Notes on raising seed financing

Last night I taught a class via Skillshare (disclosure: Founder Collective is an investor) about how to raise a seed round.  After a long day I wasn’t particularly looking forward to it, but it turned out to be a lot of fun and I stayed well past the scheduled end time.  I think it worked well because the audience was full of people actually starting companies, and they came well prepared (they were all avid readers of tech blogs and had seemed to have done a lot of research).

I sketched some notes for the class which I’m posting below. I’ve written ad nauseum on this blog (see contents page) about venture financing so hadn’t planned to blog more on the topic.  But since I wrote up these notes already, here they are.

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1. Best thing is to either never need to raise money or to raise money after you have a product, users, or customers.  Also helps a lot if you’ve started a successful business before or came from a senior position at a successful company.

2. Assuming that’s not the case, it is very difficult to raise money, even when people (e.g. press) are saying it’s easy and “everyone is getting funded.”

3. Fundraising is an extremely momentum-based process.  Hardest part is getting “anchor” investors.  These are people or institutions who commit significant capital (>$100K) and are respected in the tech community or in the specific industry you are going after (e.g. successful fashion people investing in a fashion-related startup).

4. Investors like to wait (“flip another card over”) while you want to hurry. Lots of investors like to wait until other investors they respect commit. Hence a sort of Catch-22. As Paul Graham says:

By far the biggest influence on investors’ opinions of a startup is the opinion of other investors. There are very, very few who simply decide for themselves. Any startup founder can tell you the most common question they hear from investors is not about the founders or the product, but “who else is investing?”

5. Network like crazy:

  • Make sure you have good Google results (this is your first impression in tech). Have a good bio page (on your blog, linkedin and about.me) and blog/tweet to get Google juice.
  • Get involved in your local tech community.  Join meetups. Help organize events.  Become a hub in the local tech social graph.
  • Meet every entrepreneur and investor you can.  Entrepreneurs tend to be more accessible & sympathetic and can often make warm intros to investors.
  • Avoid anyone who asks you to pay for intros (even indirectly like committing to a law firm in exchange for intros).
  • Don’t be afraid to (politely) overreach and get rejected.

6. Get smart on the industry:

  • Read TechCrunch, Business Insider, GigaOm, Techmeme, HackerNews, Fred Wilson’s blog, Mark Suster’s blog, etc (and go back and read the archives).  Follow investor/startup people on Twitter (Sulia has some good lists to get you started here and here).
  • Research every investor and entrepreneur extensively before you meet them. Entrepreneurs love it when you’ve used their product and give them constructive feedback.  It’s like bringing a new parent a kid’s toy. Investors like it when you are smart about their portfolio and interests.

6. How much to raise?  Enough to hit an accretive milestone plus some buffer. (more)

7. What terms should you look for?  Here are ideal terms.  You need to understand all these terms and also the difference between convertible notes and equity.  More generally, it’s a good idea to spend a few days getting smart about startup-related law – this is a good book to start with.

8. Types of capital:  strategic angels (industry experts), non-strategic angels (not industry experts, not tech investors), tech angels, seed funds, VCs.

  • VCs can be less valuation sensitive and have deep pockets but are sometimes buying options so come with some risks (more).
  • Industry experts can be really nice complements to tech investors (especially in b2b companies).  (more)
  • Non-strategic angels (rich people with no relevant expertise) might not help as much but might be more patient and ok with “lifestyle businesses.”
  • Tech angels and seed funds tend to be most valuation sensitive but can sometimes make up for it by helping in later financing rounds.

9. Pitching:

  • Have a short slide deck, not a business plan. (more)
  • Pitch yourself first, idea second. (more)
  • Pitch the upside, not the mean (more)
  • Size markets using narratives, not numbers (more)

10.  Cofounders: they are good if for no other reason than moral support. Find ones that complement you. Decide on responsibilities, equity split etc early and document it.  (Legal documents don’t hurt friendships – they preserve them).

11. Incubators like YC and Techstars can be great.  99% of the people I know who participated in them say it was worth it.

12. To investors, the sexiest word in the English language is “oversubscribed.”  Sometimes it makes tactical sense to start out raising a smaller round than you actually want end up with.

Best practices for raising a VC round

Having raised a number of VC rounds personally and observed many more as an investor or friend, I’ve come to think there are a set of dominant best practices that entrepreneurs should follow.

1. Valuation: Come up with what minimum valuation you’d be happy with but never share that number with any investor.  If the number is too low, you’ve set a low ceiling. If your number is too high, you scare people off. Just like on eBay, you only get to your desired price by starting lower and getting a competitive process going. When people ask about price, simply tell them your last round post-money valuation and talk about the progress you’ve made since then.

2. Never tell VCs the names of other VCs that are interested.  Reasons: 1) if you are overplaying your hand that could send a negative signal.  Most VCs know each other and talk all the time. 2) it is possible they’ll get together and offer a two-handed deal in which case you have less competition.

3. I think the optimal number of VCs to talk to seriously is about 5.  That is usually enough to get a sense of market but not so much that you get overwhelmed.  You should pick these VCs carefully – this is where trusted, experienced advisors are critical.

4. If there is a VC you really like, have a “buy it now price” and if they hit that valuation (and other terms are clean) do the deal.  Otherwise, say you’d like to “run a process” and include them in it.

5. Try to set timelines that are definite enough that investors feel some pressure to move but not so definite that you look dumb if you don’t have a term sheet by then.  (Investors have an incentive to wait – “to flip another card over” as they say – whereas entrepreneurs want to get the financing over with asap). Depending on where you are in the process, say things like “we’d like to wrap this up in the next few weeks.”

6. Once you start pitching, the clock starts ticking on your deal looking “tired.”  I’d say from your first VC meeting you have about a month before this risk kicks in.  You could have a great company but if investors get a sense that other investors have passed, they assume something is wrong with your company and/or they can wait around and invest later at their leisure.

7. The earlier stage your company is the more you should weight quality of investors vs valuation.  For a Series A, you are truly partnering with the VCs.  You should consider taking a lower valuation from a top tier firm over a non top tier firm (but probably any discount over 20% is too much). If you are doing a post-profitable “momentum round” I’d just optimize for valuation and deal terms.

8. Term sheets:  talk about terms in detail over the phone.  Only accept a term sheet once you have decided that if it matches what was described you are prepared to sign it.  After sending a term sheet VCs get worried you’ll shop it and usually want it signed in 24 hours.

9. Get to know the VCs.  Talk to their other portfolio companies, read their blogs, call references, etc.  You will be in business with this person for (hopefully) a long time.

10. Timing.  While it’s ideal to raise money once you hit the milestones you set out initially, you also need to be opportunistic.  Right now, for example, seems to be a really good time to raise a VC round.  You could make a ton of progress over the next 6 months but the market could tank and end up in a worse place than you would be today.

Being friendly has become a competitive advantage in VC

Over the last decade or two, the supply of venture capital dollars has increased dramatically at the same time as the cost of building tech startups has sharply decreased.  As a result, the balance of power between capital and startups has shifted dramatically.

Some VCs understand this. The ones that do try to stand out by, among other things, 1) going out and finding companies instead of expecting them to come to them, 2) working hard on behalf of existing investments to establish a good reputation, and 3) just being friendly, decent people.  Believe it or not, until recently, #3 was pretty rare.

As a seed investor in about 30 companies, I’ve been part of many discussions with entrepreneurs about which VC’s they want to pitch for their next financing round.  More and more, I’ve heard entrepreneurs say something like “I don’t want to talk to that firm because they are such jerks.” In almost all cases these are well-known, older firms who come from the era when capital was scarce.

Every experienced entrepreneur I know has a list of “toxic” VCs they won’t deal with. (Often because of horror stories like the “partner ambush“). There are so many VCs out there that you can do this and still have plenty of VCs to pitch to get a fair price for your company and only deal with decent, helpful investors. It sounds kind of crazy, but being a reasonably nice person has become a competitive advantage in venture capital.

Does a VC’s brand matter?

Suppose you are in the enviable position of choosing between offers from multiple VC firms.  How much should you weigh the brand of the VCs when making your decision?  I think the answer is:  a little, but a lot less than most people assume.

First, let me say the quality of the individual partner making the offer matters a lot.  However, in my experience, there is a only rough correlation between a VC’s brand and the quality of the individual partners there.  There are toxic partners at brand name firms, and great partners at lesser known firms.

There are only two situations I can think of where the firm’s brand really matters.   First, if you manage to raise money from a particular set of the top 5 or so firms, you are almost guaranteed to be able to raise money later at a higher valuation from other firms. In fact, there are VC firms whose explicit business model is simply to follow those top firms.

The other way a VC firm’s brand can help is by giving you credibility when recruiting employees.  This matters especially if you are a first-time entrepreneur whose company is at an early stage.  It matters a lot less if you’re a proven entrepreneur or your company already has traction.

In my opinion that’s about it in terms of the importance of the VC’s brand.  Too many entrepreneurs get seduced into thinking they’ve accomplished something significant by raising money from a name brand VC.  Also, remember that if you are raising a seed round, the better the firm is, the worse it can actually be for you if that firm decides not to participate in follow on rounds.

Pitch yourself, not your idea

There is a widespread myth that the most important part of building a great company is coming up with a great idea.  This myth is reflected in popular movies and books: someone invents the Post-it note or cocktail umbrellas and becomes an overnight millionaire.  It is also perpetuated by experienced business people who, for the most part, don’t believe it. Venture capitalists often talk about “the best way to pitch your idea” and “honing your elevator pitch.”  Most business schools have business plan contests which are essentially beauty pageants for startup ideas.  All of this reinforces the myth that the idea is primary.

The reality is ideas don’t matter that much.  First of all, in almost all startups, the idea changes – often dramatically – over time. Secondly, ideas are relatively abundant. For every decent idea there are very likely other people who’ve also thought of it, and, surprisingly often, are also actively pitching investors. At an early stage, ideas matter less for their own sake and more insofar as they reflect the creativity and thoughtfulness of the team.

What you should really be focused on when pitching your early stage startup is pitching yourself and your team.  When you do this, remember that a startup is primarily about building something.  Hence the most important aspect of your backgrounds is not the names of the schools you attended or companies you worked at – it’s what you’ve built.  This could mean coding a video game, creating a non-profit organization, designing a website, writing a book, bootstrapping a company – whatever.  The story you should tell is the story of someone who has been building stuff her whole life and now just needs some capital to take it to the next level.

Of course a great way to show you can build stuff is to build a prototype of the product you are raising money for.  This is why so many VCs tell entrepreneurs to “come back when you have a demo.”  They aren’t wondering whether your product can be built – they are wondering whether you can build it.