There is no formula for raising venture capital but at the same time there are principles that can serve as guides. Below are ten that come up often in my conversations, each is a rich discussion in of itself but hopefully this overview can provide some helpful lamp posts.
1) Do you need venture capital?
Many entrepreneurs think that venture capital (VC) is the best way to scale their startup. Chances are that is not true. Historically fewer than 1% of US companies have raised VC. Venture capital has come into prominence especially since the 1980s when it became the model of choice for fast-growing, typically software startups, common especially in Silicon Valley. There are a lot of businesses that do not fit that mold and can still be very successful, raising capital from other sources like foundations, grants, bank loans, joint ventures, among others. Ask yourself what kind of startup you are building and if you truly need VC. Having clarity here can be the difference of landing on the moon or ending up adrift in space.
2) Different types of venture capital for different kinds of uses
So you have decided VC is really the best way to go. But venture capital is a catch-all term — roughly speaking there are early-, mid- and late-stage investors. Early-stage investors these days typically run funds of up to $100M and focus on seed, series A, mid stage will pick up As and Bs, late stage will look for stages beyond. If you are raising say a series A from a late stage investor, even if it’s a small check size, make sure you understand why. This includes the networks and insights the investor will bring, how you might leverage other companies in the portfolio, and even as blunt as their expectations of growth and exit.
3) Value > Valuation
Which brings us to my most cherished tenet for investing, that value is not the same as valuation. Just getting a term sheet with the largest numbers does not make it the best choice. I personally would rather optimize for a firm that will maximize what I can accomplish, specifically considering the partner that is leading the investment and would potentially be serving on the Board. And for that I am willing even to take a lower valuation. There is a human impetus to maximize the current round at the expense of future growth, it’s important for a founder to not lose perspective out of greed or market pressure.
4) Convertible vs Priced
Convertible by its very nature defers the valuation question to the next round, giving more space for founders to tinker and grow their idea. Founder and investor will settle into an interest rate and cap that both agree but ultimately, a convertible does require more faith from the investor than a priced round. That said, even in Silicon Valley where convertibles are far more common for the first round, you will see priced rounds for a good reason. Priced will invariably lead to more discipline in the business, effectively “things get real”, and some entrepreneurs deliberately choose that path. You may not have the choice depending upon the investors you are talking to but if you do, ask yourself if you prefer building further the idea or if you are confident enough to peg a dollar amount to it.
5) Signaling Effect
An existing investor may not participate in your current round if they are financially unable to, if you prefer them not to, or if another investor wants to put in more money. But if the existing investor deliberately decides not to invest, say they led series A and now are not doing their pro rata in the B, then you are facing a signaling effect. Invariably other prospective firms will wonder why your existing investor is not supportive, which can be a death blow to you. Which is why be aware of a firm leading your round, make sure you understand their expectations and whether their balance sheet is healthy. Besides obviously talking to the VC, entrepreneurs should do their own independent research — it’s very easy to search the web and see how the VC has followed up on their existing / past investments.
6) Parallel vs Linear Processing
There is a school of thought that a founder should follow up with a handful of VC firms and carry the conversations forward till there is a definite answer about investment, before moving to other VC firms. This arguably minimizes the risk of cascading failure ie the founders may be able to spot and fix concerns in their pitch for the next VC. The other school of thought is for a founder to hold as many conversations with VC firms as possible and advance them in parallel. For instance, if you had a second meeting with a firm, you could go to another firm where you only had a first meeting and have a stronger case to push their decision making timeline. One big risk in overemphasizing this approach is it can backfire on you ie most major firms have heard of you but nobody is investing.
7) Liquidity for Founders
As an entrepreneur you have to balance many people’s interests — but also be aware very much of your own opposing interests. One of the bigger dilemmas is when a founder wants to reduce a bit his ownership in the company to get more liquidity. Founders worried about their mortgage or paying for their children’s schooling may let that affect how they run the business. On the other hand, if a founder owns too little of his business then he may not push himself hard enough and potentially build a “lifestyle company”. If you are considering getting liquidity ask yourself your true motivations for doing so. If you legitimately want to minimize your personal risk for good reasons than a bit of liquidity, say 10% of your shares in any given round, makes sense. But if you are considering selling your shares because deep down you do not believe enough in the company then it’s a very dangerous precedent.
8) Syndication
A fundraise rarely goes exactly as planned, but a founder should not forego having a plan. And a big part of the plan is who and how many firms to bring into a round. As a founder you should have a view on whether you want your previous investors to fill in completely the next round, they just do their pro-rata and one or more new investors come in, or new investors fill the whole round diluting previous investors, or new investors fill up the round and buy out previous investors. It is often a good idea to bring in at least a new investor every round, this creates further validation for the startup, arguably will get you better terms because there will be more competition in the round, and opens up another point of support for the company to succeed. The trade off is managing multiple relationships and incentivizing enough investors to have skin in the game.
9) Too little and too much
Raising too little money has its obvious downsides — you may simply run out of cash too early. Raising too much money actually also has downsides even if less obvious — if you have too much cash you may not take the hard decisions to make your company as efficient. Additionally, you may dilute yourself too much or peg yourself on too high of a valuation, which means you run the risk of a flat or even down round in the future. The signal to the market does matter and the effects on the team’s morale cannot be understated. As a general principle a wise founder will raise just enough capital to take it towards the next milestones, while keeping a healthy cushion for emergency. Many of the spectacular flameouts in recent years are when a founder or a VC didn’t heed this principle; careless money is a recipe for disaster.
10) It’s a Recurring Game
Fund raising is not a transaction, it’s a relationship. When a VC puts in funds in a startup they are effectively a co-owner of the company with a founder. And if they do not put funds right now they may still do so in the future, or in a different company the founder will be part of, so it’s very much in the founder’s interest to manage the relationship well. The converse is as much true, a VC that doesn’t treat a founder well may find itself ostracized by many others. And removing a VC from a cap table is far harder than firing an employee. The message for both parties is simple — approach fundraising as a recurring game. It’s not only the right thing to do morally but it’s also what makes most sense logically. You never know who is going to be on the same side or other side of the table in the future.
