Once you take money, the clock starts ticking

One of the interesting things about having been investing in startups for a number of years is that at any moment you get an inside peek at startups at a variety of different stages. In the course of a few weeks, I might talk to people who are ideating around new business ideas, people raising seed rounds, people raising later (VC) rounds, people whose products are blowing up, people whose product are struggling, people getting acquired, people leaving acquirers to start new companies, etc. Sadly, there are also usually a few companies that are struggling and facing the serious possibility of running out of money and being forced to shut down.

One side-by-side comparison struck me recently.  Company A is just now raising a seed round. The money they raised will last 12 months (personally, I strongly recommend raising 18 months of runway – if you have the option to do so). Company A was also, in my opinion, not ready to raise money (they needed to work on their plan and team more). Company B raised a seed round about 10 months ago and is now struggling to raise more. Company B had the option to raise more money back then but chose to only raise 12 months runway in order to minimize dilution. Company B also made the mistake of having a large VC invest $100K in the round (a meaningless amount to a large VC). The large VC has since said they won’t support the company (despite the fact that the company made pretty good progress on the business) creating a massive signaling problem.

In the current “frothy” environment, where seed investors are aggressively offering money to entrepreneurs, it is easy for an entrepreneur to think “well, if I’m getting offered money this easily at the seed stage, I’ll get offered money easily later.” In fact, once you take professional investor money, the attitude of investors (both insiders and outsiders) changes dramatically: you’ve gone from planning mode to operations mode. When you do planning, research, experimenting etc. without having raised money, investors think you are prudent (I recently interviewed the Warby Parker founders for TechCrunch and they said they spent 1.5 years planning/researching before they raised money). When you do it with other people’s money, and don’t make what they perceive to be enough progress, the investors can quickly lose faith.

The obvious lesson is well known by experienced entrepreneurs. Don’t raise money until you are ready, and when you do, raise enough to have a good shot at reaching “accretive milestones” so you can raise more money, become profitable, or whatever your goals might be.

 

Later-stage rounds and “setting the bar too high”

I recently had a number of conversations with CEOs of later-stage startups (generating significant revenue) that went something like this. They want to raise more money, and VCs are offering them money at a high valuation. The CEO is worried that taking money at that valuation will “set the bar too high” and make it difficult to sell the company – if the time comes when he/she thinks it makes sense to sell – at a price that isn’t a significant multiple of that valuation.

These CEOs are worrying too much. VCs know what they are doing and almost always invest with a financial instrument – preferred shares – that protects them even when the valuation is very high. Preferred shares behave like a stock on the upside and a bond on the downside.  The only way investors actually lose money is if the company is sold for less than the amount of money raised (which is generally significantly lower than the valuation).

Here is what the payout function looks like for common stock (for example, what you get when you buy stocks in public markets):

And here is what the payout function looks like for preferred shares:

 

So, to take a concrete example, Dropbox reportedly raised their last financing at a $4B valuation*. If you think of this as a public market valuation of common stock, you might think this means the VCs are betting $4B is the “fair value” of the company, and will lose money if Dropbox’s exit price ends up being less than $4B.  But in reality, assuming the standard preferred structure, the last round investors’ payout is as follows :

Scenario 1: Dropbox exits for greater than $4B ==> investors get a positive return (specifically, exit price divided by $4B)

Scenario 2: Dropbox exits for between $257M (total money raised) and $4B ==> investors get their money back (possibly more if there is a preferred dividend)

Scenario 3: Dropbox exits for less than $257M ==> investors lose money

If reports are true that Dropbox is profitable and generating >$100M in revenue, then scenario 3 – the money losing scenario – is extremely unlikely.

Will investors be thrilled with scenario 2?  No, but they are pros who understand the risks they are taking.

Going back to the entrepreneur’s perspective, in what sense is a high valuation “setting the bar high”?  In the preferred share payout model, there are two “bars”:  money raised and valuation.  I don’t see any reason why entrepreneurs shouldn’t be as aggressive as possible on valuation, especially if they are confident they won’t end up in scenario 3.

An important point to keep in mind is that, in order to maintain flexibility, entrepreneurs shouldn’t give new investors the ability to block an exit or new financings. Investors can get this block in one of two ways – explicit blocking rights (under the “control provisions” section of a VC term sheet) or by controlling the board of directors. These are negotiable terms and startups with momentum should be very careful about giving them away.

 

* Note that I have no connection to Dropbox so am just assuming standard deal structure and basing numbers on public reports. I am making various simplifying assumptions such as not distinguishing between pre-money and post-money valuation.

 

Always have 18 months of cash in the bank

I was once told by an experienced entrepreneur (I can’t remember who) to always have at least 18 months of cash in the bank. The logic behind this is: 1) as a rule of thumb it takes 3 months to raise money, 2) building/marketing/selling technology always takes longer than you think.  Subtracting 3 months for fundraising and 3 months for things taking longer than expected, this gives you 12 months to execute your plan. (Also you never want to raise money “with your back against the wall” – when you are near the end of your runway.)

More adventurous entrepreneurs might argue 18 months is too conservative. It’s true that following the 18 month rule can be extra dilutive. At SiteAdvisor, we raised our Series A about three months before we were acquired. So we gave up equity for cash that we never spent. But in retrospect, given what we knew at the time, I think it was the right decision.

The question of when to raise money is one of the few times that entrepreneurs and early-stage investors have somewhat divergent economic interests. If you control a large investment fund, you always have the option to extend a company’s runway. The entrepreneur doesn’t have this option. I’ve even heard some entrepreneurs whisper about Machiavellian VCs who deliberately try to get you to the end of your runway so they can negotiate harder. I think this is a bit of a conspiracy theory. Almost all VCs I know care primarily about the success of their companies and not about extracting every last point of equity.

The downside of accelerated investment decisions

There has been a lot of talk about how early-stage valuations have risen dramatically over the past few years. Financially, this is probably good for founders and bad for investors. But a side effect of this frothy market is that financings are occurring much faster. It is very common for investors to get introduced to founders with the proviso that a term sheet will be signed in the next few days. As a result, founders and investors are spending very little time getting to know each other before entering into long-term business contracts.

This is bad news for everyone. Most significantly, founders often give up significant control to people they won’t get along with or even might end up hating. Having bad investors might not matter if the company executes flawlessly and the financing market stays frothy. But most companies have difficult episodes, and the financing market will eventually return to normal. Sadly, founders with bad investors will likely face punishing down rounds, key employees being indiscriminately fired, and elaborate financial shenanigans engineered to dilute founders and seed investors.

“It’s only when the tide goes out that you know who’s been swimming naked.” Warren Buffet likes to say this about investors, but it applies to founders as well. Taking on a new major investor should be treated with the same gravitas as taking on a new cofounder. You can’t do it in less time than it takes to really get to know someone, which is usually weeks or months. Quick financings might seem attractive but are actually fraught with risks.

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.