Monday, 27th March 2017

Raising Capital for your Startup

Posted on 23. Aug, 2012 by in FINANCE

Over the last few weeks, I have mentored fellow graduates of Harvard Business School, local DC based entrepreneurs, and a group of very smart high school students at Thomas Jefferson on the nuts and bolts of how to raise capital for their startup. As I talked to my friends and fellow entrepreneurs, I came to realize how little many entrepreneurs know about early stage financing. Over the last ten months, I’ve raised 3.5M for my own startup, TroopSwap, an ecommerce platform focused on veteran and military discounts. We raised the first million via convertible debt, while the additional 2.5M was raised through equity.

My experience with fundraising has exposed me to the advantages and disadvantages of different types of financial instruments. I’ve also learned about the psychology of raising a round and how to effectively structure a round in order to sustain forward momentum and to ensure that commitments to invest actually materialize in the form of deposits in your company’s checking account. While nothing I’m writing in here is a secret and no one method is more right than another, there are certain norms and best practices that should be followed in order to keep as much of your time free to focus on your business as possible. I certainly wish that there had been a blog post that covered everything I needed to know in detail when I was putting together my own round.

In addition, this is my first time building a company, and I certainly did not have experience raising capital before this venture, which brings me to my first point…

Find a Mentor
In order to raise capital, you need a mentor who has been successful in the vertical you are entering. Your mentor should have three vital characteristics:

1. An impeccable reputation among both investors and business contacts.
2. A passion for both your idea and for you.
3. They should have held executive level positions in the space you are entering.

Your mentor plays an invaluable role when dealing with investors. Beyond giving a first time entrepreneur an invaluable dose of legitimacy (and reassuring investors that a first time entrepreneur won’t blow up his or her startup), your mentor can handle questions regarding the round that will help you avoid awkward or heated conversations with your investors. If the mentor and the entrepreneur divide their responsibilities with respect to financing and business questions, then you will have an optimal relationship to raise capital. There are only two rules:

1. The mentor demurs on questions of vision and strategy when dealing with investors except to note that you are a rockstar and the only reason he is spending time with you is because he loves you and the idea.

2. The founder demurs on questions regarding deal terms and the financing and allows the mentor to serve as the single point of contact for all investor questions.

The final thing you need is an investment from your mentor. Inevitably, investors will ask your mentor whether he or she is investing in the round as well. If the answer is no, then that will raise a ton of red flags. It’s also an issue of integrity and aligned incentives. As much as your mentor might claim to love you and the business, cash is truth and the smart money will walk if your mentor isn’t investing in the round.

Convertible Debt vs. Equity
An equity raise is relatively straightforward. The entrepreneur sells a percentage of his or her company, typically around 20–30%, for a particular amount of capital. A typical round might look something like this:

Pre-Money Valuation of the Company: $8M
Size of the Round: $2M
Post Money Valuation: $10M
Investors Stake in Company: 20%

The trick to putting together a round like the one described above hinges on arriving at an acceptable valuation for your startup. For a startup that may not have revenue, this is no easy task. In that scenario, the entrepreneur and investor might choose to finance the business through convertible debt.

Convertible debt is an instrument particularly suited for pre-revenue startups where an initial valuation would be a number pulled out of thin air. In this scenario, an entrepreneur might decide to offer a convertible note in order to defer the valuation of the company to the next round of financing when a sophisticated investor will be able to place a reasonable valuation on the company. In exchange, the entrepreneur will offer investors interest on the invested capital as well as the right to convert their capital into equity at a discount when the company raises a round at a specific valuation. For instance, a typical convertible note might have these terms:

Size of the Round: $1M
Interest Rate: 10%
Conversion Discount: 20%
Conversion to Equity Trigger: Series A
Round of $2M or greater
If an entrepreneur raised a round of equity twelve months later at a Share Price of $25, then the note would convert as follows:
Principal + Interest: $31.1M
Share Price: ($25)
Conversion Discount (.8): $20 Share Price to Convertible Noteholders
Convertible Noteholders Shares: 55,000
Series A Investor @ $1M: 40,000

THE TRICK TO PUTTING TOGETHER A ROUND HINGES ON ARRIVING AT AN ACCEPTABLE VALUATION FOR YOUR STARTUP.

I didn’t note how many shares were outstanding in this hypothetical scenario which would enable you to calculate the percentage of ownership. For example, if there are one million shares issued and outstanding then the convertible noteholders have 5.5% of the company. If there are 300,000 shares issued and outstanding, then they have 18.3% of the company. The large differential between 5.5% and 18.3% illustrates a deeper debate on the incentives associated with a convertible debt raise.

The large differential in percentage ownership noted above is related to execution. Linking the valuation to a later round of financing allows the entrepreneur to avoid dilution through superior execution; it also allows the convertible noteholders to capture a greater share of the company if the entrepreneur fails to execute well and raises equity at a lower valuation. In theory, the incentives inherent in a note should spur the entrepreneur to work harder to execute and to ensure the company succeeds, which creates a winning scenario for everyone, but investors also have an incentive to wait to help the entrepreneur until their convertible note becomes equity.

Depending on market conditions, an entrepreneur might choose to put a cap on the valuation at which the note converts into equity, say $8M, although some rounds go uncapped because the market supports more favorable terms for the entrepreneur or investors wanting an option to invest more money in the company during follow-on financings (Yuri Milner and SV Angel’s convertible note investments in Y Combinator companies is a good example of this strategy). The most important thing, however, is that your mentor and your board members are investing alongside your investors so that they share the same risk and accept the same terms.

No matter how you choose to raise your capital, through equity or through convertible debt, you will have to negotiate—and that leads to the next question…

When and with Whom Do You Negotiate?
First, you should remember that you aren’t supposed to handle this conversation, your mentor is the single point of contact. Not all investors are created equal and you shouldn’t treat them as if they are equal. If you are raising one million with a minimum investment of 25k, then you should resist the temptation to negotiate with investors who are only putting in 25k–50k. If you begin to make concessions to small investors, then you create a horrible precedent that will encourage your investor to keep asking for more stuff down the line and you open up every piece of the deal to negotiation with all of your other investors. Your mentor will never make this mistake if they are competent.

When dealing with an investor coming in at 25–50k who wants to negotiate, simply reply that you are open to changing the terms if they want to put in an investment of 500k or more, otherwise the terms are what they are. This position is a fair one and it will help you avoid needy investors who don’t have much skin in the game but try to armchair quarterback your company from the sidelines. It’s much better for you to hold firm and to only deal with investors who take your company seriously enough to put in a large amount of capital.

IF YOU BEGIN TO MAKE CONCESSIONS TO SMALL INVESTORS, THEN YOU CREATE A HORRIBLE PRECEDENT…


How Much Should I Raise?

You should figure out the number you think you need to hit your targets and then roughly double it. Entrepreneurs are overly optimistic—it’s in our DNA. If you think you need 500k then you should try to raise between 750k and one million. When the cash burn is higher than expected (and it will be), the extra capital can make all the difference because it allows the entrepreneur to keep operating the business rather than going out and wasting time raising capital. Your time is better spent on the business than with investors and you will be happier.

For the legal documents, you should instruct your lawyer to leave the round open up to double what you raised. That way, if you need to take on an extra 100–200k down the line you will have the flexibility to ask your investors to simply wire it over rather than to re-create an entirely new round. You get to save a lot of time and money because the documents are already on file and the terms of the deal are clear to your investors. Your investors get a bit of a sweetheart deal investing capital on the same terms after a significant amount of time has elapsed and you have (hopefully) increased the value of the company. Ultimately, it’s a win-win. How Should You Structure Your Round?

If you are raising capital via a VC, then you don’t have to worry as much about the mechanics of taking on capital and organizing a round. On aggregate, VCs are moving away from pre-revenue startups, however, and investing capital in growth businesses. Happily, the cost of starting a tech company has fallen dramatically (thanks to cloud computing) and angel investors have largely stepped in to fill the gap. When you are raising capital via angels, your investors will ask what your “first takedown” or “first close” is for the round and you should be ready with an answer.

The first investor to give you 25k takes a much greater risk than the last investor who puts in 25k to move your round from 975k to one million when the risk is shared and you already have plenty of capital. So why would that first investor take more risk and write a check? Without some sort of protection for that first investor, you could go out and spend the capital they invest without raising from anyone else. Most investors don’t want to hear, “I’m sorry. I bought ten MacBook Pros, your 25k is gone. No one else invested.” Since most investors only want to invest if other people think your idea is viable and will open up their network to help you, that scenario is unacceptable. The “first close” solves this problem.

When structuring the round, the entrepreneur must decide the minimum amount of capital needed to achieve key milestones that would enable the company to achieve organic profitability or to achieve traction that would enable the company to raise more capital at a higher valuation. For a one million raise, the first close might be 500k. That number will be written into the legal documents for the round.

The first close binds the entrepreneur to raise 500k before the company is allowed to access the capital or “take down the round.” If the entrepreneur raises 475k but no more than that, then tough luck—the money must be returned to the investors. This legal protection ensures that your first investor who writes you a check is only committed to you insofar as you can convince other investors to invest as well until you have cleared your first close target.

Okay, investors agreed to my terms and “are in.” now what?

You should anticipate that 20–30% of the money that investors have verbally committed to you will not end up in your company’s bank account. Additionally, investors have an incentive to wait and watch your company perform. The more time that elapses before they actually write a check, the more time they have to observe you execute and to see if the company risk is going down or up. The way to force the issue and to get a hard yes or no from people is to set a deadline for your first close. (Give yourself plenty of time! You’ll need at least 2–3 months to hit your target.)

Once you’ve set your deadline for your first close, you should set a deadline one week in advance of that date and tell your investors to wire or mail their funds in by COB that day. Even after you and your mentors follow up with your investors, I can guarantee that at least a third of your investors will not wire funds over by the soft deadline. The excuses will cover the spectrum: unexpected business trip, family emergency, time needed to free up investments for liquidity, etc.

Even with your mentor helping you to herd your investors, you will find that the remainder of your investors will only wire funds over at the very last minute when you inform them they are about to miss the deal. Some investors will fade away altogether, so prepare for a first close that is lower than you had anticipated. No round is secure until you have the cash in hand, regardless of the great things you hear from prospective investors at your meetings. Plan accordingly.

Should I always go for the highest valuation?
Simply put, no. There are many different reasons that could influence you to choose an investor offering less money (not all investors are created equally), but just as important are the implications that your valuation will have for future financings. If you raise five million at a 40 million valuation, you might feel like a hero, but, if you miss your targets, the market softens and you have to raise again—at a lower valuation—you will lose the majority of your company. Beware Pyrrhic victories.

Anything else?
The first investors you pitch will have a lot of questions. Write them all down and you will find that they are themed around weak points in your pitch and business plan. Those questions will keep your investors from writing checks. For example, they could be related to the size of the market, your team, the business model, or distribution. Once you figure out what is holding investors back from writing a check, you need to get out on the street and talk to customers and recruit talent. Be tenacious and never take no for an answer. You are only as strong as your will.

Post By Blake Hall (1 Posts)

BLAKE HALL:

Blake Hall is the CEO and co-founder of TroopSwap.com, the first ecommerce platform that provides military discounts exclusively to veterans, service members and their families. A combat veteran, Blake led a battalion reconnaissance platoon in Iraq for fifteen months during 2006-07. His educational degrees include a Bachelor of Science magna cum laude from Vanderbilt University and a Masters of Business Administration from Harvard Business School.

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