to economics 101 – when a willing buyer (investor) and a willing seller (company founders) come together to agree on a transaction (sale of shares in a company).
Of course, trying to sell at too high a valuation (i.e., expensive) will make the fund-raising efforts exceedingly difficult, and comes with the risk that no investors will show interest. But too low a valuation (i.e., cheap) will be dilutive to founders and syphon hard-earned potential upside towards investors.
So what are you and Fran to do in discussions with prospective VCs?
One way of setting a price is by looking at market norms and similar transactions in the industry, as well as considering capital supply and demand. Some investors try to use quantitative metrics to calculate a valuation. Personally, I believe that for early stage companies, this technique is generally inappropriate. Brad Feld (Foundry Group) has famously blogged about the trap of pricing relative to comparable companies, and thinks that a fair price is actually ‘good enough’. And as Warren Buffet says, “it’s far better to buy a wonderful company at a fair price, then a fair company at a wonderful price.”
At every stage, but especially at the early stage, the rights are much more critical to the founders than the sticker price. But having said that, valuations do matter, because the valuation ultimately is the determinant of how much of your company you are going to give away to an investor for a cash injection. You probably can’t sell your company with that price tag, but it is indicative of future growth potential as opposed to present value.
If founders and investors are unaligned on valuation, there are three levers which could be pulled to bridge the gap:
- The option pool (ESOP): This is the most common method of resolution. Options refer to that pool of shares that are reserved for employees (current and future) as a form of incentive. Let’s assume that a company offers to sell equity at a $20M pre-money valuation. If an investor finds this price too high, he could respond by saying that the company doesn’t reflect the $20M asking price today. For that valuation to make sense, the company is going to need to onboard additional talent. In order to incentivize this talent, there needs to be an option pool in place of, say, 20% earmarked for these talents. That means that for every four shares held by founders or investors, there needs to be an additional one share available to grant to employees. Now, as the $20M valuation is on a fully-diluted basis (i.e., all in), that means that the 20% option pool needs to be baked into the pre-money share base. While the investor will still hold the same percentage ownership of the company, the founders will be heavily diluted by the additional ESOP issuance. Or in other words, the pre-money valuation will be 20% lower – in our example, that’s $16M. (More on this in Part 2).
- Anti-dilution provisions: This is when the VC or investors suggest that the valuation is too high, but that they’re prepared to take a chance on the company. If in a future financing the company is required to accept a lower valuation, the initial investment is repriced to reflect the newer price. Complete repricing, known as full-ratchet anti-dilution, is the most draconian anti-dilution provision, and rather uncommon. Broad-based weighted average is a much fairer and common provision (as explained in Part 2).
- Liquidation preferences: The higher the valuation at the initial point of investment, the less gain an investor can make on an exit (all else being equal). If the VC is concerned that the company may sell out shortly after their investment, prior to showing significant growth on the new capital, they can try negotiate better liquidation-prefs into the term sheet. (Again, more on this in Part 2).
So how do you know what is the right amount to raise, and at what price? The answer: it really depends. Let’s look at both sides of the equation separately.
In my experience of deep-diligencing hundreds of startups, it comes down to trust and transparency. You need to determine how much money your company will require in order to build product or advance development sufficiently in order to get the company to the next round of investment. Typically, this period is between 12–18 months, and during this time the startup’s management will need to hit significant milestones to prove to investors that they’re worthy of future investment, too.
So, Fred, you and Fran must make sure that you have an operating budget that will signal confidence to your investors that you have thought about how you intend to deploy their hard-earned capital.
- DO disclose granular line items in your P&L (no one likes to see $150K quarterly spend for “G&A” if they can’t deep dive into it).
- DON’T include gargantuan rainy-day buffers of 30% of your P&L for “sundry expenses” (which, sadly, I’ve actually seen).
Investors shouldn’t push back on the raise amount; after all, they want to see the company grow and should realize that you’ll need to water the seeds before the flowers start to bloom. In fact, an undercapitalized company poses much higher investment risk than an over capitalized one.
In terms of the amount of equity to forfeit – there is a balancing act between three groups of shareholder interests: founders, employees, and new investors. Founders and employees need to maintain sufficient skin in the game to be incentivized to continue working, usually under a new board structure. Investors want to know that they are getting value for money, after all, it is their capital which is building the value of the equity of the company.
What’s interesting about valuation is how greed (from either the entrepreneur or the VC), can cause tremendous harm down the road. If the entrepreneur succeeds in raising initial funds from a less-savvy angel investor at an overpriced valuation, the new post-money valuation after that funding may be higher than any future potential pre-money valuation at which VCs would be prepared to invest. This is called valuation overhang and can create difficulties in future financings, or in the best-case scenario, an unrecognized loss on the initial investors’ capital.
On the other hand, if VCs try to hard-arm too low of a valuation, management/founders can lose incentive to grow the company. This demotivation can be compounded by consideration of future dilutions as additional capital is required down the line.
There are two basic strategies for fundraising:
- Swing for the fences – raise as much capital as possible. This will allow you to sprint towards your end goals without having the headache of cash flows and future funding rounds down the line. Proponents of this methodology are believers that you don’t raise capital when you need it, but rather when you can. Follow the markets and plan your rounds around bullish climates. The downside of this methodology is that you risk turning off investors if your company tries to raise more money than is justified.
- Hand to mouth – Raise only that which you absolutely need, and spend as little as possible. Slow and steady, your valuation will rise as you meet your KPIs, but your photo probably won’t make it into Forbes. Fred Wilson “recommends that entrepreneurs keep the funding amounts small in the early rounds when the valuations are lower and then scale up the amounts in the later rounds when it is a lot more clear how money can create value and when the valuations will be higher. This model has worked out pretty well. David Karp (founder of Tumblr) raised $600K, then $4M, then $5M, then $25M, then $80M (or something like that). And at the time of the sale to Yahoo!, he owned a very nice stake in the business even though he had raised well north of $100M. He did that by keeping his rounds small in the early days and only scaling them when he had to and the valuations offered were much higher.” The downside of this methodology is that you are always fundraising, and never free to just build your company. You are also usually undercapitalized, adding further stress on the company and posing additional fundraising risk.
A balanced approach will probably work best for most businesses.
Some investors will also claim that regardless of how much capital a company raises, they will still manage to burn through it all within 18 months, and that there isn’t a compelling reason to over-finance a startup (unless that is the only way to increase your ownership; i.e., if valuation is fixed).
Back to our story: you and Fran have pinpointed five potential angels who are willing to put up the capital. Which do you onboard - does it matter? After all, money’s money, right?
Wrong! Every line on your cap table – AKA, every shareholder - should add value to your company. Each person or entity should make your company more attractive to employees, investors and partners. David Stark, founder of Ground Up Ventures, highlights the following key attributes of an optimal angel investor:
- They must be able to offer mentorship and be a sounding board to the CEO, ideally leveraging their own experiences and knowledge of how to navigate the business waters;
- They must be patient and share the long term vision of the company, and not simply try to make a quick 3x return;
- They should be positioned to help you with future financings, introductions to VCs and have a useful network of initial business development contacts.
To quote serial angel Mark Cuban’s book, How to Win at the Sport of Business, “It’s not whether the glass is half full or half empty, it’s who’s pouring the water.” Capital provision is not a differentiator. Plenty of people have cash to invest.
So who will you choose as your ideal investor? These critical next steps set the tone for your company’s entire structure. Stay tuned for Part 2, to understand common vs preferred shares, preemptive rights, ESOP, and more essential knowledge for understanding how startup fundraising works.