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.

The importance of investor signaling in venture pricing

Suppose there is a pre-profitable company that is raising venture financing. Simple, classical economic models would predict that although there might be multiple VCs interested in investing, at the end of the financing process the valuation will rise to the clearing price where the demand for the company’s stock equals the supply (amount being issued).

Actual venture financings work nothing like this simple model would predict.  In practice, the equilibrium states for venture financings are: 1) significantly oversubscribed at too low a valuation, or 2) significantly undersubscribed at too high a valuation.

Why do venture markets function this way?  Pricing in any market is a function of the information available to investors. In the public stock markets, for example, the primary information inputs are “hard metrics” like company financials, industry dynamics, and general economic conditions. What makes venture pricing special is that there are so few hard metrics to rely on, hence one of the primary valuation inputs is what other investors think about the company.

This investor signaling has a huge effect on venture financing dynamics. If Sequoia wants to invest, so will every other investor.  If Sequoia gave you seed money before but now doesn’t want to follow on, you’re probably dead.

Part of this is the so-called herd mentality for which VC’s often get ridiculed. But a lot of it is very rational. When you invest in early-stage companies you are forced to rely on very little information. Maybe you’ve used the product and spent a dozen hours with management, but that’s often about it. The signals from other investors who have access to information you don’t is an extremely valuable input.

Smart entrepreneurs manage the investor signaling effect by following rules like:

Don’t take seed money from big VCs – It doesn’t matter if the big VC invests under a different name or merely provides space and mentoring.  If a big VC has any involvement with your company at the seed stage, their posture toward the next round has such strong signaling power that they can kill you and/or control the pricing of the round.

– Don’t try to be clever and get an auction going (and don’t shop your term sheet). If you do, once the price gets to the point where only one investor remains, that investor will look left and right and see no one there and might get cold feet and leave you with no deal at all. Save the auction for when you get acquired or IPO.

– Don’t be perceived as being “on the market” too long.  Once you’ve pitched your first investor, the clock starts ticking. Word gets around quickly that you are out raising money. After a month or two, if you don’t have strong interest, you risk being perceived as damaged goods.

– If you get a great investor to lead a follow-on round, expect your existing investors to want to invest pro-rata or more, even if they previously indicated otherwise.  This often creates complicated situations because the new investor usually has minimum ownership thresholds (15-20%) and combining this with pro-rata for existing investors usually means raising far more money than the company needs.

Lastly, be very careful not to try to stimulate investor interest by overstating the interest of other investors. It’s a very small community and seed investors talk to each other all the time. If you are perceived to be overstating interest, you can lose credibility very quickly.

Backing out of a term sheet

Venture capital term sheets are not legally binding (except certain subclauses like confidentiality and no-shop provisions). That said, there is a well-established norm that VC’s don’t back out of signed term sheets unless they discover something really, really bad – fraud, criminal backgrounds of founders etc. The best VC in the world, Sequoia Capital, whose companies account for an astounding 10% of NASDAQ’s market cap, has (according to trustworthy sources) only backed out on one term sheet in the last 10 years.

Yesterday, one of the 40 or so startups I’ve invested in (either personally or through Founder Collective) had a well-known VC back out of a term sheet for no particular reason besides that they decided they no longer liked the business concept. It’s the first time I’ve seen this happen in my career.

In later stage private equity (leveraged buyouts and such) it is a common trick to “backload diligence” – you give the company a quick, high-valuation term sheet, which then locks the company in (the no-shop clause prohibits them from talking to other investors for 30 days or more). Then the firm does their diligence, finds things to complain about and negotiates the price down or walks away. If they walk away, the company is often considered “damaged goods” by other investors who wonder what the investor discovered in diligence. This gives the investor a ton of negotiating leverage. In later stage private equity, this nasty tactic can work repeatedly since the companies they are buying (e.g. a midwestern auto parts manufacturer) are generally not part of a tight knit community where investment firms depend heavily on their reputation.

I learned the basics of VC when I apprenticed under Jeremy Levine and Rob Stavis at Bessemer.  It was at Bessemer that I learned you never back out on a term sheet except in cases of fraud etc. I never saw them back out on one nor have I heard of them doing so. In fact, I remember one case where Rob signed a term sheet and while the final deal documents were being prepared (which usually takes about a month), the company underperformed expectations. The CEO asked Rob if he was going to try to renegotiate the valuation down. Rob said, “Well, if you performed better than expected I don’t think you would try to renegotiate the valuation up, so why should I renegotiate when you performed worse than expected.” That’s how high quality investors behave.

Besides simply acting ethically, firms like Sequoia and Bessemer are acting in their own interest: the early-stage tech community is very small and your reputation is everything. Word travels fast when firms trick entrepreneurs. What happened yesterday was not only evil but will also come back to haunt the firm that did it.

Don’t shop your term sheet

There are all sorts of protocols in the VC world. Most of them make sense upon further examination, but if you’re a first time entrepreneur, they aren’t obvious, and it’s very easy to mess them up. Here’s one of them.

From VC’s perspective, one of the most annoying things an entrepreneur can do is “shop” a term sheet.  That means after they’ve offered you a term sheet in writing you take it to other investors to try to get a better deal. Most VCs I know won’t even send anything in writing until you have verbally agreed on all essential terms precisely to avoid this possibility.

Why are investors so sensitive to this?  First of all, no investor wants to think they are “just money” – the idea that you want to get an explicit auction going suggests that.

More importantly, what often happens is that once a VC has offered you a term sheet – especially if that VC is well respected – other VCs suddenly become interested.  It is pretty much guaranteed that if Sequoia offered you $4M pre, there are many other investors who, simply because of Sequoia’s offer, would offer you a higher price.  So if Sequoia allowed their term sheets to be shopped they’d never get deals done.

Some entrepreneurs think they are being savvy by shopping a term sheet but I would strongly caution against it.  The VC/startup community is extremely small and this will usually come back to bite you.

Note that I am not saying an entrepreneur shouldn’t get a competitive process going and try to get the best deal with the highest quality investors.  You just need to do it in the right way.  Discuss things verbally and only accept a term sheet when you have agreed on all significant terms.  At that point, assuming the term sheet agrees with what you said, you should sign it and return it within a day or two.  (Don’t say you need to wait for you lawyer to review it – if you want to be an startup CEO you need to learn how to review and evaluate term sheets.  Have your lawyer teach you about term sheets before you receive them.).

Also, don’t shop a verbal offer.  You can’t go to, say, Greylock and tell them Accel offered you 4 pre.  First of all they might collude.  Secondly it’s very likely to get back to Accel (they all know each other) and you might lose both deals.  What you can say is “I’m planning to wrap things up by X day and I have a lot of interest” and see what Greylock does.

TheFunded term sheet

TechCrunch has a post today about TheFunded’s ideal first round term sheet.   I think what Adeo Ressi is trying to do with TheFunded is great, and he has clearly been a leader in exposing VC shenanigans and simplifying term sheets.

I looked through his ideal term sheet and from my summary reading the only thing I disagree with is full acceleration on single trigger (company is acquired).  The term I favor regarding single trigger is to have acceleration such that the founders only have a maximum N (say 12) months remaining. This seems to me a reasonable compromise so that 1) the founders only have to stick around at the acquirer for a maximum of N months (since they will probably be miserable at BigCo if they have to stay longer) 2) the acquiror gets some comfort that the founder will stick around long enough to integrate the startup into BigCo, thus getting the full value out of the acquisition.

I know some lawyers are telling entrepreneurs they shouldn’t have any acceleration on single trigger because it will make the company less attractive to acquirers.  Having been through a couple of acquisition negotiations on the business side (I know many lawyers will say they’ve been through many acquisitions but lawyers only see 10% of what really goes on in the process), what I learned is that acceleration on single trigger doesn’t hurt you from an acquirer’s perspective as long as founders are incented to stick around for some reasonable period of time (approximately 1 year, not 2-4 years).

Actually, the negotiation over acceleration on acquisition ends up pitting the founders against the investors, not the acquirer.  The way the (rational) acquirer figures it, they are going to agree to pay, say, $100M for a company with founders who have built incentives to stick around (some vesting left).  If the founders get full acceleration, then the acquirer figures they are going to have to set aside, say, $10M for future incentives, so will only pay $90M to buy the company, thereby leaving less for the investors. I didn’t understand this dynamic until I went through the process myself.

Of course a lot of this depends on the type of acquisition.  If it is a small trade sale the acquirer will probably want the founding tech team to stick around for as long as possible.  If it’s a profitable business then BigCo will probably want to put their own managers in charge and only need founders to stick around for 6-12 months.

I definitely support TheFunded’s full acceleration on double trigger (company acquired and founder is fired).  In fact – I think I might be alone on this one – I support double trigger for all employees.  I don’t see why only founders should have this basic protection.

I didn’t see any mention in the term sheet of initial vesting of existing founder shares (maybe I overlooked it…?).  I think that this is a very important term and that founders should vest over 4 years from seed funding or perhaps starting a few months before (for “time served” as they say).  In my experience, entrepreneurs way overestimate the odds that greater initial vesting will protect them from the VCs, and way underestimate the odds that less initial vesting will protect them from their co-founders.   I don’t care if your co-founder is the greatest person in the world, things happen in people’s lives, moods change, relationships get complex, etc. and founders leave startups.  Pretty often.  A better way to protect yourself from VCs is to only do deals with high integrity ones.