Startup Fundraising: Keep it Clean

When fundraising for a startup, keep your focus on your company’s long-term needs by keeping your funding rounds on the straight and narrow.

Embarking on the path of raising capital to fund a startup demands meeting many requirements and creates a cascade of consequences.  As I described in my post, Should I Raise Venture Capital, many businesses do not lend themselves to the financial investment characteristics that make them attractive to investors.  Remember that most who start down the fundraising road do not succeed. Before starting down the path of trying to raise money, take the time to evaluate whether your plan really will produce a startup that both demands the investment of substantial capital and has the potential for providing the types of returns that investors are looking for.  If those two conditions are not met, you will struggle and likely fail to raise the money.

Once you have convinced yourself and hopefully a few knowledgeable mentors that your concept has the right characteristics, including the need for substantial capital, the next step is to prepare (see my post on Getting Baked for Fundraising) and then begin your initial raise. Now we come to the subject of this post. If you are going to raise at all, you will likely need to raise multiple funding rounds to enable your startup to achieve its potential. External funding provides the fuel to invest heavily, go fast, and build up substantial competitive barriers. Once you start, you need to move – and that will almost always require you to fill up your financial fuel tank along the journey.  Because of that usual necessity, you need to be wise in building a clean capitalization table that supports multiple fundraising rounds. Suppose you deviate substantively from a clean capitalization table. In that case, you risk (a) not successfully raising at all, (b) creating hurdles in your path to raising future rounds, and (c) reducing your potential participation in the startup’s planned-for success.

Here are some tips to keep in mind that will help you build a clean capitalization table as you raise substantial capital:

• Begin with the right business structure to support raising significant capital from multiple investors. For the cleanest capitalization table, this is almost always a C-corporation, typically based in Delaware.  While some may consider LLCs or S-corporations for cost or tax reasons, these structures have limitations that become painfully apparent further down the road, requiring switching or ever-increasing complexity to manage. If you are going to swim in the deep waters of venture-backed startups, bite the bullet and start with a Delaware C-corporation right out of the gate.
  
  
• Get familiar with the model legal documents offered by the National Venture Capital Association. These legal document templates are free and are offered as an industry-embraced best-practices resource to the venture industry, including investors and entrepreneurs, to reduce the time and cost required to complete financings and focus attention on the most critical high-level issues and tradeoffs inherent in every funding deal. These documents have been developed by a national coalition of attorneys who specialize in venture capital financings. They have been refined over many financing rounds, attempt to be balanced rather than overly biased towards either side of the deal, present several options that reflect variations in terms, and provide explanations for the logic behind specific terms. The documents are updated regularly to reflect new information and even include some statistics on how frequently certain terms are used. They are a great place to begin to get familiar with typical terms in venture rounds even if you are starting with a convertible note raised from angel investors because that convertible note needs to feed well into the future VC-led preferred stock round.
  
  
• Remember that good model documents do not replace the need for an experienced attorney on your team. A smart, experienced attorney will help you avoid numerous traps. It is especially helpful to have someone familiar with current practices in some of the very active fundraising regions (the “coasts” in the U.S.) so that you do not introduce less common and accepted terms into your early rounds. Some of my painful early lessons, both personally as an entrepreneur and when helping other CEOs, emanated from not finding the right attorney to support the company.
  
  
• Name your round using commonly understood stage-related terms. This is an area that evolves a bit. Still, the principle is this: while technically you can call your round whatever you want, what you call it will be enshrined in your financing documents that stick with your company for all or most of its life, and the terms you use to name the round have commonly understood meanings.  You do not want to be wasting precious time explaining your unique term or why you didn’t use a standard term like “Seed Round” or “Series A” or “Series A-1” as that distracts from the main value proposition you are trying to get new investors bought into as you raise future rounds. You also do not want to get ahead of your company’s actual stage because there are expectations amongst investors about what will have been accomplished by a company at each stage. For example, if you are raising a Series C round as a pre-revenue company, that will look odd because Series C companies are expected to be scaling commercially. Get feedback from your experienced and knowledgeable attorney and friendly, experienced, and knowledgeable investors, so you do not confuse matters with an arbitrary round name.
  
  
• Try hard to use plain vanilla financing terms. This may mean working with a lead investor (here is my post on the Role of a Lead Investor), or it may mean establishing a term sheet offered by the company early on. Regardless, when establishing or negotiating a term sheet, avoid fancy custom terms or out-of-the-norm discounts, multiples, or other numbers. It is a sign of sophistication in a startup and its early investors if the terms of early financings are kept to standard structures. Your experienced attorney can help with this, as can using templates and model documents. While the SAFE structure has been offered, my conversations with experienced VC investors indicate you may be better off sticking with a standard well-understood convertible note, if applicable. Over the years, I have run across entrepreneurs who tried some exotic financing structures. While they enticed some less sophisticated investors, many of the more sophisticated investors shied away because they understood the future financing risk introduced.  What you can do is limited by your negotiating power in any given financing. However, I find that a frank conversation about financing risk and the value of expected terms can be persuasive. If it is not, think hard about whether you are getting together with an investor who will cause future problems every step of the way and consider carefully if you want to accept an investment from them.
  
  

Conclusion: Why accept balanced terms and work hard to keep our capitalization table clean? Because when you deviate from the norms, you are introducing future financing risk. Startups already come with enough risk without introducing extra layers of it! To do this well, you need to be educated on standard terms, backed up by an experienced attorney, and know when and how to stick to your guns to navigate around less sophisticated investors that want to introduce “special terms” into your financing rounds. If it helps, know that I have become tougher and tougher on this point as I have gained experience and seen the consequences of coloring outside the lines. Hopefully, you can avoid learning this lesson directly yourself!