Things I Wish I Knew When I First Started Fundraising
For first-time entrepreneurs, fundraising for your startup is fraught with unexpected pitfalls. Here is a list of some of my key lessons learned over 20 years of raising over $75M for startups.
As I coach and consult with other entrepreneurs, I am reminded of some of the fundraising gotchas I ran into as I learned to raise angel and venture capital for five different startups. I am confident that there are other mistakes I have not made yet that I will learn about in the future, but perhaps this list will save someone else the pain of having to learn them personally! In no particular order, here are some tips on what to learn about before they bite you:
Prior to closing, the Company will be organized as a Delaware C-Corporation.
When forming a startup company, many founders do not realize that they should incorporate as a Delaware C-Corp if they intend to raise venture capital. This is because venture investors are familiar and comfortable with Delaware corporate law. While an LLC or other state C-Corp is technically possible, any answer other than a Delaware C-Corp adds unnecessary complication and risk to the venture investment and indicates that the founder is inexperienced. A condition of closing sentence like this enters the term sheet, and you must scramble to make it true before you can close your financing. Here is my story of how I almost lost my Company when I made this mistake when forming one of my first startups.
A lead investor may not want to include all the investors who have told you they are interested once you have a lead.
When you are out raising money, you will encounter investors who get excited about what you are doing, but then they tell you that their fund does not lead (aka negotiate the terms of the deal) and to let them know when you have a lead investor lined up as they would be interested in considering participating in the round. This can feel like great progress as you seek to line up these potential investors and their possible “bite-size” in a spreadsheet that adds up to your target round size. However, this can easily be an illusion. Lead investors will often take a very hard-nosed approach to structure a round’s syndicate – and they may well have other co-investors they often invest alongside that they wish to bring into the round. They may well tell you that they are not interested in the potential co-investors you have identified. The word to the wise is to focus the vast majority of your attention on finding that pivotal lead investor and then let them collaborate with you to assemble the syndicate of investors who will fill out the round. Be careful not to promise any potential syndicate investors (possible co-investors) that you can get them into the round. To preserve your integrity since it may not be your call, just say that you will be glad to keep their interest in mind when the time comes to round out the syndicate – and keep looking for that lead investor.
Strengthen your negotiating position by developing competing lead investors (and their syndicates) willing to put a term sheet on the table whenever possible.
Admittedly this is hard. However, if you can persuade multiple lead investors to get excited about your Company in a similar timeframe, you can sometimes create a scenario where you can secure two or more competing term sheets. This puts you in the position of choosing the most attractive terms for the Company – and allows you to get refinements in your preferred term sheet by letting it become known that you are also considering other options (which can trigger investors’ fear of missing out and make them more willing to give on some terms during the negotiation). So, remember that it is not always wise to fully or specifically answer the question, “who else are you talking to?” Investors all know each other, and if you reveal who else is particularly excited, you may find that the investors connect behind the scenes and start negotiating with you as a unit.
Seek early investors who are savvy enough to know that you will likely raise multiple rounds of funding and who reserve some of their capital for the next round.
Future investors will expect existing investors to step up, often for nearly as much as they previously put into the Company, and invest in future funding rounds. Existing investors’ willingness to keep supporting the Company is viewed as a sign of confidence in the Company’s progress.
No reserves are rarely a problem with venture capitalists because they know they should not commit all of their capital allocated to a given company in the first funding opportunity. Reserves are built into the VC business model – as are the expectations that you will require multiple rounds of capital. They will typically have an initial investment target range as well as a target range for the total they will invest in any given company. However, be advised that sometimes I have had VCs exhaust the fund they were investing in my Company from and, as a result, not be able to participate fully in future rounds. Do not assume. Ask.
On the other hand, angel investors vary in sophistication, and sometimes they will invest all their appetite into the first round they participate in. That means they may not be willing to step up when you come asking for more money in a later round. If this happens enough, it can create a real perception problem for the startup with potentially interested investors in the next round because they may view the lack of willingness of current investors to invest again as an indication that the existing investors are not excited about the Company (and, therefore, they must know something the new investors don’t!). Try to educate your investors so that you have at least some stepping up next time.
Understand the preferences embedded in preferred stock and how they flow through to the distribution of proceeds upon exit
First-time fundraisers often do not understand what preferred stock means when sharing the proceeds of an exit – which is a fundamental mistake. Many do not initially realize that a 1x preference means that your preferred investors will get 100% of their original investment back right off the top of whatever the amount of the exit cash distribution is. It is a big deal if an investor asks for a 2x or 3x preference. And, if the preferred is participating, then the preferred shares will be dumped into the same bucket as the common shares to determine what percentage of the remaining proceeds each investor gets. This waterfall analysis across multiple rounds is essential to model, so you understand the often complex cash distribution dynamics. You want to know that the more money you raise across more rounds, the more preferences you have to payout before the common gets anything at all.
Expect to pay your lead investors’ legal and potentially some due diligence fees.
It always comes as a bit of a shock the first time you realize that, after closing, your investors will expect the Company to pay their legal fees (and possibly due diligence fees like the cost of the IP lawyers who reviewed your patents) out of the proceeds of the capital round. Of course, you had no control over those lawyers, and with every back and forth during legal negotiations, you were actually racking up fees on both sides! Note also that these fees for a priced round do not typically scale with the size of the round, so it is helpful to try to raise somewhat bigger rounds so that the legal fees represent a smaller portion of the total.
The experienced fundraising CEO/CFO knows to budget the legal fees from the lead investor (usually just the lead investor as they are the ones who should be incurring legal fees on behalf of all of the investors, but you might want to ask to be sure!) into their use of proceeds. For example, I usually take my legal counsel’s estimate and multiply it times 1.5x to estimate what the investors’ legal counsel’s bill might cost and put it in my financial budget. This is such a standard practice that investors do not always think to mention it. I remember that the first time it happened to me, it was a painful and unexpected ~$50K bill representing ~6% of my hard-won proceeds. Sometimes I have even managed to negotiate a cap on the legal fees that will be charged back to the Company to put a little bit of fee accountability into the mix.
Targeted and agreed-upon closing dates will often slip.
For startup teams who see a targeted closing date listed in the signed term sheet, there is a tendency to start assuming that the closing will go as planned and to line up actions to start moving right after closing. Be careful! It is quite common for something to come up that causes a few days to a few weeks of slippage in the closing date. For example, some last-minute issue is identified, and someone pushes the pause button until that issue can be sorted out, the documents can be updated, and finally, the closing can happen. While I do not have statistics on how frequently this happens, I do know that during one VC-led Series A I raised, the lawyers on both sides of the deal actually laughed at us when my CFO and I expressed our determination to close on time – and then when we wrestled the alligators enough to actually make it happen, they congratulated us and expressed their amazement that we had managed to pull it off. Clearly, the lawyers who do this work every day know that the date slips more often than not.
Remember, the round is not complete until the money is in the bank.
Know that on the “glide path” to closing, many strange things can happen – and those peculiar things can mean that the round does not close, or the closing is delayed. Here is one example of something that shocked me when it happened. On closing day, one of the four VCs in the round called to ask if the other VCs had sent their wires yet. He did not want to initiate his wire until the others had initiated theirs. Seriously? It is closing day, all the signatures are in, and you are worried about who is initiating a wire first? Absolutely do not assume that everything is set until the money has actually hit your bank account. And make sure you keep your calendar clear on closing day to deal with anything that comes up, as it almost inevitably will.
Suggestion: If you are thinking about startup fundraising, note that I have several posts on various aspects of the process under the “Fundraising” category at www.StartupCEOReflections.com.
