Leveraged buyoutWhat’s nice about investing is you don’t have to swing at pitches. You can watch pitches come in one inch above or one inch below your navel, and you don’t have to swing. No umpire is going to call you out.
—Warren Buffett
Some founders can launch their enterprises and achieve financial stability solely with their own and/or their families’ and friends’ money. Others start and grow their companies with revenue from customers who pay in advance for products or services before they exist. These are the lucky founders, and this is not as easy as it sounds. In fact it’s often incredibly hard. For everyone else there is the even harder challenge of raising outside financing—often raising it and raising it and raising it.
Too many people fall into the trap of declaring victory when they raise money. Raising money is just a means of selling your company with the right to buy it back (also known as borrowing, and you should be so lucky as to be able to borrow) or selling the company in big blocks at a time with no buy-back option, otherwise known as selling equity. It’s important to remember that raising funds is not a measure of success; it’s only a tool to achieve it. Money comes with a cost. Count that cost.
Many entrepreneurs say that getting investment in a company is a mixed blessing, and too much of it is often not a blessing at all. Anecdotally, it seems that bootstrapped companies often have a better chance of succeeding than companies that start out with all the money they need and more. Experience certainly says that money alone does not solve most problems or make companies grow. Too often, throwing money at a problem or opportunity ends up creating a lot of structure and process, wasteful spending on nonessentials, and precious little progress on the problem or opportunity. Money doesn’t solve problems; people solve problems with or without a lot of money. Money can make people complacent, even lazy. When it suddenly dries up, old habits are hard to unlearn, and time is short. The most important advice many entrepreneurs feel they can give is never to waste a dollar even if you can afford to. A business that has grown up living lean knows how to live when hard times come. It isn’t carrying a lot of extra baggage such as overbuilt overhead and impatient, panicky investors or, worse, dependent on continuing investment that often is shut off abruptly when times turn hard.
Occasionally there is an enterprise that can be started and built without infusions of cash from somewhere, but it doesn’t happen often. Starting up takes a lot of time and effort, but it especially takes resources. The start-up needs money for things such as prototyping, entering the market, building out capacity and inventory, and fueling expansion. Cash is the key focus in an early-stage enterprise, not profits. Businesses don’t fail when they are not profitable; they fail when they run out of cash.
There is a mountain of information in print and online on how to finance early-stage enterprises. Here we will only try to set out a useful framework, provide some guidance on resources so that you can learn more, and offer some advice on how to finance your enterprise in a way that best protects you and maximizes your chances of getting what you need. Financing is never an easy chore or one lightly taken on by anyone but the uninformed.
What do you need? Actually, you should always ask the question differently: “What do you really need”—as contrasted with “What would be ideal?” Financing is expensive, and the earlier the stage, the more expensive it is. What would you think if you went to a bank for a home loan and they wanted 20 percent interest? Interest is another way of talking about the rate of return (ROR) on money raised. Another term investors use is internal rate of return (IRR).
A target IRR of 20 percent can be low for seed and angel stage investing. Investors need those kinds of returns if their companies are successful because the risk that they will never get anything back is so high. The bank can foreclose and take your house if the loan sours. If a start-up fails, usually there is little or nothing to take back. The point? Early-stage investment is really, really expensive when you can get it at all, and finding money is almost always terribly time-consuming, in fact often all-consuming. In addition, early-stage money often comes with all sorts of strings, such as involvement by investors, which may be very valuable but can be counterproductive and frustrating. It’s not uncommon for investors to take control of a company from its founders and put it in other hands.
In light of the cost of early money, always try to take your venture as far as you can on as little as you can before you raise money. Remember risk versus valuation: The more risks you can take out of the venture by getting things done before you seek outside financing, the higher your chances of raising the money you need and the lower its cost. Staging investments as you reduce risk helps keep the cost of capital down. As you prove up a phase or eliminate a major risk, you can (one hopes) raise additional money on more attractive terms.
However, balanced against this is the fact that not only is early-stage money expensive and hard to get, it may not be available at all when you need it. Many investors and entrepreneurs say you should raise all you can when you can. Investment opportunities sometimes come in waves; suddenly a sector is all the fashion and money is flowing. You may find yourself with an opportunity to raise money when you may not feel you need it. Investor psychology can have a herd mentality to it. Enthusiasm and pessimism come in cycles, so learn to recognize when investors are hungry to invest in early-stage deals. Times like this, rare as they are, often mean raising money is easier (relatively), and valuations are often better as well. What to do? Raise money when you might not need it? Take more than you absolutely need? An angel investor friend of ours in the financial community often reminds entrepreneurs, “When cookies are passed, take a cookie.” Another friend describes the waves of enthusiasm in financing as water sloshing back and forth in a bathtub. “When it comes your way,” he says, “take all you can.”
In the end, this is another of those moments for judgment : Take more or less? Sooner or later? Circumstances determine, and you need to make the call, not the investors or common wisdom. There are few things less sensible than deciding to do something because everyone else is doing it. Have a solid work plan and budget tied to exactly what you need to hit the milestones you have defined. cost-effectiveness is always vital. Nothing can set up a company for failure faster than building a culture of wasting money, of spending more on anything than you really need to. Ravi Kalakota, author of E-Business: Roadmap for Success and founder of the failed online marketplace Hsupply.com, wishes he hadn’t burned through his venture capital investment so fast. He launched the company in March 1999, and when he closed down Hsupply.com in December 2000, the company had 90 employees and had spent $5 million. “We hired like crazy,” he said. “Don’t hire marketing people. The race is not to an IPO; it’s to build a sustainable business model.”1 Gail Goodman, founding CEO of Constant Contact, says the biggest thing she learned in building the company through some really tough times is, “No matter how much money you have, never waste a dollar.”2
You will always be worrying about where available cash will come from, or at least you should be. There is a progression of sources of cash that can be available at different stages of growth. Some sources are available at the beginning; some, such venture capital and banks, only when you are more developed. What are your funding choices?
1. You. This is sometimes called bootstrap financing, pulling yourself up by your own bootstraps. The National Federation of Independent Businesses found in one survey that 70 percent of small business owners started with less than $20,000.3
a. Some people max out as many credit cards as they can. Remember, though, that you have to pay back that money, and credit card interest is expensive. You may have savings or assets you can use to secure bank loans, but take care not to expose more than you are prepared to lose. Some founders work part- or full-time to pay their living costs and get money for a business. If this seems to be an option, be sure to take into account that there are only so many hours in the day; at some point making money to start a company can become a full-time demand and crowd out your ability to build the company.
b. Some companies, particularly in technology and IT, get consulting engagements to bring in dollars they can use to build the company. In this mode, strategies that generate cash quickly are a must. Pay attention to receivables and collections; slow-paying customers are a problem for any company but especially for a hand-to-mouth bootstrap. Some companies raise cash by borrowing against their accounts receivable (factoring), though this can be expensive. Some companies lease equipment and any other capital assets they can, until there is enough free cash that the economics of purchasing are better. Often they have an office at home or share offices with other companies.
c. Investors generally want to see that you are invested in your company, that you have “skin in the game.” Some want to see you put in everything you have first so that they know you are committed to making it work for you and them. We emphatically give other advice. You may need to invest some of your money in the early days—that’s almost inevitable—but don’t invest it all. Obviously, you should never put at risk more than you can stand to lose. But there’s another reason to hold back a significant portion of your powder. Almost invariably somewhere along the line to sustainability there will come a moment (or more than one) when you are down to the last dollars and there is nowhere to turn on short notice to bridge the gap. At that moment you may or may not want to go all in with the last of the dollars you allocated to the project, but if you have held some money back, you will be glad to have that option. We have seen more than one company make it past a tight spot that might have been fatal because it had held something in reserve for when it really needed it.
2. Customers are the single best source of cash. Sales are revenue; they don’t cost you equity or interest. Sometimes you can get customers to pay in advance for products or services you will develop and deliver later. For a long time this was a standard model in the software industry, though it’s not as common as it once was. Always test the chances that a customer will buy in advance. It’s the best cash and the best market validation all at the same time.
3. Family and friends are the most common source of first outside investment. This mixes relationship and money, always a dangerous proposition. The risk of losing an investment is highest at this stage. Valuations are often impossible to guess. Frequently, friends and family are inexperienced and trust you more than they should. Valuations often are way too high, causing problems in later financings. Fortunately, there is a mechanism to help with this; see the section below on convertible notes. A good rule: Never take an investment that you’re not prepared to face at the Thanksgiving dinner table when it’s gone sour. Friends and family should assume they will never see their investments again, and if that’s okay, maybe it’s safe to proceed … maybe !
4. Foundations and grants support research, especially in biomedical applications, and often bridge the funding gap between the end of basic science funding from organizations such as the National Institutes of Health and the National Science Foundation and money from venture capital or industry. If you are launching a social enterprise, foundations and grants are your main target. Chapter 14 covers social enterprises in detail.
5. Government programs often are a great source funding for early-stage companies. The Small Business Innovation Research (SBIR) Program is the best-known and one of the most important subsidies to small businesses in the country. It has invested over $16 billion in small businesses through 11 government agencies, including the Department of Defense, the National Institutes of Health, the National Science Foundation, the Department of Energy, and NASA. You can learn more at http://grants.nih.gov/grants/funding/sbirsttr_programs.htm.
a. There are a number of other federal programs, including Small Business Technology Transfer (STTR) grants; the Advanced Technology Program (ATP) at the National Institute of Standards and Technology; the guaranteed loan programs of the Small Business Administration; numerous contracts and grants from places such the departments of defense, agriculture, and energy; and new programs at the National Institutes of Health supporting translational research. Most states also have a variety of loan, grant, and investment programs to foster company formation and growth in their states. Occasionally there are state and federal tax credit programs that are attractive.
b. On the plus side, government funding is usually nondilutive, consisting of grants or contract work. However, most of those grants are competitive, meaning you must invest a lot of time in chasing them and have to take a chance that you’ll get the funding. There are often lots of restrictions on the use of funds, and there are almost always heavy reporting requirements.
6. Strategic partners are generally large companies that enter into financing and joint venture arrangements with start-ups to align a new opportunity with their current strategies, explore new opportunities, or complement current business lines or sometimes just for the financial returns in a business they understand. Several major technology companies have corporate venture capital groups charged with making early-stage investments. Some have mandates to stay within strategic connections to existing business lines of the company; some focus on financial returns. Usually there is at least a goal of leveraging the assets and resources of the company. Examples include funds at Intel, Cisco, Microsoft, Google, Amazon, and Johnson & Johnson. An online search will turn up directories and other listings of potential partners.
On the plus side, the start-up gains credibility and access to technical and market resources. On the minus side, big company processes can be time-consuming and frustrating. More important, a close association with a big company has significant implications for the future, when you may want to sell your company. At that time being so closely tied to a major player can be an impediment to getting other competitors interested in buying the company. Worse, strategic joint ventures or investments often carry preemptive rights in the event of a sale, and that can suppress your cash value. Still, sometimes partnering is the best way to launch a company at the beginning. It’s a judgment call between pay me now and pay me later.
7. Banks lend money at lower interest rates than other forms of early-stage investment; that would be good news except for the fact that banks don’t lend money to start companies. The reason banks lend at lower rates is that they take less risk of not getting paid back. Generally, they lend only to the extent that they can get pledges of assets whose value more than covers the amount owed. Start-ups generally have few or no securable assets.
Banks will lend against your personal assets, however, and many startup entrepreneurs guarantee loans to their companies or borrow on home equity lines to raise money. The Small Business Administration has programs of loans to small businesses that are placed through banks, but in almost all cases the borrower has to pledge assets against the borrowing and put in cash from another source as well. Even if you are not getting bank funding, you should always establish a good working relationship with a bank right from the start. Get an operating line of credit open as soon as you can and use it. At first it probably will have to be secured, but over time you may be able to get the security released or at least expand the line over the amount you have pledged as security. Lines of credit don’t solve all your financing needs, but they can be valuable cash management tools.
Perhaps the best-known sources of start-up funding are angels and venture capitalists.
Some people loosely use the term private equity synonymously with venture capital. Venture capitalists are a subset of the larger world of private equity, a tiny one at that. In terms of dollars under management, private equity is dominated by later-stage investment and buyout funds. Types of private equity include:
Leveraged buyout
Venture capital
Growth capital
Distressed and special situations
Mezzanine capital
Secondaries
Search funds
Real estate
Other strategies
In 2008 private equity as a whole had over $2.5 trillion under management. Venture capitalists in total represented about 0.8 percent of the industry. They raise capital in the high twenties to low thirties of billions of dollars per year, though they have been under significant stress since 2009. They invest in the twenties to thirties of billions annually in 3,000 to 4,000 transactions. None of the largest private equity firms, as measured in dollars under management, is a venture capital firm. Venture capitalists focus on early-growth to midgrowth stages, but some do invest seed capital. Table 12-1 shows venture capitalist investments by sector.4
Table 12-1 Venture Capital Investment by Sector in 20095
Apart from venture capitalists, private equity includes another major group of investors in start-up companies: wealthy individuals or groups of individuals known as angels. In an average year angels invest about the same amount of money as venture capital industry and participate in many more deals. Table 12-2 summarizes angel investments over a sample three-year period.
Table 12-2 Angel Investments for a Sample Three-Year Period
Many kinds of people are angels, including entrepreneurs, successful managers, and professionals in medicine, law, or finance. Often angels’ experience and networks can be as valuable as their money. Their level of expertise and experience varies widely, as does the time they will devote to being involved. As with anything involving people, get comfortable with your angels before taking their investments to avoid unhappy surprises. Because angel investments often involve substantial ownership positions and sometimes significant control rights, you want to see good compatibility and no potential for destructive micromanagement or worse.
Angels generally look for returns of 15 to 25 percent over five to seven years. No one wants to be paid back with interest and/or collect dividends; they expect a return of capital and profit through a sale, a merger for liquid stock, or an initial public offering (IPO). Historically, about 35 percent of angel investments end in acquisition, 27 percent in IPO, and 5 percent in a buyback; 32 percent are written off.6
There is substantial regulation around raising money privately from individuals under the Securities and Exchange Commission (SEC), as well as securities laws in all states in which securities are offered or sold. For example, under the Securities Act of 1933 the SEC’s Rule 501 requires that your angel investors be accredited. Accredited investors are defined as individuals who have a net worth of at least $1 million7 or an annual income of at least $200,000 in the most recent two years (or $300,000 combined income, including a spouse). There are extensive regulations and requirements for registering securities offered for sale to investors, but Section 4(2) of the Act provides an exemption for private offerings that meet certain requirements, including the amounts offered (up to $1 million, Rule 504; up to $5 million, Rule 505) and the number of accredited and sophisticated investors (Rule 506). In addition, SEC Rule 10b–5 prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.8 If you plan to solicit angels for investment—or anyone else for that matter, including friends and family—you must do your homework and be sure you have oversight from a knowledgeable attorney. Compliance failures can be lingering liabilities in the company and often are caught by investors’ attorneys during the due diligence associated with investment rounds, sales, or IPOs.
Some angels invest alone, and others cooperatively in groups. There are many ways to find them. Organized groups actively source deal flow. There are a number of resources to search for angels, including the Angel Capital Association and Inc.com’s Web site. Use your networks. Many professionals, including attorneys, accountants, finance professionals, and venture capitalists, know of angels and are often angels themselves.
Angels’ investment processes vary widely. Groups tend to be structured, with scheduled meetings and formal presentations. In these cases, if an investment is going to happen, generally at least one of the angels will step up to lead the investment and act as the primary interface with the company. Outside groups and solitary individuals may take a presentation from you or just want to have a conversation. As with any investors, the people factor dominates: the way they assess you and the team will dominate the investment decision.
Angels usually look to buy equity ownership in the company in return for their investment. Documenting an equity investment in a company is not a trivial undertaking and has to be done by attorneys. Since there are two parties involved, there will be at least two attorneys: one for the investor group and one for the company. Sometimes the individuals in the company also want personal legal advice and need a lawyer separate from the one advising the company. Conventionally, the company bears all the costs of legal work on the transaction for both the investors and the company. So legal bills can mount quickly, especially if you let the negotiation process run away with itself. When you are raising smaller amounts of money, the legal costs alone can eat up a significant fraction of the investment you just raised with your precious equity.
An alternative form of investment for early stages—friends and family and angels alike—is the convertible debt instrument, which helps with both the legal costs of closing and the difficulty of valuing the company. This is a simple document of no more than a few pages that often can be done from an attorney’s boilerplate. Essentially, the investors lend money to the company (not the founders personally), with the provision that at the next round of funding they will get the same kind of equity shares as the next-round investors but will pay a discount on the share price—or, what amounts to the same thing, get more shares for the same price—to compensate for the added risk they took by investing early. A sample term sheet for such a note might look something like Figure 12-1:
Figure 12-1 Sample convertible note term sheet.
The advantages of using a convertible note instead of equity include the following:
A simple note means much lower legal costs.
Since the debt amount is fixed, valuation of the company is deferred to a later time when the company has progressed, there is more information, and (presumably) professional investors are involved in the valuation.
Convertible notes permit repeated closings. Equity offerings generally have to be closed at one time or in no more than a small number of stages. Convertible notes can be written as often as you like over an extended period, letting you raise more money as you go.
Note holders are not shareholders and don’t automatically have legal rights to participate in shareholder decision making until the notes convert.
Doing notes reduces the number of classes of stock.
Notes offer early investors some protection from later investors. Holders of the notes will convert to the same class of stock issue as the next-round investors. Otherwise, investors in later rounds often insist on classes of stock that assert privileges not conferred on stock issues from earlier rounds.
Not all angels like convertible notes. They don’t like feeling that the step-up in value between their round and the next is capped at the share price discount. However, they avoid the risk of a down round, in which the valuation actually drops, or of seeing less than the fixed step-up in the next round. You can alleviate the “capping” objection by sweetening the offer with warrants, which give the investor the right for a period of time to buy a certain number of shares at a predetermined (low) price. A new model caps the funding amount in the next round so that even if the round raises more than the cap, the conversion is capped at the defined amount, meaning that the upside gets better the higher the valuation of the company above the cap. Still, some angels want the equity and the rights to participate in decision making in the company that go with owning shares. At the friends and family stage, convertible notes are definitely preferable, especially because they defer the dicey issue of pricing the company to a later round when it’s done more at arm’s length and presumably by experienced investors.
Often the involvement of angels, which comes along with their investment, can be one of the biggest advantages you get. Many angels invest for more reasons than just the money. They often say they remember people who helped them be successful along the way and look at investing as a way of giving back. Some invest to stay active and get involved in interesting things. Good angels can provide a wealth of experience, advice, networking, encouragement, and accountability that is often what a team needs to make the leap to effective and consistent execution.
Bob Molinari, Retrotope, Inc.
Bob Molinari specializes in biotechnology reagents, genomics, proteomics, and biopharmaceutical research. He is currently the founding CEO of Retrotope, Inc., focusing on isotopic control of diseases related to oxidative stress. He was the founding CEO of Coda Genomics/Verdezyne, a computational proteomics company, and the cofounding CEO and president of Protogene Laboratories, Inc., where he led the company to become the world’s largest supplier of custom DNA before it was acquired by Life Technologies, Inc. An active angel investor and start-up board member, Bob is on the biotech screening committee of the Bay Area Life Science Angels. He has this advice for raising angel investments:
Court potential investors who have built or managed companies in your industry or by using similar technology. Even if they don’t invest, if you impress them, they will lead you to the right knowledgeable investors.
Not even highly expert industry investors or organized angel groups respond to cold calling. Network aggressively for referrals to mentors and “smart money” investors. Go to industry events and work the room. If you can’t afford the events, meet people outside the conference rooms and chat them up. Get introductions. Generously reward people who help you with stock options; it’s the best way to incentivize them without using precious cash.
Don’t solicit all your friends and family for money under the terms you want. For one thing, this will fundamentally change the nature of your relationships whether you succeed or fail. Take this sort of investment only if the investors/friends honestly say they don’t believe your relationship will change if they lose everything they invest.
Angels often expect you to invest your own cash. Invest only what you can afford to lose. If you are investing your time, skill, and reputation and are forgoing a salary for sweat equity, you need at least some offsetting balance in your personal risk profile.
Finally, never, ever take “dumb money” simply because you can get people unfamiliar with your industry to invest at high prices. These investors will be the first to become disillusioned and will be no end of trouble if their expectations are not met.
In contrast to the unstructured world of angel investing, venture capitalists are experienced investment professionals who work in formal partnerships. These limited partnerships are organized to raise money from limited partner investors—generally foundations, endowments, pension funds, and wealthy individuals—and invest in early-stage companies. They make equity investments in young companies with the potential for rapid growth and exits at high multiples of their investment over a time horizon of 3 to 10 years. They raise money in discrete funds and then make 10 to 25 investments out of each fund over a period of a few years, assist in the development of the companies, and often facilitate the eventual sale, merger, or public offering of the companies. The investment model was created in the late 1950s mostly on the West Coast by a pioneering group of technology-focused investors, including Tom Perkins, Don Valentine, Arthur Rock, and Dick Kramlich, among others. A documentary film produced by the venture capitalist Paul Holland of Foundation Capital9 tells the story of the creation of this investment industry that went on to become one of the great engines of innovation in the last century, growing companies such as Intel, Apple, Cisco, Atari, Genentech, and Tandem.
Tuck’s Center for Private Equity and Entrepreneurship compares angels and venture capitalists in Table 12–310:
Table 12-3 Angels and Venture Capitalists Compared
A new sector has emerged within the venture community in recent years: the so-called social venture funds, which explicitly focus on a dual bottom line: doing well and doing good. For examples, check out the Silicon Valley Social Venture Fund (http://www.sv2.0rg/) and Grey Ghost Ventures (http://www.grayghostventures.com/), which invested in one of our Dartmouth start-ups, Pharmasecure. If you can make the argument that you are solving a social problem with your start-up and can do it in a way that harnesses the power of the for-profit motive, this can be an interesting alternative. To learn more, a good resource is the Social Enterprise Alliance (http://www.se-alliance.org/). A quick Web search will turn up many other resources.
Venture investors are highly selective. A typical venture firm’s deal “funnel” is depicted in Figure 12-2.
There are two key points in this figure:
1. To put it mildly, your odds of being funded by a venture capital firm are not high. As Warren Buffett says, no umpire will call a venture investor out on strikes. Investors can stand at the plate all day long looking for the perfect pitch before they swing.
2. Note the headings toward the top of the chart that show where venture firms source their deals. There is one important source missing: unsolicited submissions. A venture investor hardly ever evaluates an investment that comes in unsolicited. Investors want to come and find you or have you come by referral from someone they know and trust. Many have young associates who do nothing but source potential investments. The conclusion: If you want to be considered by a venture firm, get the best referrals you can from people it considers credible. Beware of finders: people who say they can get you funded for a fee, usually a few percentage points of the funds raised. Most venture capitalists don’t like having finders involved and don’t feel their fees represent a good use of invested funds.
In seeking venture funding, presenting to venture capitalists, and negotiating with them (should you be so fortunate), it helps to understand their investment strategy and psychology. First, think of the odds of success any early-stage investor faces. For an example, look at Table 12-4, in which the chances of success are almost laughably high.
Note: This was only an illustration. In reality, only six risk factors that are risky is a low number, and a 75 percent chance of success is completely unrealistic. At a 50 percent chance of success, the same six factors turn into a 1.6 percent overall chance of success! Of course, venture investors think they can do better than these odds by doing smart screening, seeing lots of deals, choosing carefully, and adding value afterward. Even so, they need a few big wins to get the 3:1 return on capital that produces the 25 percent internal rate of return (IRR) investors want. In a portfolio of 10 investments, for example, one may return 10 times the investment, a couple others return 5 times, maybe two return 2 or 3 times, and the rest break even or lose money. Basically, it’s those two or three big wins that make or break a fund.
Figure 12-2 A venture firm’s funnel
Table 12-4 Odds of Success for an Early-Stage Investor
What does this mean to you? First, the same old point: Early-stage money is expensive. Note that venture investors look for a return three times their money to be a 25 percent IRR, but that is a portfolio average, not what happens to the individual companies. A company that achieves a “modest win” has a 15 to 25 percent IRR, which is expensive enough, but the wins that carry the fund have a much higher IRR. That’s expensive money indeed. Imagine borrowing your capital at 40 or 50 percent interest.
Second, venture investors are not at the plate looking for a bunt or a single. They are looking to hit a home run on every investment. Because the risk is so high, they have to swing for the fences. That means they are looking for companies that will stretch and go for the home run, even if that means loading up on risk. The venture investors can stand the risk; they have 10 to 25 other deals to cover their risk, and only a few have to hit it big. For you, swinging for the fences means a chance of a high return but certainly high risk, and high risk means substantially higher risks of nothing—failure. If you think your chances are a lot better if you don’t aim so high, you may want to think twice about doing venture financing, assuming you have a strategy to get the funding needed to chase the more modest opportunity.
A last key point: Despite all the visibility and press they get, most businesses don’t raise money from venture capitalists. Not even angels are a dominant source of money to launch businesses. That honor falls to the entrepreneurs themselves and their friends and families.11
The list following gives more details about investments in early-stage businesses:
0–2 years (3 million ventures)
Founders: $200 billion
Family and friends: $70 billion
0–4 years (50,000 ventures)
Angels: $30 billion
0.5–4 years (799 ventures)
Venture capital: $4.4 billion
8 years (84 ventures)
IPOs: $8.4 billion
Some companies find closing early-stage investments a layup, but those are usually the teams that have done it before and made money for investors. For the rest it’s generally a long and frustrating process. An important first step is to do your homework about whom to approach. Whether angels or venture firms, the best investors know your space and are comfortable with it (but are not invested in a competitor), are good to work with, and can add value intangibly with their experience and contacts.
Once you have your targets, find the referral to them—no cold calling. In a presentation, play to their investment objectives (see above). For the investor, the exercise is always a matter of tension between greed and fear. Investors fear risk but need profits, and so your job is to allay fears of the risks with your proofs of concept, market validation, and competitive advantages and the quality of your team. Feed the hopes that they will make big profits.
Phil Ferneau, a founding partner of the venture firm Borealis Ventures and a professor of private equity at the Tuck School, offers this advice about presenting for investment:
Prepare the pitch; make it clear, concise, and compelling.
Pick your targets: not just the firm but the person.
Find the back door; get a referral.
Use time effectively; be prompt and flexible.
Get to the point; answer “So what?” up front.
Pique interest; get a next meeting.
Feed the dream; provide analogies.
Be honest; if you don’t know, say so and fix it.
Be poised and personable but persistent.
Often venture firms need multiple meetings to make a decision. Even if you have a partner who buys in early and sponsors you inside the firm, generally all the partners have to agree before they commit to an investment. Often venture investors send you back to the drawing board more than once to eliminate risk factors or develop some aspect of the company and then come back. At some point they may get serious enough to do extensive due diligence on you, which will be an exercise in close scrutiny of everything from technology or science to execution capabilities, customer opinions, rights to intellectual property, and other assets. If all goes well and they are still interested, they will offer you terms in a nonbinding term sheet. Once you agree, more due diligence will be done, including finances, legal agreements, site visits, and even a look at your corporate book.
How to value the company for the investment is almost always a big issue. This is the great valuation question: How much is the company worth now? The answer is: It depends. There are a number of ways to look at valuation, none of them much more than a pretext to disagree. Basically, it comes down to a tension between the golden rule (of capitalism, that is—“He who has the gold makes the rule”) and the fear of losing out on a great opportunity, especially to a competing firm. Unfortunately, the golden rule usually wins. Remember, investors don’t have to swing. No one will call them out on strikes.
The fundamental formula underlying equity investment is simple:
Pre-money valuation + new investment = post-money valuation
For example, a venture firm offers to invest $2 million in your company for equity at a pre-money valuation of $3 million. Once the investment is closed, the company has $2 million more in cash on its balance sheet and so is worth a post-money of $5 million, and the $2 million investment represents ownership of 40 percent of the company.
A number of factors figure into a valuation. You read about them in previous chapters:
Leadership/operating team/board.
Technology, IP, and know-how.
Growth potential and attractiveness of the market.
Sales growth (profitability comes later; venture investors want to see revenue growth with a later jump in net profits shortly before selling the company or taking it public).
Stage of development of products and sales revenue.
Financials—cash flow, profit and loss, balance sheet (often proprietorships and closely held companies will have accounting practices that are either less than ideal—see Chapter 19—or are skewing earnings downward for tax purposes, requiring add-backs to the profit and loss statement. These need to be cleaned up before due diligence).
Likely prospects going forward without investment (how badly do you need money now?).
Ability to attract future financing or otherwise cover cash needs.
Location. Some investors want companies close by, where the logistics of staying in touch are easy. Others are less concerned about this.
Note one thing that is not on the list: previous investment. Money raised in prior rounds and the valuations used in them are irrelevant. Investors have no reservations about pressing for a lower valuation than in a previous round—a down round—if the company has stumbled or the investment climate has changed. This means founders and employees may be taking a significant hit to their percentage ownership of the company. The same fate awaits previous investors, especially if they don’t participate in the new round. Worse, if you have agreed to nondilutive provisions with previous-round investors, a down round can be punishing.
When there is any financial information to work with, a number of valuation methods can be used:
Multiple of earnings or cash flow. Varies from sector to sector.
Multiple of revenue. Also varies by sector.
Discounted present value of future earnings. Can be run even on forecasts from companies that have no revenue yet, but it’s all fiction.
Comparables. Sometimes mergers and acquisitions transactions on comparable companies indicate what you might sell for in the future, which can be discounted back to the present.
Assets. Book value, replacement value, liquidation value.
Of course for companies with no revenue yet or those just getting into the market, none of these methods are worth the electrons it takes to calculate them. For the earliest-stage companies there are other guesses taken out of thin air:
Rule of thirds. One-third for founders, one-third for seed investors, one-third for employees. Normally investors insist that at closing the company reserve a pool for future employees—15 percent is the norm, with the rest of the third going to current employees, founders, and others.
Rule of one-half. Pre-money valuation = amount to be raised.
Point system:
$1 million for idea/opportunity
$1 million for working prototype
$1 million to $2 million for capable team/quality advisors
$1 million to $2 million for market validation
The most reliable method, when the information can be had, is the ‘look around you” method: What are investors paying to invest in comparable deals? In the end there is no right answer. The best driver for valuations is competition. If you are negotiating with only one investor or investor group, you’re not negotiating, you’re begging. Conclusion: The minute you think you have interest from one group, try to get another group interested too.
Perhaps the most important point on valuation: It’s not the most important point. Getting the best investor is more important than getting the highest valuation. Early-stage valuation is all a fiction anyway. Remember, in the end the value you take out of the company is a product of three factors: How much the company might end up being worth is one and your share in the company is another, but there is an all-important third: What’s the chance the company will ever amount to anything? This is called expected value:
Expected value = future value × your ownership share × chance of success
People chronically overlook the importance of the probabilities of success. Anything times zero is zero, and realistically, there is a significant probability that the chance of success is zero. You and your investors, with hard work, good judgment, and cooperation, can have the biggest effect on the chance of success. Actually, there are any number of scenarios for the future value of the company, each with its own probability. This is why focusing on who your investment partners are is more important than getting the best valuation now. An early-stage valuation is quickly mooted by what happens afterward, but the choice of investors lasts a long time, and helful investors can change the probabilities of success significantly.
An offer to invest typically comes in the form of a nonbinding term sheet. There are dozens of basic forms, and there is a veritable library of information in print and online describing term sheets: the terms they contain, what they mean, what you should seek and avoid. Term sheets are not binding, but they contain most of the major points in a transaction. Deal terms generally are negotiated and agreed on by using a term sheet before both sides invest major effort in due diligence and bring in the lawyers. It’s generally accepted that unless major adverse information is found during due diligence, the terms agreed stay agreed on once the lawyering starts. Good partners—meaning you and the investors—agree to reasonable terms that are fair to both sides and then stick to them. Speed bumps in this department are a good signal that you should consider other partners even if that means more working and waiting.
Most term sheets include most or all of the following:
Size of raise and price
Percent equity given for the investment; type of security (usually convertible preferred with a liquidation preference)
Dividend preference
Conversion rights
Antidilution and price protection
Voting rights
Participation rights (preemptive rights, or rights of first refusal, and rights to participate in a cosale with a founder or other holder)
Timing of money invested
Milestones for the company to achieve
Board, voting, and control issues, sometimes including the right to replace founders
Vesting schedules for management
Information and reporting rights
Registration rights (right to force the company to register with the SEC so that shares can be sold in the public markets) and drag-along or cosale rights
Rights to trigger a liquidity event and/or redemption rights (right to force the company to repurchase its stock at a future date)
Vesting, option pool for employees (15 percent is the norm)
No-shop/exclusivity provisions
Closing conditions and costs
Here are some last thoughts about looking for angel and venture capital money:
Remember, different investors want different things. Understand your investors, do your homework, and work with investors who can add value rather than just dollars. Implication: Getting a good deal means more than getting the best price.
Be persistent: Tempt greed, allay fears. Understand the terms and pick your fights. Implication: Value is not what you think it is; it’s what the market pays.
Pick the right investors for more than their money. Rely on character, not contracts. Implication: Good people will save you from bad contracts, but good contracts can’t save you from bad people.
“When people are free to do as they please, they usually imitate each other”12 Trends count. Investors generally run with the herd, because it’s easier to explain why you did what you did if most others were doing the same thing no matter how it comes out. Most investors feel they’re the contrarians finding the hidden value, but most of the time they’re being contrarians together. Know the trends and where you fit in relation to them.
Don’t look over the fence whether the grass there is greener or not. Some other company is always getting funding at a level that will mystify you. Life isn’t fair. Some people win lotteries; most don’t. Raising money is not synonymous with business success, and often the two do not correlate. Focus on building a solid business opportunity, remove risks to increase your value, work diligently for the investment you need, and let events take their course.
Investors respect entrepreneurs who understand that execution is what creates value. Get work done, build as much business as you can first, and then raise money. The farther advanced you are for the stage of funding you’re seeking, the better your chances of getting funded and the higher the valuation.
There’s an old saying: “Ask for money and you’ll get advice; ask for advice and you’ll get money.” Build your relationships and access to investors early, before you really want funding. Investors live on deal flow and like to build relationships with companies that show promise that they will be attractive opportunities to invest in for the future.
Like the Wizard of Oz sending Dorothy for just “one more little thing”—the Wicked Witch’s broomstick—investors often send you away for one more difficult thing after another. It’s only natural: Each risk they can get you to eliminate without risking their money, the better the deal looks to them. The best way to drive this process to an offer is always a tough question. You often have to force a deal to happen. Competition and wanting to get a deal moving faster are the most common drivers to a term sheet.
The investors are always right even when they aren’t. Jonathan Swift reportedly once said, “It’s useless to reason a man out of something he was never reasoned into.” That’s certainly true when it comes to talking with investors. Investing is more an emotional and experience-based process than a coldly analytical one. Often prejudices, rumors, and the sum of past experiences leave investors with a negative mindset that seems completely incomprehensible. It doesn’t matter. Often they haven’t based their opinions on the facts, certainly not the facts you have presented. It’s useless to reason a man out of something he was never reasoned into, so don’t try.
It’s not called capitalism for nothing. Launching a company without investment is just about impossible in our economy. If you’re lucky, it won’t take a lot, and if you’re very lucky, you have the funds yourself or have them among your friends and family. If you do not, raising money is a critical part of the job of the start-up entrepreneur, one of the hardest, and often it never ends. Still, the discipline of the investment marketplace is one of the great producers of fitness, and in reality it’s a great resource for you. Investors may not always be right, but because they are responsible for lots of other people’s money, they always try very hard to be right. You do that too, presumably, so take full advantage of this powerful asset of our economy as you figure out what it will take to make you successful.
How much can you get done on your own money or other noninvestment sources?
When do you think you must have investment? What kind? From whom?
What forms of investment might be acceptable to you? How realistic are you being about that?
How long can you go before you run out of the money you plan to raise?
1. Gilbert, Alorie, “Lessons Learned from Failure,” Information Week 817 (December 18–25, 2000): 111.
2. Gail Goodman, in a DEN-Boston event, “The Constant Contact ‘Adventure’ from Startup to IPO—A Candid Conversation about Entrepreneurs, Venture Capitalists, and Boards of Directors.” November 28, 2007
3. Dennis, William J., “Business Starts and Stops,” Wells Fargo-NFIB Education Foundation Series, November 1999.
4. Venture capitalists like markets with a lot of change or growth and prefer technology to consumer goods and manufacturing sectors.
5. Source: Center for Study of Income and Productivity, Federal Reserve Bank of San Francisco, “Venture Capital, VC Investments,” Data and Charting, http://www.frbsf.org/csip/data/php.
6. Bygrave, William D., and Andrew Zacharakas, The Portable MBA in Entrepreneurship (Hoboken, NJ: Wiley, 2010): 194.
7. The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law on July 21, 2010. It contained a provision in which the net worth test remained $1 million but required the SEC to issue a regulation excluding the value of the investor’s primary residence in the calculation of net worth. In addition, the act requires the SEC to review the accredited investor definition not earlier than four years after enactment and at least once every four years thereafter.
8. Codified at 17 C.F.R. § 240.10b–5, accessible at http://ecfr.gpoaccess.gov/cgi/t/text/text-idx?c=ecfr&sid=958fa2ab168a6d7b5dd6044510616ca0&rgn=div8&view=text&node=17:3.0.1.1.1.1.57.71&idno=17.
9. More Than Money: The Untold Tale of Risk, Reward and the Original Venture Capitalists, www.morethanmoneymovie.com Directed by Dan Geller and Dayna Goldfine, produced by Paul Holland of Foundation Capital and Molly Davis of Rainmaker Communications. (Paul Holland was one of the early investors in EnerNOC, Inc., featured in Chapters 8 and 22.)
10. Wainwright, Fred, and Angela Groeninger, “Note on Angel Investing,” Tuck Center for Private Equity and Entrepreneurship, Case #5–0001, January 10, 2005.
11. Bygrave and Zacharakas, 2010: 185.
12. Hoffer, Eric. The Passionate State of Mind. (New York: HarperCollins, 1954).
