Cash, surprises and logic are what to focus on as your fundraise draws to a close. Plus some thoughts on naming a price, and what really matters in startups
You’re CEO of a fast-growing startup, and you’re in the middle of a fundraising round. You’ve carefully considered whether you should raise the money yourself or use a professional intermediary. You’ve made sure to reach out to enough potential investors early on. You’ve qualified those investors to make sure they’re not wasting your time. And you’re aware of the signals and behavioural signs that indicate that the VCs you’re talking to are serious and moving forward at an appropriate pace. To sum up, your pipeline is appropriately full and it’s progressing at the right speed. What could go wrong?
As I argued in this primer on how to fundraise for a startup, four mistakes are commonly made by CEOs at the start of the process. They’re not hard to sidestep if you’re aware of them early enough. And your chances of success also go up significantly if you can predict whether a given potential investor is likely to close — a task that can be done using this simple checklist, which captures the important issues in the charmingly appropriate acronym F*CKWITS.
But once you’ve done these things, you’re still at risk for a few months as you try to convert those engaged, interested VCs into people who’ve signed an investment agreement and actually sent you money. There are some big issues likely to come up that can derail a promising funding round. I’ve learned some useful techniques in how to deal with them from some of the CEOs that I work with as a coach or investor.
You’re still at risk for a few months as you try to convert interested VCs into signed documents and cash in the bank
One way to think about these issues is that they represent the Three Last Mistakes, which we could number 5, 6 and 7 since they follow the First Four Mistakes. Avoid them, and you’re home and dry. To borrow Winston Churchill’s words in a speech in 1942, closing a round isn’t the end of your struggles as a startup founder. It’s not even the beginning of the end. But it is, perhaps, the end of the beginning.
It’s not the end. It’s not the beginning of the end. But it’s the end of the beginning
Mistake #5: You forget to manage cash during your fundraising
I know a talented founder who built a good startup in the travel industry, and negotiated an attractive exit to a big company whose name you’d know. The terms were agreed, the paperwork was prepared, and the transaction was due to close on 23rd December. Then came the call: unfortunately, BigCo had discovered a problem — and sadly, wasn’t going to be able do the deal on these terms. “We can still complete the transaction,” said whichever VP it was who’d drawn the short straw of making the call, “but the price is going to have to be 40% lower.”
What was this deal-breaking problem the buyer had discovered? Well, it wasn’t much of a problem, but the buyer had noticed that company being acquired was running out of cash. The seller’s BATNA — its Best Alternative To A Negotiated Agreement, the idea from negotiation theory of its most advantageous course of action if the talks didn’t succeed—had rapidly worsened, because with no safety net it couldn’t make its end-of-year payroll. It would be forced to shut down operations in the next few days if the deal didn’t close. The buyer realised that the deal didn’t have to be attractive to the founder who was selling. It just had to be better than her BATNA. And the buyer took advantage of this, by giving the price a savage haircut.
The buyer took advantage of her vulnerability by giving the price a savage haircut
Here’s another story with the opposite outcome. Another female founder, this time the CEO of a professional marketplace. She starts the fundraising process with eight months of cash. She hopes the negotiations will be done in six, so the company will have a two-month buffer to get it done. But she likes having a plan B, so she raises a chunk of debt. The money comes from an existing investor, who gets a high interest rate, plus a bunch of warrants, plus an arrangement fee. It’s a high-return deal for the lender, who also gets a fixed and floating charge over the company’s assets — meaning that if the company can’t pay back the money when it’s due, then the lender gets the business.
But this debt deal, expensive though it may seem, has the following effect. As the potential investors move further into the process, they get to examine the company’s financials, and they can see that there’s no urgency on the sell side about the deal. Contrary to what you might read in the blogs, most VCs aren’t evil people; they wouldn’t knowingly try to take advantage in this way. But those who might just be tempted to get the company into exclusivity and then slow down the process a little and watch the CEO squirm as the business slides towards insolvency, now know that strategy won’t work. If she has to wait them out, the CEO has more than enough runway to to do so.
When you think of it in those terms, it doesn’t seem complicated. The lesson is straightforward: manage your cash so that during the fundraising, and for a good buffer of time afterwards, you’re solvent.
Mistake #6: Give your investors unpleasant surprises during the due diligence
It’s a cliché that greed and fear are among the ‘animal spirits’ that the economist J. M. Keynes identified in the behaviour of investors. VCs, like buyers of public equities, switch back and forth between the two: desperate one day not to miss out on a ‘hot’ deal that some other investors they’re jealous of are doing, and terrified the next day of looking like an idiot for having backed a terrible company. But one difference between a VC deal and a public-equity investment is that unlike venture investments, stock prices on the NASDAQ or the NYSE change every few seconds as new information comes in. Elon Musk casually tweets that he’s thinking of taking Tesla private at a well-chosen price of $420 a share? Great; the company’s worth more. Buy, buy, buy. Oh, the funding isn’t secured after all? Quick, sell.
When a VC invests in your company, by contrast, they’re locked in for years (even the old-fashioned European investors who insist on a clause in the investment agreement giving them a right to force a sale after a certain period of time). This makes sense, and the general partners of funds build their businesses around this expectation: they make their own investors commit to a ten-year partnership, usually with a couple of extensions in case they haven’t had time to exit from all their deals by the time the partnership has to wind up.
So you’d expect the short-term vicissitudes of your company’s fortunes wouldn’t make much difference on such a long-term investment. But you’d be wrong. Because the VC's bipolar journey back and forth between greed and fear is especially agonising during the weeks between the day you shake hands on the price and the day the money hits the bank.
Since venture deals are mostly about the promise of the future, even things that might not seem like deal-breakers to you — a team member quits, a potential pilot doesn’t happen, a customer decides to cancel — can rapidly cause a VC to lose enthusiasm for investing in your company. Because those little nuggets of bad news don’t just make them look bad to their partners in their Monday meetings. They also might indicate that you’re a bad manager, that you don’t know your own business, or — worst of all — that you’re in the habit of making promises you can’t fulfil.
The VC’s bipolar journey between greed and fear is especially agonising during the negotiation period
The lesson for CEOs during fundraising is this. As you start the process, and as you look at what’s in your slides, pay careful attention to what predictions you’re making that could come to fruition (or be disproved) during the negotiations. And make sure that you’re unshakably sure you can deliver on them. That way, you never have to give your proposed new business partner an unpleasant surprise — because you’ve simply kept back from them the things you hope for but aren’t sure will happen. And as a result, they won’t need to share your disappointment, and deal with its psychological side-effects.
Better still, keep some good news in reserve. I’ve seen some CEOs skate quite close to deliberately prearranging positive surprises, where they’re able to use small pieces of good news as an excuse to move the conversation forward. It’s not great to have to email an investor to say “Hey, you said you were going to get us a term sheet by Monday; it’s now Thursday. We’re pretty desperate — when are you going to send it over?”. By contrast, it’s a better look to write: “Hi, just thought you might like to know we closed the month with $10,000 more revenue than forecast. BTW, we’ve had an offer in from another fund, but we’d love to work with you as investors. Would you like a bit more time to get that term sheet over to us?”
Mistake #7: Try to use logic to negotiate the valuation and terms
Last month, I was having dinner with the general partners of half a dozen VC firms, and we were talking about the revenue forecasts that we produce internally when negotiating deals, and the the competing forecasts that the companies send us. “It’s a kind of battle of the spreadsheets,” said one VC, “a cloud version of the medieval trial by combat.” “I’ve been amazed,” said another, “how much I’ve changed my mind about the potential market size after looking at the CEO’s bottom-up estimates.” A third replied: “Yeah, and we just closed a deal at a 30% higher figure than we first offered, all because the founders convinced us we were using the wrong discount rate in valuing the cashflows.”
Actually, I made that story up. It’s not true. I’ve never heard a serious VC investor admit to having changed the price they’re willing to pay based on new information from the company about market size, or on superior analysis of forecast financial performance that they were given by the company. To oversimplify just a bit:
You’ll never increase the valuation with a better spreadsheet
It’s usually possible to get VC investors to move on some of the deal terms if you ask them nicely, as long as your wish-list isn’t too long. But on the core issues of the pre-money valuation, the liquidation preference, the anti-dilution rights — on the big items that clearly affect the economics of the deal — there’s just one thing guaranteed to get VC investors to improve their terms: competition. If they’re convinced there’s another credible investor willing to pay more, and that you’re seriously considering doing the deal with the other guys, then that can prompt a second offer. It may covered up with the fig-leaf of the investor listening carefully to your valuation arguments, but that’s usually a matter of professional pride: nobody likes to admit that they’re being pushed around.
A credible competing investor: that’s what prompts a second offer
If you’re a risk-taker, then it might be tempting to follow the strategy described by Ben Horowitz in his Hard Things book, and simply bluff (ie pretend you have an offer that doesn’t actually exist). But you should bear in mind two things if you do. First, VCs talk to each other. It’s dangerous for founders to tell investor A that investor B is further ahead in the process, or more firmly committed, than they really are, especially if you made the mistake of telling them who you’re talking to. It only takes a text or a two-minute call between them for your credibility to plunge to earth in flames. And second, even if you’re sure there’s no way for the VC to test the credentials of their phantom competitor (the equivalent of a shill in an auction or a find-the-lady con game), you’re taking a risk with the investor’s psychology.
It only takes a text or a two-minute call to shoot your credibility out of the sky forever.
Here’s why. Some investors (and I’m one of them) recognise that it’s a form of cognitive distortion to allow the price someone else is willing to pay for an asset to influence the price they should pay. People who try to resist this distortion therefore won’t budge when you threaten them with the competing offer, whether or not it exists. You might think that if they’re so super-rational and quantitative, then you have nothing to lose by trying the bluff and then if it fails coming back to them and accept their price after all. But that’s not always how things works out. You’ve demonstrated a behaviour that they may find unappealing, and they may decide not to give you money on those grounds.
So the moral of the story is: try to get multiple separate, competing offers at the same time. That’s the best way to achieve a good valuation for your company.
Some final words about the fundraising process. This year I’ve seen two different companies run into trouble when fundraising, and all arising from an internal discussion with their existing investors on the board about what valuation to ask for. They told all the potential new investors who invited them in for meetings that this was the price they wanted, but then found the new investors separately (and rapidly) withdrew from negotiations, complaining that the price was too high.
Some founders get into the same position almost by mistake. Knowing there’s an advantage in negotiation to getting the other guy to name a price first, they try to parry valuation questions by saying something like “We don’t know yet; we’re going to see what signals we get from the market”. But then the VC brushes off that response and pushes for a number, and under pressure the founder names one.
But if you’re a CEO, you should realise that the VCs you’re meeting will have seen hundreds of companies this year, if not low thousands, and will have had the chance to compare the valuations all those companies were asking for (and the final price at which deals actually got done) against lots of detailed metrics, including their growth rate, their unit economics, and the size of their target market . To put it another way, the VCs are surprisingly often in a great position to know the fair value of your business.
They’re not going to tell you that value: that would require too much self-denying honesty. You, by contrast, may be basing your guesses about what your valuation should be on what you read about some other company in a related space in Techcrunch last week, or what you heard from your board chair or your biggest current investor — people who are likely to know less than the VCs do about next-round pricing, and may also have a cognitive bias towards a higher valuation because that will make their prior investment in your company look smart.
This is particularly problematic at the first professional funding round. Amateur angel investors are less well-informed than VCs; that’s partly why they mostly make worse returns. They’re also less price-sensitive. So it’s galling for them to learn, only after working with you for a year or two, that the price they paid for their shares way back when was too high, and that as a result their paper profits are going to be a lot lower than the percentage increase in your sales since they invested.
Which brings us to a fundamental truth about fundraising. Founders spend a lot of time agonising over the details of how they pitch to investors. What clothes should I wear? How many slides should I put in the deck? What fonts should I use? How confident should I seem during the meetings? How long should I wait before I follow up with investors? And so on. Yet in one sense, all these activities are like agonising over lipstick colours for your pig.
All these activities are like agonising over lipstick colours for your pig.
The fundamentals of your business — how good your product is, how much your customers like and use it, how much evidence they’ve given of willingness to pay for it, how profitable it is, how fast you’re growing — all these things are real, and all of them have a profound effect on your future. It’s these things that will ultimately determine whether VCs or others are willing to give you money. And if you focus on them, you’re unlikely to go far wrong.
I’m Tim, and these articles come from my work coaching Series A and B CEOs backed by VC firms in Europe, America and Asia. Since 2013, I’ve run a seed fund out of London that invests in SAAS, platforms, marketplaces and tools. I’ve backed 50 companies, sat on 19 boards, founded a startup, and taken it to an IPO on the NASDAQ. Before that, I worked for The Economist and the Financial Times and wrote business books.
About this publication
This is one in a series of blog posts covering nine of the most important skills I’ve seen in founders who successfully scale their companies. If you’d like to read more of them, please follow; if you’d like to review a copy of my forthcoming book, let me know in a comment or DM. And if you think you know a CEO who might find these ideas valuable, please give a few claps or share:)
Photo credit: Christopher Carson