What the VCIC can teach us about Finding Good Investors.

Finding an investor for your startup is hard, and as I partly covered in my last post: What Tier is your Investor (or what to look for in an investor)It involves taking a lot of meetings and dealing with a lot of rejections while at the same time ascertaining how much value-add the investor you are speaking with will provide, above and beyond their investment.

vcic2011

Last month, I had the pleasure of judging my local VCIC event at the London Business School and it reminded me of the importance of the symbiotic relationship between investors and founders. The Venture Capital Investment Competition (VCIC) is a competition for MBA students aspiring to become VC’s after graduation or trying to better understand the investment process for when they start their own companies. The competition is about how well they analyse a business opportunity and then recommend and close an investment with the founder of that opportunity. It’s a great experience. Probably one of the best experiences to get a business student a feeling for how the entire academic body of knowledge comes together into evaluating and investing in a company. If you are currently doing your MBA, you HAVE to do this if you really want to exercise what you’re learning across all of your classes.

More than 8 years have passed since my personal VCIC experience as a participant, but I still remember it vividly to this day. Since then, I’ve had the pleasure of judging it every year thereafter and seeing many MBA teams go through the process and trying any number of things, ranging from the silly, to the creative in their attempts to out-do their competing ‘VC Firms’ to secure an investment-agreement with one of the presenting founders (which, btw, are always real-live companies). Every time I judge this event, I’m reminded of how important it is for founders to not only find the right investors, but also for investors courting a founder to demonstrate their value (their ‘tier’ so to speak).

During my judging of these events over the years, I’ve noticed there are six key areas that differentiate the best VCIC  teams (read: VC firms) from the worst (both from the point of view of the founder and the judging VCs). These are:

* The best VCIC teams build rapport with the founders & ask the key questions – Sometimes as an investor you have to ask difficult and probing questions. Some are questions that signal your doubt on a current company strategy or perhaps on how the company’s thinking revolves around any operational area. As the VCIC teams ask questions to get these answers and better understand the founding team’s thinking, they need to do so while at the same time respecting the founders and not making them feel like they, just because they have money, know it all, for no one does, no matter what their experience. I consistently saw VCIC teams failing in this area, but a few that really stood out made an effort in asking questions not from a position of patronising the founders, but from trying to understand them and dig into the right issues.

* The best VCIC teams understand the opportunity & dig only into the right issues with their time– Doing your homework is an important part of any mutual discussion. Some VCIC competitors haven’t even looked at the product that the company makes. The VCIC teams that fared better were the ones that, logically, didn’t get hung up on semantic arguments, but rather dug deep into any number of issues that are important. As a founder, you know what are your biggest challenges. If an investor identifies those as well, particularly without you spoonfeeding them on it, that’s a good thing and bodes well for having them on your board. As an investor, don’t show up unprepared and pretend like you can make up for it by picking up a trivial argument. In the competition itself, sometimes you have to dedicate your time to researching a specific company at the risk of showing up unprepared to interview the companies that you are not interested in for investment. This counts against you, so keep that in mind. In real life, as a VC, its as if  you took a coffee meeting with a founder, and then were rude to them.

* The best VCIC teams demonstrate value to the founder – One of the things that VCIC teams have to do when they are asking questions of the startups, is explain who they are. In the context of the VCIC they can fictionalise their ‘fund expertise’ since none of them are running real funds, but part of this exercise is also marketing the right attributes vis-a-vis what the startup team needs. For VCIC teams where a resident expert exists it can be useful, but also consider that you can showcase value by bringing in the right people external to your fund to help the company along.

* The best VCIC teams demonstrate an understanding of the financial requirements of the company – Some VCIC  teams fall short of true analysis and research here, they just take whats given to them. Sometimes they underfund companies and sometimes they over-fund the companies as part of getting their numbers to work. There is probably more to say on this point than can fit into this post, but what I’d recommend is that the VCIC teams explore proxy companies in the market and truly understand the impact of offering too little (or too much) to the company. One point on VCIC valuations: Teams, DCFs don’t work well on companies that don’t have historic data!

* The best VCIC teams don’t overcomplicate their termsheets – First of all, if you are a VCIC competitor, you should familiarize yourself with actual termsheets, and word of advice: keep it simple. Check out the Series Seed docs for the USA and the Seedsummit Docs for the EU as a starting point. Secondly, as a VCIC participant (and real investor) keep in mind that term sheets can actually signal quite a bit to the founder of what you think of them and that this does have an emotional impact on the founders. Do they have too many control provisions, for example, or are the economics of the deal indicating some concern? While supervision isn’t necessarily bad, as a founder, the smart thing to do is ask what the investor’s expectation is engaging with founders post investment. Are they meddlesome, for example? Are those control provisions there to protect you or are they draconian in how they operate? Ask to speak to the CEOs of other portfolio companies of theirs. Regarding the economics of a deal, perhaps the economics imply that they think you are overpriced. Ask them to walk you through how they came to that value and why. As a VCIC team, be mindful that overly complicated termsheets can come back and haunt you by providing perhaps too many mixed messages to the founders. As a founder, push back on items that don’t make sense.

If you are a team about to participate in the upcoming finals, I wish you the best of luck. If you are a founder, keep the above points in mind when you are doing a review of your investors-to-be. As for me, I look forward to continuing to be part of the VCIC experience in the future, I always learn a ton and am continuously impressed what teams achieve in such a short amount of time. I find that every time that I judge it, I’m reminded of the delicate interplay between investors and founders and how trust needs to be built over time.

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What Tier is your Investor (or what to look for in an investor)?

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One question that I often get from founders is what ‘tier’ a prospective investor is. As in, what differentiates their prospective investor over another as ‘better’ or ‘worse’, relatively speaking, and on what basis.

Just to clarify, although there is no formal ‘ranking system’ for the tiers of investors, generally speaking, every investor sort of knows where they ‘rank’ relative to others or at least relative to the top investors. The best funds, generally known as ‘Tier 1 investors’ are the most in demand, and then, the tiering is largely subjective from that point onwards as to whether a fund is Tier 2, or Tier x, so there isn’t a huge benefit to spending too much time trying to actively find the ‘objective’ rank of an investor.

That said, what IS worth exploring is what differentiates the better ‘tier’ investors from the rest. Below are the seven attributes that I believe differentiate ‘the best from the rest’.

As you seek out potential investors, keep an eye out for these variables, the more of these your prospective investor has, the likely better off you will be as a founder.

1) Has a great network – the biggest value-add, in my opinion, that an investor can bring to the table, is their network. The larger their network, the more doors they can open for you. Nothing beats a direct intro to someone you need to meet.

2) Has a great brand-name – this helps with the network, but having an investor with a great brand name, either as an individual or fund, can help not only open doors indirectly (as in not requiring an introduction), but also to provide your startup with instant validation to potential customers, partners, and new investors.

3) Has sufficient levels of capital to support you – Although different investors have different strategies around this (eg. an Angel rarely can follow-on as much as an institutional fund), it is generally a good thing to have an investor who can invest in your company throughout the lifecycle of your company.

4) Has sector expertise – One way that investors can differentiate themselves as a top tier investor from the usual suspects is by having focused experience in your sector. For example, an investor could be a generalist Tier 2 fund (remember that this is subjective), but as an ecommerce investor they may be a Tier 1, great if you are a ecommerce company, but just ok if you’re a fintech company. This is because they will likely have a large network (see point 1 above) in their sector of expertise.

 5) Has deal experience – You will go through a lot of unique and stressful situations during a fund raise. It really helps to have someone who has gone through the process before and can help smoothen things out between all parties involved if needed.

6) Isn’t burdensome – An excellent investor does not burden the founder during the investment process with unnecessary or unusual diligence requirements for the stage your company is in. For example, a company that is very early stage will likely not have much to be ‘diligenced’, if an investor is requiring you to have an accurate version of what will happen in your company 5 years from now and you started your company three months ago, question whether they truly think the information you will give them has any likelihood of being true (and whether you think they’d make a good investor for you).

7) (Lastly, and most importantly) Has a big vision – Good investors on your board will help you by working with you on best practices for company building, but great investors will help you by helping you set the right vision for your company. The better investors help you think big because they think big themselves. This means not only having an attitude of can-do vs can-not, but also having the experience on how to coach you through this type of thinking.

Now, keep several things in mind, however, after reviewing this list:

1) There are many new investment funds and or individual angels that come to the ecosystem and therefore may not have an established brand name, but have great networks and experience. Don’t dismiss them prematurely, however, do ask others that they’ve worked with what it’s like to work with them.

2) Although founders that have done well and gone on to join a fund can be awesome people to have on your board, however, investors don’t have to have been founders themselves to be great investors. Experience as investor, having done many deals and knowing how the best companies operate, can count for a lot, so look for  a blend of all attributes in your investor and not just look for a founder-turned-investor that can empathetically relate to what you’re going through, but provides little beyond aged anecdotes about how they did things.

3) If you’re ever stuck between two potential investors, really really consider that the person that will be working with you on the board will help you define many things about your company over the coming years. Choose wisely and ask yourself who you would rather work with long term, you wouldn’t want too chose someone on a brand name alone, but causes you hair loss, heart burn, and emotional stress on a regular basis.

I hope this helps you in your quest to find your potential investor.

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How do you issue the right number of shares/options to an employee or an advisor?

HM Revenue & Customs at Mevagissey Harbour
HM Revenue & Customs at Mevagissey Harbour (Photo credit: Cross Duck)

Most founders have desire to share their equity with people that helped them along the way, both as a thank you, but also as a motivation tool. However, how to share is always a big question mark for every Founder. The two most frequently asked question is, “How much equity should I assign an advisor?”, which is shortly followed by “How do I know when to issue shares to new employees and how much do I give them?”.

So, let’s take step back and look at why we are doing this in the first place.

Motivating employees and or advisors is a key part of having a productive workforce. One key element to unlock this productivity is by creating a culture of fairness. In his book titled ‘Drive’, Daniel H. Pink talks about how an employee’s productivity can be binary provided that the right results-oriented work environment is created AND they are treated fairly from a compensation point of view. Effectively, if you don’t create a feeling of fairness in terms of compensation, relative to the market, employees will simply not be ‘open’ to be fully motivated as they will feel slighted. It’s a simple concept on paper, harder to implement in practice.

Therefore, the word ‘fairness’ is what’s important here.. how do you define the fairness culture in your startup?

Let’s start with advisors:

Advisors need to commit some time to your company to ‘earn’ their equity. The first thing to do is to define what kind of role this advisor is going to take. Is he going to provide board-level feedback and help or just operational help (marketing, for example). Is she going to meet with you once a week or once a month?

Then, define a time period for this relationship before you review it for extension. As in, Joe, your marketing advisor, will work with you once a week for 9 months, at which point you can review your working relationship to see if he is needed any further or if it is working out.

It’s really quite simple, find someone that can help you, narrowly define expectations you have of each other and for how long, and then find an equity amount that is in line with the market and that makes them happy.

For the USA, the Founder Institute has come up with some guidelines on numbers, and you can read about those here:
http://techcrunch.com/2011/09/22/free-startup-docs-how-much-equity-should-advisors-get/

They also include an agreement you can sign with your advisor to narrowly define the engagement. For the UK, I’ll be linking to one soon… stay tuned.

Onto Employees (which is a bit trickier and I’ll include the topic of valuations as a bonus):

Back to the topic of Fairness… Fairness is defined by having the total compensation of your employee meet his or her expectations as defined by the market. As such, you need to think of your employee’s total compensation (cash + equity) as something that is within the boundaries of the market norm for his or her role. Deviate too much and not only is hiring hard(er), but you will have inherently unmotivated employees. Total compensations at startups usually have low or no salary, so that fairness is established by assigning equity.

So in order to quantify the value of the equity portion of the total compensation of an employee, one important thing to consider is that the total value of the option package issued, is a function of both the total number given, but also the strike price they have. The two go hand in hand.

But before we go any further, a quick definition check on Strike Price:

An option’s strike price is the fixed price assigned to an option for the purchasing of the underlying share (typically ordinary shares) in the company. In effect, you have to pay the [strike price x  the options] you’ve been granted, to exercise your right to buy the underlying shares. Once you’ve ‘exercised’, you own the shares.

Pricing strike prices is a bit of a pain. In the USA, you have to do 409A valuations. More on that from Fred Wilson here:
http://www.avc.com/a_vc/2010/11/employee-equity-the-option-strike-price.html

Pricing in the UK is both simpler and more difficult. More difficult because it isn’t as clear as the USA, but simpler, because there is more flexibility.

Here is the exact language from HMRC (http://www.hmrc.gov.uk/shareschemes/emi-new-guidance.htm#10):

If EMI options in an unquoted company are granted the company can, if it wishes, agree the market value of the shares with HMRC Shares and Assets Valuation (SAV). To agree a market value with them the company will need to propose a value for the shares and provide background information to support the proposal. It will need to complete form Val 231 for EMI options.
The form outlines the information needed to support the proposed valuation. When it is complete, it should be sent it to HMRC Shares and Assets Valuation (SAV).
If the form is not used or the company does not supply all the information requested, it may be asked to supply the missing information before a valuation can begin. This could delay the agreement of the valuation. When HMRC Shares and Assets Valuation (SAV) receive your completed form, they will tell you within ten working days if they need any further information.
Asking HMRC to agree a valuation is not the same as:

  •    notifying HMRC of the grant of EMI options
  •    or making the annual tax return required for EMIs

This language does give you some flexibility on how you want to value and define your company’s value at the time you are setting the strike price. Book an appointment with someone like
http://www.completeaccountingsolutions.co.uk/ to discuss how you might go about setting this, or with your lawyers. Getting this right is important because if you don’t get it right, it will have serious tax implications for your employees or any other option recipients.

So back to strike pricing and its effect on the value you give to your employees:

If you have a very high strike price, you affect the employee’s total return on an exit. In a simplified equation (that isn’t designed to give you the present value of your options (Black–Scholes), but rather just the mechanics of cashing out), the value of the options will be:

(Share Price at Exit * Options you have) – (Strike Price you have * Options you have) = value to employee in cash at exit

You can see where to match employee 100, who comes in when the company is worth a lot more, with employee 10, who came in early, you’d have to issue employee 100 many more shares to ‘equal’ the same given to Employee 10. Try explaining all that to your hundredth employee and also to your first few, who might feel slighted that someone has more ‘shares’ than they do for the same job function.

Also, here is an interesting point to consider: different exercise prices for fully vested employees will cause them to behave differently. An employee who has 100 shares to buy, but only at $1 each will act differently (buy the shares and be a passive shareholder) vs an employee that has 100 shares at $100 (more likely to make a calculated decision as to whether to exercise (or not) the options upon a departure). Remember, if you set an exercise period after someone leaves the company, the question is, do you want them to keep the shares as a bet (low price) or only keep them if they really believe in the company (high price)? Again, no right answer as you balance between equity you give out.

So how much equity to give them?

After the above exercise, you see the challenge between articulating fairness mathematically, but also in terms of how employees chat between themselves and can sometimes get the wrong impressions based on not having all the facts.

Transparency is very useful in the early stages of a business, but as you grow, you may choose to just share the basic information of your company’s equity buckets, or strata. It’s really up to you and how you want to stratify the different kinds of employee equity issuances, for example: director level, supervisory level, and admin level.

The trick here, is really in how to ‘define’ who is what. I’d say that the important strata are:

  •    Those that set strategic direction overall (typically the founders or CEO)
  •    Those that set functional strategic direction (typically someone like a CFO, or CMO)
  •    Those that set budgets to hit strategic goals (Directors, VPs)
  •    Those that manage people according to budgets (Supervisors, Line Managers)
  •    Those that execute (Developers, Sales people, etc)

Then, you define what’s a fair total comp bucket value for each of these, and then use the math equations to give you the relative values of equity for each strata.

As with most things of this nature, however, there are more than one way to slice the onion.

Fred Wilson’s post below on what to issue each strata is useful as a guide for both an equation to calculate absolute numbers, but also to help understand the different tiers of employees.
http://www.avc.com/a_vc/2010/11/employee-equity-how-much.html

And here is Guy Kawasaki’s suggested split (via @brandid):
http://blog.guykawasaki.com/2006/03/nine_questions_.html

Lastly, here is another version of how to divide things ‘fairly’ between everyone (via @gosimpletax): http://www.brightjourney.com/q/forming-new-software-startup-allocate-ownership-fairly

Once you’ve chosen your preferred method, one mistake to avoid is to promise early employees ‘percentages’. Meaning, don’t say, I’ll give you 2%, but rather say, I’m giving you 2,000 shares which represent 2% of our current cap table. The reason is that if you leave it verbally at 2%, you may inadvertently make them believe that at the next round the will continue to have 2%. Don’t assume all employees understand the mechanics of financing rounds and/or dilution.

Another mistake to avoid is not including a vesting period. Without a vesting period, your employees have full access to what you’ve promised them, whether they’ve spent time to ‘earn it’, it is dangerous for the company to not have one. Read here an explanation of why that’s important:  http://www.seedcamp.com/2012/11/seedhack-founders-collaboration-agreement-version-2-0.html

In the end, this is more of an art, and you will get it wrong at least once, and don’t be afraid to experiment, but as long as you have a process, I believe you will have less issues going forward, particularly when the company grows larger, than if you leave things entirely open-ended.

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Setting Appropriate Milestones in an Early-Stage Startup

Madagascar milestone

Updated Post on Nov 11, 2013 – See bottom of post for updated notes.

When looking to plan for your company’s growth strategy or to go fundraising, it’ll serve you and your company well to break down what you need to do in terms of projected milestones. Technically speaking, I believe a milestone is a future ‘marker’ within your company’s stated growth trajectory.

Therefore, milestones, in the context of startups, are effectively points in time along the company’s timeline prior to a future event or goal. These points in time are usually defining points in a company’s history…  such as a key hire, a product launch, a certain number of users, a retention rate, first revenues, first profit, etc.

Rather than the goal itself (an example goal could be to create a successful, cash-self-sufficient company, that provides tangible value to its customers and is floated on the public market), milestones are a subset of ‘the goal’. As such, milestones of any size can be created throughout the lifetime of your company as it progresses to your company’s ultimate goal.

Milestones are important from a fundraising point of view because they can define whether a company is caught with little to show to potential investors at the point of fundraising or with a strong showing of what the company’s been able to accomplish to date.

Lets, for example, look at the following points in a company’s history (I’m making the timing up for example only, don’t assume these are ideal timings):

  • Month 3: Minimum Viable Product
  • Month 5: Private Beta Launch
  • Month 8: Key Hire
  • Month 11: Public Beta Launch
  • Month 12: x% daily growth rate in subscribers

If a company knows how much money they need at all points in the timeline (see the article on how much money should I raise), then the question is which is the best milestone to fundraise on?

From an investor’s psychology point of view, risk is what is being managed. Minimization of risk while not losing an opportunity to invest in a hot company is the balance game that all investors play. Investors are constantly trying to find the least risky point to invest in a company relative to what they afford to invest (valuation) and the ability for them to invest (there is space in the investment round for new investors).

As such, the best time for a company to fund raise is either right before the completion of a key milestone or right after the completion of key milestone but before too much time lapses right after its completion such that there isn’t a sustainability of the reached milestone.

Let me explain. First, let’s look at the psychology of investing right before a key milestone is completed:

If an investor feels confident that the company is on track to hit its milestone, the investor knows that once the company succeeds, the company will inherently be more valuable to the outside market because it has been meaningfully de-risked by some amount. As such, the investor wants to ‘get in’ on the deal right before ‘launch’ for example, so that they can get a specific valuation while the company is still a little bit riskier, but not overly so.

This makes sense and is therefore quite simple to understand, but only companies that can instil confidence in potential investors of managing growth post milestone completion, generally get investors rushing to get this done. However, it’s a great for a start-up to be in, because generally, for things like a product-launch milestone, it is easier to control than say, a specific user growth rate.

Now let’s look at the psychology of investing post a key milestone being completed:

If an investor feels like he wants to ‘stall’ to see if the company is completed, or the number of users hit, etc.… then he is trying to effectively fully de-risk the investment before committing cash. However, he knows that being playing the cards this way, other players will also be on the table quite quickly because the company is not only attractive to him, but also to many others that were standing by the sidelines waiting to see what the company would do (relative to their risk profiles as in, this doesn’t mean that late stage investors, for example, will change their mind to invest in your company). Therefore, the investor in question wants to get in before the company is too valuable for them to invest in.

Therefore, the art of picking milestones is trying to determine which ones are the key ones to focus on.

As a rule of thumb, these are the biggest ones:

Human Resources  – Hiring key people that will make a huge impact on your organization (not just employees for workload purposes, but like a shit-hot marketing person, for example).

“In terms of team growth, I believe there are other significant milestones, where organization changes happen roughly every doubling in size:  founding team (usually 3 -5) expands to 7 -12, expands to 25-30, expands to 50-70, then above 100 and beyond. More often I see companies do quick jumps rather than continuous growth, and the jumps are always followed by significant growth management challenges.”*

Product – Product launches vs. version releases

Market – Market validation. As in, first customers, or first paying customers, etc.

Funding – Maybe some money being committed to a round that the investor in question can lead or participate in.

You can break these down into smaller and smaller ones if you’d like, but that’s where you start having to make judgement calls as to what is meaningful and what is not.

Other examples of milestones include*:

  •  Proof that you can work together as a team, usually historical evidence
  •  Proof that you can build something, i.e. working prototype
  •  Proof that it’s useful to someone – first users and clients
  •  Proof that you can talk to investors – every financing round, even small ones
  •  Proof that you can talk to audiences – 100k users or 1M users or 10M users…
  •  Proof that the initial team is able to attract talent – key hires are C- ad VP- level professionals, which will drive your growth further. Every startup will eventually need a functioning management team consisting of CEO, CTO, COO, VP Sales, VP Marketing, and possibly some others depending on what you’re building.
  •  Proof that ecosystem agrees with your ideas – bringing respected industry advisors or partnerships on board
  •  Proof that there is market – $1M annually
  •  Proof that you can manage your finances – cash-flow positive operation
  •  Proof that you can scale – $10M annually
  •  Proof that the market is big! – $25M annually and beyond

Just keep in mind, milestones are all about moving from one stage of risk to the next. As you start planning your fundraising strategy, you want to make sure you time it so that you have ample time to fundraise so that you are in control of which milestone your company hits when. You just want to make sure your fundraising strategy uses these milestones to your benefit and not get caught between them and stranded for cash.

* Additional Comments from Bostjan Spetic of Zemanta.com

Update Note from Nov. 11, 2013

You should raise as much money as you can, but at least enough money for you to accomplish your next most meaningful ‘validated’ milestone + some buffer funds to help you spend time fundraising afterwards. This means you should look at a variety of points across your company’s timeline to see which can be made into meaningful milestones.

Whichever country you are in, you will have different fundraising challenges depending on the mix of individual and institutional investors. In a country where the funding comes mostly from individuals, you will likely not be able to raise substantially large rounds, in countries where you have access to organised groups of individuals, you’ll have access to larger rounds, and in countries where you have access to many institutional investors, you will likely be able to raise the largest rounds.

If you want to go for really really big, you should go to the geography where you can get that meaningful amount. Otherwise you will be underfunded, regardless. Keep in mind that in those markets, costs of running startups are going to be higher, so you need to include that in your plan…hiring star coders, for example, in the USA is very very hard these days.

In markets where you are not going to be able to raise the appropriate amount you need up front, try and articulate your requested amount this way: “This is what I need [big number], but this is what I can accomplish [milestones] with this [smaller number]”

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How much money should I raise from an Early-Stage Investor?

An assortment of United States coins, includin...
An assortment of United States coins, including quarters, dimes, nickels and pennies. (Photo credit: Wikipedia)

Raising money for your startup is never fun. It takes time, distracts you from developing your product, is fraught with emotional ups & downs, and doesn’t have a guaranteed outcome. Frankly, many founders would rather go jump into an icy lake than take another fund raising meeting where they aren’t sure what they should say to ‘convince’ an already hesitant investor to open their purse strings and invest in their company.

So, back to the main question… how much money should I raise?

The flippantly short version of the answer is, “as much as you can”… but in some cases, more isn’t necessarily better. Although you should raise as much money as your company needs to achieve major proof-points/milestones, overfunding a company can also have its drawbacks.

Let me explain this last point before going further on the ‘how much money should I raise’ question:

Many founders are obsessed about raising as much money as possible all at once because well, if you do raise a big war chest, then that’s one less problem you need to worry about. However, with a large amount of money come several potential problems:

1) With more money usually come more investment terms and more due diligence. It is probably a fair statement to say that the more money involved, the more control provisions an investor will want as well as more diligence to make sure that their money isn’t going to be misused.

2) A high implied post-money valuation. In order to accommodate a large round, investors need to adjust your valuation accordingly. For example, if your business is objectively worth 1 million, but you are raising 2m, unless the investor plans on owning 66% of the company after investment, they need to adjust the valuation upward (I’ll abstain from giving ranges for now). Having an artificially higher valuation prematurely can put a lot of strain on a startup if things don’t go well and then later need to raise money again, as it increases the likelihood of a subsequent round being a down-round (when you take a negative hit to your valuation) or rather, other new investors passing on the deal in the future because it is ‘too expensive’.

3) A propensity to misuse ‘easy money’. You could argue this point from a psychological point of view if you wanted, but suffice it to say, I know many VCs that believe that over-funding a company leads to financial laxity, lack of focus, and overspending by the management team. Perhaps it is lingering fear over the hey-days of the late 90’s were parties were rife, and everyone got an Aeron chair, but the general fear with overfunding a company is that it will be tempted to expand faster than it can absorb employees into the culture, integrate new systems, or expand real-estate needs without substantially disrupting the efficient operations of the company.

4) A last one, which is hard to really quantify and happens only to very few startups, is the media’s reaction (positive or negative) to how much money you’ve raised relative to what you have. Think about this story, although very rare, it’s what the effect of what too much can cause.

Ok, got it, overfunding can be bad… too much money can be a bad thing, but if you said I should raise as much as I can, where do I start and what is the ‘magic’ number to ask for then?

Alright, let’s look at this question from a different point of view, as I mentioned in my previous post on how an investor evaluates your financial plan, an investor (depending on their areas of focus) may not necessarily know what the exact figures your business will need to grow to its next major milestone, but rather, the investor will rely on your ability to communicate this on your financial plan for the investor to then make a decision on whether your accurately understand your cash needs or not. Tied to this cash need is an implied understanding of your company’s milestones.

Let’s define what a milestone is before proceeding:

A milestone is a quantifiable achievement, be it in terms of product development, team expansion, or market adoption of your company’s value proposition.

Your financial plan will likely be a series of chronologically organized milestones. For example:

Month 6 – Hire UX guy to optimize app
Month 8 – Launch mobile app
Month 10 – Start charging on the mobile app
Month 11 – Hit 10,000 users
Month 12 – Launch partnership with key distributor
Month 18- Hire CMO

These are all milestones. Some more important than others, and frankly an investor will likely want to talk to you about the importance of each one of them to get a feeling for which ones are the key ones to focus on to determine if your business is going to ‘take off’.

The reason for this is simple, the best time to go fund raising, is RIGHT BEFORE or SHORTLY AFTER the successful completion of a key or series of key milestones. For example, right before a key milestone, you can woo new investors with the promise of how successful you will be at the completion of the milestone and basically you convince them that if they don’t get into your company by investing now, that they won’t have a chance after you’ve achieved the milestone because many others will also be interested and the competition will be stiff (remember, investors don’t want to lose out on potentially hot deals). Shortly after achieving a key milestone is also a good time to try and convince investors because you’ve effectively accomplished a major thing (like launching a product), which de-risks the investment for them, but they can still get in the company before it ‘takes off’. Frankly, the worst time to go fundraising is when your last major milestone has grown stale and the next one is too far away to be de-risked. So, this is why it is key to know your milestones, and when they are happening.

Parallel to this milestone timeline is the ‘cash timeline’. As in, how much money, in aggregate, you will have spent to get there. So using my examples from above:

Month 6 – 60K
Month 8 – 80K
Month 10 – 100K
Month 11 – 110K
Month 12 – 120K
Month 18 – 240K

Ignore whether this is a realistic example for your business for the time being, but I’ve assumed a 10K cash burn on this example up to the end of year 1, and then starting in Year 2, I’ve assumed 20K monthly cash burn. If you don’t know what your monthly cash burn is, you’re in trouble. Monthly Cash Burn is a KEY figure to know before meeting any investor.

As you can see, an investor could choose any of the milestones above to focus on for your cash needs. The idea is simple, fund your company through the achievement of major milestone(s) (to reduce investment risk and to see if your company has any traction before putting more money in) and then go fund-raising for more money, hopefully on a strong note, where you will have met your timelines and expected outcome (be it market traction, or successful completion of your product, or hiring of the appropriate person).

For example, an Angel investor (someone that usually invests from their own money) typically can’t invest millions, so their investments tend to be less than 300K. However, they’ll want to make sure your business is going somewhere before putting all their money in, so it’s likely they’ll want to come in early to give you enough cash to achieve something plus a little extra to help you fund-raise after, but also to see how you achieve the milestone before putting in more. So, perhaps this Angel may opt for funding you through month 10 with your requirement of 100K plus a few more for fund-raising. This would get you through your product’s launch and give you a couple of months to see how it goes in terms of market traction (all the time you will be speaking to new potential investors) so that you can have something strong to talk about for fundraising purposes.

Alternatively, an institutional investor (one that invests other people’s money as well as their own), say a VC fund, may see that your company has some real potential in what it is trying to do, sees that you have a plan that requires 100K to launch before you start trying to monetize, but with their experience of seeing your kind of business having to do a few pivots before getting the launch product 100% right, think that perhaps the best quantity to give you based on your calculations is about 500K for about a year to a year and a half. This should also give you some breathing room to work on achieving your various milestones rather than having to focus on having to be constantly in fund-raising mode.

So now you are probably asking yourself, how is it that some investors have different perceptions of how much money I need and wish to give me? Effectively, how much money does an investor ACTUALLY think I need vis-a-vis what I ask for?

Your exact calculations may have said that you needed 100K to launch your product, but an experienced investor may have seen various companies like yours and seen that there are usually mistakes done along the way that consume cash without quantifiable progress towards the agreed milestone (you may have learned something, but you may be delayed in your launch because of some screw up). Because of this, investors some times include ‘buffers’ into the number they offer you in a deal. This buffer could come from the various sensitivity analysis the investor did, such as, what if the company is delayed in launching their product by two months, or what if the company can’t find that key employee, or what if the company can’t start charging for their product for an extra few months, or what if the product needs a pivot, or what if people aren’t willing to pay what the company expected? All these things will affect the cash flow of the company and because of them, the investor may assume some or all will occur, leading to the company needing more money than was planned by the founder. Effectively, your 100K in a perfect execution timeline, may actually be 250K after some minor delays and mistakes, and with the extra cash the investor in my example above gave you, you now may have enough cash to go fund-raise without having to panic about having to get cash in ‘yesterday’ or be constantly in fund-raising mode.

Keep in mind that this larger amount an investor may be willing to give you will also affect your valuation range, too much and it ‘inflates’ the valuation range your company sits in (as per my point number 2 in the intro), so an investor won’t give you ‘excessive’ buffer so that it forces the company to be ‘overpriced’ for them and for the company’s future. Inversely, hopefully you can also see where an investor may deem a company to be ‘underfunded’ if it doesn’t have enough money to get to where it can achieve a meaningful milestone(s) upon which to go fundraising with a strong foot forward for future investors to be attracted.

In conclusion, raise as much as you can but understanding your monthly cash burn and map out your company’s important timelines and the cash you will realistically require to achieve them. Then have an engaging conversation with your potential investors as to how much they think you need based on their experience. As a rule of thumb, try and raise enough money so that you have time to go fund raising after you’ve accomplished your next key milestone(s). In a future post I’ll discuss how much time you should set aside for fundraising, but to make the rule-of-thumb complete, add AT LEAST 6 months to the amount of money you need for your next milestone to include time to go fundraising.

Hope this helps

Update 1:

A friend of mine emailed in and mentioned that perhaps there was a difference in how investors from different geographies look at this issue of how much they want to invest in a company up front, and yes… I would agree with that statement, but the point of my post is merely to provide the reader with a ‘framework’ by which to approach the question of how much to raise, not so much to answer the multiple varied ways that investors might look at the amount required and subsequent fundraise amount. For example, some investors may choose to just want to back the team and thus will just give them an amount that they think startups typically get for the stage the company is in, and others will give an amount of money merely to exclude the investor competition from winning the deal from them!

However, I believe the framework I’ve mentioned in this post can help a founder assess how much money they may need for a period of upcoming time no matter the risk averseness (or not) of the investors they meet with. Whereas a bolder investor may not really focus on minor milestones, but rather just focus on a larger one such as ‘grow the network’ and for that the amounts invested is done with far less due diligence and far more quickly, a more risk averse investor will probably be more specific about what you plan on accomplishing with his money.

In the end, the most important thing, is to be keenly aware of your cash needs on a month by month basis, so that if the question comes up, you know how much you plan on spending and by when. You should also focus on raising enough money in your timeline so that you also have time to accomplish your key milestone(s) before going fundraising again, and lastly you should include enough buffer in your last fund raise to help you through your next fundraising period post-milestone. If you meet an investor that wants to invest a lot quickly, great, if you meet with various investors that are more risk-averse, at least you won’t get caught not understanding your execution plan. If you want another rule of thumb, many Early-Stage VCs will look at the next 12month to 18month worth of cash needs + a buffer to estimate the cash needs of a company. Add to that 6 months of additional cash burn and you have a rough starting point for a ‘headline figure’ from which to start discussions.

Hope this helps clarify the question further..

 

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