Fundraising in 2023: When Everyone Wants To Be The First Follower
It was mid-2021 and we were raising a $15M A round for a deep-tech company. On paper, the round was oversubscribed twice over. We had VCs, angels and corporations all wanting to participate. But there was one thing we didn’t have. That was a lead investor with a valid term sheet. One of the investors commiserated. He said “yes, these days everyone wants to be the first follower…”.
We closed that round eventually — in fact we doubled the size of the fundraise from the initial goal. But to do that we had to outsmart the market and play some tricks. I wrote a post about it titled “Fundraising in 2021: When Everyone Wants To Be The First Follower” but never published it…
You see, 2022 happened. It was irrelevant. The cheap money bubble of the COVID-19 era was gone, and the days of the elusive valuations were over. Or were they?
It is Q4 2022. And some aspects of fundraising are so much like 2021.
When Valuations Are In The Eye of The Beholder, But The Beholder Is Not Beholding.
A year ago, we were sitting at the INTRO CEO Club meetings and hearing about A rounds at 100x ARR valuations, first-time CEOs raising 8-digit seed rounds from non-tech investors for companies whose product they couldn’t fully articulate etc. etc.
Many of the people funding these companies knew full well that the market was over-valued, but you “don’t argue with Mr. Market”. One of the partners at a tier-one VC said a few months ago “the question was simply whether there was a bigger fool”, i.e. if we price the company at X, will someone come after us and (based on our cred) invest at 3X next year. If they did, we look like geniuses and will be able to… raise a bigger fund.
So the concern for investors was “is someone else willing to pay this (probably inflated) price”. They were looking for someone else to take the responsibility of setting the terms. In other words — “if you find a lead, we will follow. We like the company, but find someone with the guts to set the price.”
Normally, you’d expect the lead to take at least a third to half the round. We saw funding rounds where the lead only put in 10–15% of the money — but lots of others were very willing to follow. Your challenge as a CEO fundraising was to get that lead (more on that below).
To my astonishment — Q4 2022 is a very similar.
Just like there was lots of money for startups in 2020–2021, there was also a whole lot of money for VC funds themselves. Huge funds were raised in 2021 and that money is waiting to be invested. A friend said to me the other week “the VCs who were lucky enough to close funds in 2021 are going to a huge party now — funds deployed in 2022–2024 will have great returns in 6–7 years. The reset in valuations will allow “buying low”, layoffs will mean talent will be available at lower prices, and a financial climate where other assets under-perform makes long term investment at VC returns relatively attractive, so LPs are committed to that money. All that’s left is to judiciously deploy that capital. But this time, we need to actually be judicious. Because a recession is coming, so we need to invest in companies that can withstand a recession.”
For an early-stage company that means… being able to raise again in 1–2 years, at a higher valuation. But in a market that is still in flux, where everyone knows a whole lot of down rounds and revaluations are coming in 2023, what is the right valuation? One you’re willing to take now and will allow you to raise an up-round eventually? Who is willing to take the responsibility and set a price?
…and just like that, we’re right back to 2021, where (some) investors have the money — but want someone else to take the responsibility.
So — How do YOU raise a round in this environment?
Focus on getting a lead.
There are many funds that “will be happy to invest in you” but just don’t lead. It may literally be against their charter, or it’s not their strategy, or they don’t lead rounds of the size you’re raising but may follow a credible lead. They may soft-commit to your round — “when you find a lead and get a term sheet.”
Beyond some feedback for the pitch and, in some cases, warm intros (only effective if indeed it’s clear that they can’t lead) dealing with them is a waste of time. You will not see one dollar from them until you find a lead investor. And when you do, followers will come out of the woodwork anyway.
Your job is to figure out which of the investors you might be pitching is actually, currently leading rounds. Look at Crunchbase / Pitchbook and figure out who has been leading similar sized rounds recently. Make sure those are not just follow-ons in their existing portfolio co’s. Look for firms that have raised a fresh fund in 2021/2022. When you take meetings, your first or second question should be “do you lead rounds”. If they don’t, make sure not to spend much time on them — until they credibly suggest introducing a potential lead. Time spent pitching or doing deep due diligence with followers is time you’re not pitching a potential lead, and when a firm will get the confidence to put a term sheet on the table, rest assured other investors will just rely on the lead’s due diligence anyway.
Worse — many funds today are in zombie state. They take meetings, they “dig deep”, they do all the things they didn’t do in 2021 — and they still don’t invest, because they are waiting for the market to hit bottom, or licking their wounds from 2021, or keeping reserves for their portfolio. They call this “we are more selective”. What they actually are doing though, is wasting your time to justify their management fees.
In that A round last year, we had over $30M soft-committed before we had a term sheet. But it took us 6 months to get the first term sheet — which was never real in some ways. More on that below.
The sign of a lead is a Term Sheet
“We have a term sheet” is the statement that will separate the wheat from the chaff. Once you have a term sheet, the message to other investors is “the company is credible, and there is a deal to be had”. If they are followers, this is truly the time when they get to make the decision. If they are leaders, it’s a sign that someone else thinks the company is fundable — and validates their interest. They literally go to their partnership meetings / investment committees with the message “someone else thinks it’s investible, so should we”. This is also why a term sheet often begets a term sheet, and while it may have taken you many months to get to a term sheet, all of a sudden there may be multiple term sheets on the table, and you will be able to pick the best investor (note: generally more important than the best terms). Within weeks of getting that term sheet we had 2 more, from investors we preferred, which allowed us to close a great deal. How we got that term sheet though, is quite the story.
How To Make A Lead When There Isn’t One
Some people have the guts, but don’t have the cash. They can write a check for $1–2M, but you can’t lead a $20M round with that check. They really want to say they led a round, but can’t. Guess what? If you have two of these, and call them co-leads, all of a sudden you got an anchor. You have a term sheet.
Remember — A term sheet often begets a term sheet.
In crazy 2021, we had a VC that was able to write a $2M check, and a strategic investor that was able to write a $2M check and willing to “consider being a co-lead”. The VC was super gung-ho on leading. So we suggested they co-lead with the strategic. But we would only introduce them to the co-lead after we see a term sheet we like. They ran ahead and put a term sheet on the table.
The first thing we did was inform everyone we were talking to that we had a term sheet.
The second thing was to actually facilitate a dialog between the potential co-leads.
Eventually, the strategic investor came back with “we’re not going to co-lead with that fund, they are not credible enough in our mind and will not be able to help in the future”. But by the time they made that decision — two other VCs already stepped into the fray, and with the validation of a 3rd party term sheet that they’ve never seen — put their own term sheets on the table, and the rest is history.
Co-leading is a way to make a lead that’s hesitant sure, and a follower that’s sure — a lead.
Another solution, that typically comes from the investor side, is an SPV. Sometimes a VC with limited funds will pool money with another partner — an LP, a strategic investor or a family office, and this way be able to write a bigger check. The larger check may be big enogh to lead a round, allowing them to put a term sheet on the table. The VC typically benefits from carry over the entire sum, and you get a lead.
If you have a committed, ambitious investor that cannot write a big enough check, and followers you can cajole into this structure — it’s worthwhile raising this suggestion.
The Shrinking Lead And The Willing Followers
Just last week I was in a meeting with a largish VC, discussing a potential $50–100M round. That VC can write a $10M check, maybe $15M. Here’s what they proposed:
“We will write a term sheet and put in $10M. You will take this to the strategics that you’re already in business with and we know want to get in, and leverage this to a $30–40M round. The momentum will get other players on board — you will talk to strategics, we can bring in institutional investors. We can get to $100M this way.”
So basically — they will attempt to lead a round with 10% of the funds. In their eyes — it’s valuable because they believe in the company, are existing shareholders, and being able to say they led a $100M round reflects positively on their brand (and ego!). From the perspective of the market — apparently it’s totally doable. Because so much money is out there looking for some leadership.
Punting The Ball
Closing a straight up priced round is usually the preferred outcome. But in the current climate, some clearly fundable companies are struggling to raise because investors are having a hard time setting a valuation. Nobody wants to be the sucker who overpays.
In such a case, convertible loans or preferably SAFEs are a valid alternative. But how do you show that you are fundable?
In one of the companies in my portfolio, we closed a SAFE from a new investor earlier this year — but to do this we had to actually get a term sheet. We got a term sheet we didn’t like, from an investor we didn’t want — but that enabled the person doing the transaction to go to his committee and say “the company has alternatives — other financial investors are trying to get in”. It got the company the cash to go through another year of growth, and look for the right investors at the right terms.
A Quick Discussion of Ethics
In all of the cases above, we never told a lie or expressed a falsehood. We were stating facts as they were, and making sure we had the paper-trail to show it, if one day it will be needed. That is my advice. Nothing is worth jeopardizing your reputation or morals. In game theory terms, your career and life itself is a long game. I would not advise you to win one round and lose the rest.
Rest assured though, there are people who do just that.
When Leads Are Leaders
Finally, if you are building a great company, with some grit and some luck, often things do work out. A very old friend’s SaaS company was really struggling with an A round for awhile, getting close to running out of cash. Eventually, a very suitable VC put a good term sheet on the table — and also said it wants to take the entire round. Why not? It’s a great company, the valuation is cheap, and the fund gets to own a meaningful chunk that it could protect in subsequent rounds. For management, this is a strong signal that what they have works, regardless of the state of the financial market.
2023 is shaping up to be a tough year for fundraising. Many VCs will be tangled in follow-up rounds for companies they invested in at bloated valuations in 2020–2021. These down rounds will take more work and more pain then up rounds, and will introduce negative sentiment that will affect companies across the board. In such an environment, the tactics of fundraising will be as important as the fundamentals. Be prepared.
