Do’s and Don’ts of Venture Seed Fundraising
Here’s some of the “Sausage Making” of early stage venture funding. When we’re raising capital, we tend to over-index on getting the meetings and honing the pitch. Both are critical to the process. But, there are a number of other factors you need to take into consideration during the process, especially in a Venture or priced round of funding.
Fundraising is a Process – Not an Event
No one is going to write you a check the day they see your deck (well, there are maybe some angels, but not a VC). Venture Capital firms represent “other people’s money,” or a Limited Partners (LPs). It’s likely a 60-120 process. Given that, they invest along an investment thesis or charter that they have provided the LP as part of their fundraising process. This charter can limit the types of vertical markets or geographies where they can invest the fund’s capital. There is a method for decision making in the firm that may or may not be known to you. It may require 100% consensus, majority or a single Managing Partner. There is a due diligence process they will go through, usually using a data room like Dropbox or a more secure version with better features like OneHub. In this data room you’ll set up folders and files for the following:
- Organizational Matters
- Articles of Incorporation
- Founder Matters
- Stock Purchase Agreements
- Vesting Schedules
- IP Assignment Agreement
- Financial Statements
- Balance Sheet
- Income Statement
- Security Issuances
- Prior Fundings docs
- Employee /Service Provider Agreements
- List of all persons providing services
- Current and past employees
- Patents, Trademarks, Copyrights
- Domain Names
- Material Agreements
- Standard Form Agreements
- Real Estate
- Any correspondence or documents threatening action
- Regulatory Matters
- Inquires or applications
- CPA Firm
- Tax Returns
Go here for a detailed downloadable version of Financing Due Diligence Checklist. This document was provided by Joe Wallin (LI) at Carney Law in Seattle.
What Types of Deals Qualify for VC?
Not all deals qualify for Venture Capital. Just saying. Keep in mind, raising Venture Capital isn’t a definition of success. There are a lot of great businesses that don’t fit the target. For example:
- Lifestyle businesses: if you have a business that can create jobs, a lifestyle and an income that works for you, you don’t need venture. Keep in mind, when you take on venture, you take on the Venture business model and exit expectations!
- Services companies: your business scales with people, not a product. That’s totally OK, it’s still a great business, but it doesn’t fit the definition of “venture scale”
- You can’t be a 10X+ return. Venture returns are based on the Venture Power Law, more here on that topic by Fred Wilson’s blog. The idea that portfolio of investment is broken into four quartiles of investment.
- First Quartile – returns the fund, the strongest companies don’t need much help and will likely not take more cash. From the fund’s perspective, they can’t get enough capital into the company.
- Second Quartile – provides a solid return and in small funds create a great Internal Rate of Return (IRR) for the fund, especially when the fund has 25 investments vs 100 investments
- Third Quartile – these companies take the most time to support and are most needy of capital from existing investors. Sometimes, they become the zombie startups or the companies that never quite hit their stride
- Fourth Quartile – are the companies that fail
In that process, we see some great “second quartile” companies. They are good, but it’s hard to see how they return 10X plus to the fund. You’re not bad in that category, but you’re not exciting to the fund either.
The other category of investments, especially for funds that are at the end of their fund life, are companies that can be a fast return. When a fund is at end of life, they have limited capital to invest and are looking to fill out their “dance card”. The other option is when you think a company has a clear exit path and will likely be sold before they need additional capital. These investments lean to markets that have known buyers with a track record of transactions.
On average, each investment round will create dilution (increasing the total number of shares in the company) by 20-33%.
Why You Need a Lead Investor
There are rare exceptions – sometimes called a party round – but you’re going to need a person or firm to lead the round of funding. If your round isn’t priced, e.g. you’re using convertible debt, then you won’t need a lead, but it will help. Expect the lead investor to take 30-60% of the round. A small check on a big round isn’t viewed as a vote of confidence. The firm will also be writing the term sheet (amount, price, voting rights, etc.) as well as taking a Board seat.
It’s important to understand the legal terms. Ask the “why questions”, why does the VC want the terms they are asking for? Engage them in the discussion. It’s cheaper than negotiating through the attorneys.
A lead investor will also help you syndicate the round of funding. They have other investors they’ve worked with in the past or think may fit the profile of your investment. They have an incentive to get the deal done, push the deal to other firms and help you integrate the back-channel feedback from your meeting.
But be clear here, you are quarterbacking the fundraising round. There are a lot of strong personalities in VC, but it’s your company. We (the collective VC we), think we add more value than we do. The lead is helping to syndicate, but you need to pick the final investors and make sure you get what you want. It’s likely to be a negotiation, but you need to keep your opinion front and center.
What’s Happening in the Background
Meanwhile, in the background, the VCs are likely talking to each other:
- Have you seen this deal?
- Did you like it or are you going to pass?
- What would you want to see to get you interested in this round?
- What do you think about the CEO and the team?
- What do they think about their traction and numbers?
- What are the percentage of the deal and total investment amounts?
- What do other firms think of the valuation?
As part of the process, VCs are going to ask to call your customers. Be aware that multiple firms will ask to make those calls and it will be time-consuming to your customers. Given that, you’ll want to make sure that you gain customer approval in advance. VCs can share due diligence, and many will want to do their own. That doesn’t mean you shouldn’t ask them to do so if you think it puts a customer at risk.
Also, you need to qualify the VC’s interaction and strip out the tire kickers from the investors that will lead. I would suggest a qualifying question, in an email, like this
Thanks (VC Name),
I’m happy to provide customer references. Because the process creates overhead for my customers (revenue and relationships) I want to make sure I use those requests only as required.
If you receive the positive outcome from the customer call I expect, is that all that is required for you to lead or invest in this round of funding? If there are other items you require first, let’s make sure we knock those off before we do the customer call.
Wow, Dave isn’t that presumptive of you? Not at all. You’re looking for your lead investor and if this fund isn’t willing to commit to either leading or a large percentage of the total round of funding than you don’t want them making unnecessary customer calls. You are qualifying your investor just like they are qualifying you.
Time Kills All Deals
This is an old maxim in M&A and Venture investing. The lead should be pulling your deal forward. If you have additional interested investors but you’re pushing them (email reminders, calls to set meetings) so they might follow, then they aren’t going to lead.
Do’s and Don’ts
- Keep your eye on the ball – you don’t want to lose revenue or miss you plan while you’re fundraising
- Run the process like an Enterprise sales process
- Qualify investor leads with qualified questions
- Track progress
- Gain commitment (BATN)
- Budget – are they currently investing in this size/stage of a round
- Authority – who are involved in the decision
- Timing – where are they in fund life/timing
- Need – is this the type investment they like/would lead
- Quarterback the process – even if you’re new to fundraising show your leadership
- Ask for permission to document the meeting notes in a Google Doc, share with the participants
- Tag owners of tasks, ask for timelines
- Set regular standups or next meeting dates
- This includes managing legal expenses (on both sides)
- Ask for a budget from your firm (or multiple firms), manage them to that budget – if you’re surprised by the price, it’s your fault
- Ask for permission to document the meeting notes in a Google Doc, share with the participants
- Create a reason to close: push toward a date that you expect to close
- Clearly explain the Before and After difference that your customers feel before your solution and after your solution. Investors aren’t really quick, you need to make it simple for them.
- Ask for feedback, if you feel like someone is patty you on the head, ask why they aren’t investing. You may not like the feedback and you can’t take it personally, but you need it
- Don’t hide the ball on bad news. If you lose a key employee or customer or even legal threat, let the investors know
- Don’t be overly optimistic – we know that you won’t be a founder if you weren’t and for some people, there’s a fine line between optimistic and delusional. Self-awareness is a great trait for fundraising. It’s better to be right on your forecast vs. sandbagging or inflating the numbers. Becuase the timing is going to last 60-120 days, missing the forecast is a bad thing
- Don’t create a reason to wait (aka pre-release news)
- I received an email from a startup recently where they were doing a “major partner announcement,” that’s great news! I’ll wait to invest
- I’ve been told that we are launching a major release, awesome! I’ll wait to invest
- I’ve been told that their pipelines and major customers are signing, more revenue! I’ll wait to invest
- Don’t be “too transparent.” Have you ever been around an uber-needy person or relationship? Yeah, don’t do that
I hope this provides some insight to the “Sausage Making Process.”
Thank you for your insights into the “Sausage Making Process”. It really looks like B2B enterprise sales, how you screen your customers (VCs) and lead to a close (investment). I like your e-mail sample as well. I will definitely add my sample e-mail folder and use it when the right time comes.