CHAPTER 2
How to Raise Money
Your goal when you are raising a round of financing should be to get several term sheets. While we have plenty of suggestions, there is no single way to do this, as financings come together in lots of different ways. VCs are not a homogeneous group; what might impress one VC might turn off another. Although we know what works for us and for our firm, each firm is different; so make sure you know who you are dealing with, what their approach is, and what kind of material they need during the fund-raising process. Following are some basic but by no means complete rules of the road, along with some things that you shouldn't do.
Do or Do Not; There Is No Try
In addition to being a small, green, hairy puppet, Yoda was a wise man. His seminal statement to young Luke Skywalker is one we believe every entrepreneur should internalize before hitting the fund-raising trail. You must have the mind-set that you will succeed on your quest.
When we meet people who say they are “trying to raise money,” “testing the waters,” or “exploring different options,” this not only is a turnoff, but also often shows they've not had much success. Start with an attitude of presuming success. If you don’t, investors will smell this uncertainty on you; it'll permeate your words and actions.
Not all entrepreneurs will succeed when they go out to raise a financing. Failure is a key part of entrepreneurship, but, as with many things in life, attitude impacts outcome and this is one of those cases.
Determine How Much You Are Raising
Before you hit the road, figure out how much money you are going to raise. This will impact your choice of those you speak to in the process. For instance, if you are raising a $500,000 seed round, you'll talk to angel investors, seed stage VCs, super angels, micro VCs, and early stage investors, including ones from very large VC funds. However, if you are going out to raise $10 million, you should start with larger VC firms since you'll need a lead investor who can write at least a $5 million check.
While you can create complex financial models that determine that you need a specific amount of capital down to the penny to become cash flow positive, we know one thing with 100 percent certainty: these models will be wrong. Instead, focus on a length of time you want to fund your company to get to the next meaningful milestone. If you are just starting out, how long will it take you to ship your first product? Or, if you have a product in the market, how long will it take to get to a certain number of users or a specific revenue amount? Then, assume no revenue growth; what is the monthly spend (or total burn rate) that you need to get to this point? If you are starting out and think it'll take six months to get a product to market with a team of eight people, you can quickly estimate that you'll spend around $100,000 per month for six months. Give yourself some time cushion (say, a year) and raise $1 million, since it'll take you a few months to ramp up to a $100,000-per-month burn rate.
The length of time you need varies dramatically by business. In a seed stage software company, you should be able to make real progress in around a year. If you are trying to get a drug approved by the Food and Drug Administration (FDA), you'll need at least several years. Don't obsess about getting this exactly right—as with your financial model, it's likely wrong (or approximate at best). Just make sure you have enough cash to get to a clear point of demonstrable success. That said, be careful not to overspecify the milestones that you are going to achieve—you don't want them showing up in your financing documents as specific milestones that you have to attain.
Be careful not to go out asking for an amount that is larger than you need, since one of the worst positions you can be in during a financing is to have investors interested, but be too far short of your goal. For example, assume you are a seed stage company that needs $500,000 but you go out looking for $1 million. One of the questions that the VCs and angels you meet with will probably ask you is: “How much money do you have committed to the round?” If you answer with “I have $250,000 committed,” a typical angel may feel you're never going to get there and will hold back on engaging just based on the status of your financing. However, being able to say “I'm at $400,000 on a $500,000 raise and we've got room for one or two more investors” is a powerful statement to a prospective angel investor since most investors love to be part of an oversubscribed round.
Finally, we don't believe in ranges in the fund-raising process. When someone says they are raising $5 million to $7 million, our first question is: “Is it $5 million or $7 million?” Though it might feel comfortable to offer up a range in case you can't get to the high end of it, presumably you want to raise at least the low number. The range makes it appear like you are hedging your bets or that you haven't thought hard about how much money you actually need to raise. Instead, we always recommend stating that you are raising a specific number, and then, when you have more investor demand than you can handle, you can always raise more.
Fund-Raising Materials
While the exact fund-raising materials you will need can vary widely by VC, there are a few basic things that you should create before you hit the fund-raising trail. At the minimum, you need a short description of your business, an executive summary, and a presentation that is often not so fondly referred to as “a PowerPoint.” Some investors will ask for a business plan or a private placement memorandum (PPM); this is more common in later stage investments.
Once upon a time, physical form seemed to matter. In the 1980s, elaborate business plans were professionally printed at the corner copy shop and mailed out. Today, virtually all materials are sent via email. Quality still matters a lot, but it's usually in substance with appropriate form. Don't overdesign your information—we can't tell you the number of times we've gotten a highly stylized executive summary that was organized in such a way as to be visually appealing, yet completely lacking in substance. Focus on the content while making the presentation solid.
Finally, while never required, many investors (such as us) respond to things we can play with, so even if you are a very early stage company, a prototype, or demo is desirable.
Short Description of Your Business
You'll need a few paragraphs that you can email, often called the elevator pitch, meaning you should be able to give it during the length of time it takes for an elevator to go from the first floor to your prospective investor's office. Don't confuse this with the executive summary, which we discuss next; rather, this is between one and three paragraphs that describe the product, the team, and the business very directly. It doesn't need to be a separate document that you attach to an email; this is the bulk of the email, often wrapped with an introductory paragraph, especially if you know the person or are being referred to the person, and a concluding paragraph with a very clear request for whatever next step you want.
Executive Summary
The executive summary is a one- to three-page description of your idea, product, team, and business. It's a short, concise, well-written document that is the first substantive document and interaction you'll likely have with a prospective investor with whom you don't have a preexisting relationship. Think of the executive summary as the basis for your first impression, and expect it to be passed around within a VC firm if there's any interest in what you are doing.
Work hard on the executive summary—the more substance you can pack into this short document, the more a VC will believe that you have thought critically about your business. It also is a direct indication of your communication skills. A poorly written summary that leaves out key pieces of information will cause the VC to assume that you haven't thought deeply about some important issues or that you are trying to hide bad facts about the business.
In the summary, include the problem you are solving and why it's important to solve. Explain why your product is awesome, why it's better than what currently exists, and why your team is the right one to pursue it. End with some high-level financial data to show that you have aggressive, but sensible expectations about how your business will perform over time.
Your first communication with a VC is often an introductory email, either from you or from someone referring you to the VC, that is a combination of the short description of your business along with the executive summary attached to the email. If your first interaction was a face-to-face meeting either at a conference, at a coffee shop, or in an elevator, if a VC is interested he'll often say something like “Can you send me an executive summary?” Do this the same day that it is requested of you to start to build momentum to the next step in the process.
Presentation
Once you've engaged with a VC firm, you'll quickly be asked either to give or to email a presentation. This is usually a 10- to 20-page PowerPoint presentation consisting of a substantive overview of your business. There are many different presentation styles and approaches, and what you need will depend on the audience (one person, a VC partnership, or 500 people at an investor day type of event). Your goal with the presentation is to communicate the same information as the executive summary, but using a visual presentation.
Over time, a number of different presentation styles have em-erged. A three-minute presentation at a local pitch event is just as different from an eight-minute presentation at an accelerator's investor day as it is from a 30-minute presentation to a VC partnership. Recognize your audience and tune your presentation to them. Realize also that the deck you email as an overview can be different from the one you present, even if you are covering similar material.
Regardless, spend time on the presentation flow and format. In this case, form matters a great deal—it's amazing how much more positive a response is to well-designed and well-organized slides, especially if you have a consumer-facing product where user experience will matter a lot for its success. If you don't have a good designer on your team, find a friend who is a freelance designer to help you turn your presentation into something visually appealing. It will pay off many times over.
Business Plan
We haven't read a business plan in over 20 years. Sure, we still get plenty of them, but it is not something we care about as we invest in areas we know well, and as a result we much prefer demos and live interactions. Fortunately, most business plans arrive in email these days, so they are easy enough to ignore since one doesn't have to physically touch them. However, realize that some VCs care a lot about seeing a business plan, regardless of the current view by many people that a business plan is an obsolete document.
The business plan is usually a 30-ish-page document that has all sorts of sections and is something you would learn to write if you went to business school. It goes into great detail about all facets of the business, expanding on the executive summary to have comprehensive sections about the market, product, target customer, go-to-market strategy, team, and financials.
While we think business plans prepared specifically for fund-raising are a waste of time, we still believe that they are a valuable document for entrepreneurs to write while they are formulating their business. There are lots of different approaches today, including many that are user- or customer-centric, but the discipline of writing down what you are thinking, your hypotheses about your business, and what you believe will happen is still very useful.
Now, we aren't talking about a conventional business plan, although this can be a useful approach. Rather, if you are a software company, consider some variant of the Lean Startup methodology that includes the creation, launch, and testing of a minimum viable product as a starting point. Or, rather than writing an extensive document, use PowerPoint to organize your thoughts into clear sections, although recognize this is very different from the presentation you are going to give potential investors.
Regardless, you will occasionally be asked for a business plan. Be prepared for this and know how you plan to respond, along with what you will provide, if and when this comes up.
Private Placement Memorandum
A private placement memorandum (PPM) is essentially a traditional business plan wrapped in legal disclaimers that are often as long as the plan itself is. It's time-consuming and expensive to prepare, and you get the privilege of paying lawyers thousands of dollars to proofread the document and provide a bunch of legal boilerplate to ensure you don't say anything that you could get sued for later.
Normally PPMs are generated only when investment bankers are involved and are fund-raising from large entities and banks that demand a PPM. That being said, we've seen plenty of early stage companies hire bankers and draft PPMs. To us, this is a waste of money and time. When we see an email from a banker sending us a PPM for an early stage company, we automatically know that investment opportunity isn't for us and almost always toss it in the circular file.
Our view is that if an early stage company has hired a banker to help with fund-raising, either it has been unsuccessful in its attempt to raise money and is hoping the banker can help it in a last-ditch effort or it is getting bad advice from its advisers (who may be the ones making a fee from marketing the deal via the PPM). While many later stage investors like to look at all the stuff they get from investment bankers, we generally think this is a pretty weak approach for an early stage company.
Detailed Financial Model
The only thing that we know about financial predictions of startups is that 100 percent of them are wrong. If you can predict the future accurately, we have a few suggestions for other things you could be doing besides starting a risky early stage company. Furthermore, the earlier stage the startup, the less accurate any predications will be. While we know you can't predict your revenue with any degree of accuracy (although we are always very pleased in that rare case where revenue starts earlier and grows faster than expected), the expense side of your financial plan is very instructive as to how you think about the business.
You can't predict your revenue with any level of precision, but you should be able to manage your expenses exactly to plan. Your financials will mean different things to different investors. In our case, we focus on two things: (1) the assumptions underlying the revenue forecast (which we don't need a spreadsheet for—we'd rather just talk about them) and (2) the monthly burn rate or cash consumption of the business. Since your revenue forecast will be wrong, your cash flow forecast will be wrong. However, if you are an effective manager, you'll know how to budget for this by focusing on lagging your increase in cash spend behind your expected growth in revenue.
Other VCs are much more spreadsheet driven. Some firms (usually those with associates) may go so far as to perform discounted cash flow analysis to determine the value of your business. Some will look at every line item and study it in detail. Others will focus much less on all the details, but focus on certain things that matter to them. For instance, what is your head count over the next few quarters and how fast do you expect to acquire users/customers? Although none of us know your business better than you do, VCs are in the business of pattern recognition and will apply their experience and frame of reference to your financial model as they evaluate how well you understand the financial dynamics of your business.
The Demo
Most VCs love demos. In the 48 hours before we wrote this section we got to play with an industrial robot, wear a device that tracked our anxiety level, interact with software that measured the number of times we smiled while we watched a video, saw a projection system that worked on curved walls with incredible fidelity, and played around with a Web service that figured out the news we were interested in based on a new approach to leveraging our social graphs. We learned more from the demos, especially about our emotional interest in the products we played with, than any document could communicate. Each of these demos also gave us a chance to talk directly to the entrepreneurs about how they thought about their current and future products, and we got a clear read of the enthusiasm and passion of the entrepreneurs for what they are working on.
We believe the demo, a prototype, or an alpha is far more important than a business plan or financial model for a very early stage company. The demo shows us your vision in a way we can interact with. More important, it shows us that you can build something and then show it off. We expect demos to be underfeatured, to be rough around the edges, and to crash. We know that you'll probably throw away the demo on the way to a final product and what we are investing in will evolve a lot. But, like 14-year-old boys, we just want to play.
Demos are just as important in existing companies. If you have a complex product, figure out a way to show it off in a short period of time. We don't need to see every feature; use your demo to tell us a story about the problem your product addresses. And give us the steering wheel—we want to play with the demo, not just be passive observers. While we are playing, watch us carefully because you'll learn an enormous amount about us in that brief period of time while you see how comfortable we are, whether our eyes light up, and whether we really understand what you are pursuing.
Due Diligence Materials
As you go further down the financing path, VCs will ask for additional information. If a VC firm offers you a term sheet, expect its lawyers to ask you for a bunch of things such as capitalization tables, contracts and material agreements, employment agreements, and board meeting minutes. The list of documents requested during the formal due diligence process (usually after signing of the term sheet, but not always) can be long. For an example, see the “Resources” page on AsktheVC.com. The number of documents you will actually have will depend on how long you have been in business. Even if you are a young company just starting up, we recommend that before you go out to raise money you organize all of these documents for quick delivery to a potential funding partner so you don't slow down the process when they ask for them.
Keep in mind that you should never try to hide anything with any of these fund-raising materials. Although you are trying to present your company in the best light possible, you want to make sure any issues you have are clearly disclosed. Deal with any messy stuff up front, and if a VC forgets to ask for something early on, assume you will be asked for it before the deal is done. If you happen to get something past a VC and get funded, it will eventually come out that you weren't completely transparent and your relationship will suffer. A good VC will respect full disclosure early on and, if they are interested in working with you, will actively engage to help you get through any challenges you have, or at least give you feedback on why there are showstoppers that you have to clear up before you raise money.
Finding the Right VC
The best way to find the perfect VC is to ask your friends and other entrepreneurs. They can give you unfiltered data about which VCs they've enjoyed working with and who have helped build their businesses. It's also the most efficient approach, since an introduction to a VC from an entrepreneur who knows both you and the VC is always more effective than you sending a cold email to vcname@vcfirm.com.
But what should you do if you don't have a large network for this? Back in the early days of venture capital, it was very hard to locate even the contact information for a VC and you rarely found them in the yellow pages, not even next to the folks that give payday loans. Today, VCs have web sites, blog, tweet endlessly, and even list their email addresses on their web sites.
Entrepreneurs can discover a lot of information about their potential future VC partner well beyond the mundane contact information. You'll be able to discover what types of companies they invest in, what stage of growth they prefer to invest in, past successes, failures, approaches and strategies (at least their marketing approach), and bios on the key personnel at the firm.
If the VC has a social media presence, you'll be able to take all of that information and infer things like their hobbies, theories on investing, beer they drink, instrument they play, and type of building or facility—such as a bathroom—they like to endow at their local universities. If you follow them on Foursquare, you can even figure out what kind of food they like to eat.
While it may seem obvious, engaging a VC that you don't know via social media can be useful as a starting point to develop a relationship. In addition to the ego gratification of having a lot of Twitter followers, you'll start to develop an impression and, more important, a relationship if you comment thoughtfully on blog posts the VC writes. It doesn't have to be all business—engage at a personal level, offer suggestions, interact, and follow the best rule of developing relationships, which is to “give more than you get.” And never forget the simple notion that if you want money, ask for advice.
Do your homework. When we get business plans from medical tech companies or somebody insisting we sign a nondisclosure agreement (NDA) before we review a business plan, we know that they did absolutely zero research on our firm or us before they sent us the information. At best, the submission doesn't rise to the top compared to more thoughtful correspondences, and at worst it doesn't even elicit a response from us.
A typical VC gets thousands of inquiries a year. The vast majority of these requests are from people that the VC has never met and with whom the VC has no relationship. Improve your chances of having VCs respond to you by researching them, getting a referral to them, and engaging with them in whatever way they seem to be interested in.
Finally, don't forget this works both ways. You may have a super-hot deal and as a result have your pick of VCs to fund your company. Do your homework and find out who will be most helpful to your success, has a temperament and style that will be compatible with yours, and will ultimately be your best long-term partner.
Finding a Lead VC
Assuming that you are talking with multiple potential investors, you can generally categorize them into one of three groups: leaders, followers, and everyone else. It's important to know how to interact with each of these groups. If not, you not only will waste a lot of your time, but also might be unsuccessful in your fund-raising mission.
Your goal is to find a lead VC. This is the firm that is going to put down the term sheet, take a leadership role in driving to a financing, and likely be your most active new investor. It's possible to have co-leads (usually two, occasionally three) in a financing. It's also desirable to have more than one lead VC competing to lead your deal, without them knowing whom else you are talking to.
As you meet with potential VCs, you'll get one of four typical vibes. First is the VC who clearly is interested and wants to lead. Next is the VC who isn't interested and passes. These are the easy ones—engage aggressively with the ones who want to lead and don't worry about the ones who pass.
The other two categories—the “maybe” and the “slow no”—are the hardest to deal with. The “maybe” seems interested, but doesn't really step up his level of engagement. This VC seems to be hanging around, waiting to see if there's any interest in your deal. Keep this person warm by continually meeting and communicating with him, but realize that this VC is not going to catalyze your investment. However, as your deal comes together with a lead, this VC is a great one to bring into the mix if you want to put a syndicate of several firms together.
The “slow no” is the hardest to figure out. These VCs never actually say no, but are completely in react mode. They'll occasionally respond when you reach out to them, but there is no perceived forward motion on their part. You always feel like you are pushing on a rope—there's a little resistance but nothing ever really moves anywhere. We recommend you think of these VCs as a “no” and don't continue to spend time with them.
How VCs Decide to Invest
Let's explore how VCs decide to invest in a company and what the process normally looks like. All VCs are different, so these are generalizations, but more or less reflect the way that VCs make their decisions.
The way that you get connected to a particular VC affects the process that you go through. Some VCs will fund only entrepreneurs with whom they have a prior connection. Other VCs prefer to be introduced to entrepreneurs by other VCs. Some VCs invest only in seasoned entrepreneurs and avoid working with first-time entrepreneurs, whereas others, like us, will fund entrepreneurs of all ages and experience and will try to be responsive to anyone who contacts us. Whatever the case is, you should determine quickly if you reached a particular VC through his preferred channel or you are swimming upstream from the beginning.
Next, you should understand the role of the person within the VC firm who is your primary connection. If an associate reached out to you via email, consider that his job is to scour the universe looking for deals, but that the associate probably doesn't have any real pull to get a deal done. It doesn't mean that you shouldn't meet with him, but also don't get overly excited until there is a general partner or managing director at the firm paying attention to and spending real time with you.
Your first few interactions with a VC firm will vary widely depending on the firm's style and who your initial contact is. However, at some point it will be apparent that the VC has more than a passing interest in exploring an investment in you and will begin a process often known as due diligence. This isn't a formal legal or technical diligence; rather it's code for “I'm taking my exploration to the next level.”
You can learn a lot about the attitude and culture of a VC firm by the way it conducts its diligence. For example, if you are raising your first round of financing and you have no revenue and no product, a VC who asks for a five-year detailed financial projection and then proceeds to hammer you on the numbers is probably not someone who has a lot of experience or comfort making early stage investments. As mentioned before, we believe the only thing that can be known about a prerevenue company's financial projections is that they are wrong.
During this phase, a VC will ask for a lot of things, such as presentations, projections, customer pipeline or targets, development plan, competitive analysis, and team bios. This is all normal. In some cases the VCs will be mellow and accept what you've already created in anticipation of the financing. In other cases, they'll make you run around like a headless chicken and create a lot of busywork for you. In either case, before you jump through hoops providing this information, again make sure a partner-level person (usually a managing director or general partner) is involved and that you aren't just the object of a fishing expedition by an associate.
While the VC firm goes through its diligence process on you, we suggest you return the favor and ask for things like introductions to other founders they've backed. Nothing is as illuminating as a discussion with other entrepreneurs who've worked with your potential investor. Don't be afraid to ask for entrepreneurs the VC has backed whose companies haven't worked out. Since you should expect that a good VC will ask around about you, don't be afraid to ask other entrepreneurs what they think of the VC.
You'll go through multiple meetings, emails, phone calls, and more meetings. You may meet other members of the firm or you may not. You may end up going to the VC's offices to present to the entire partnership on a Monday, a tradition known by many firms as the Monday partner meeting. In other cases, as with our firm, if things are heating up you'll meet with each of the partners relatively early in the process in one-on-one or group settings.
As the process unfolds, either you'll continue to work with the VC in exploring the opportunity or the VC will start slowing down the pace of communication. Be very wary of the VC who is hot on your company, then warm, then cold, but never really says no. While some VCs are quick to say no when they lose interest, many VCs don't say no because either they don't see a reason to, they want to keep their options open, they are unwilling to affirmatively pass on a deal because they don't want to have to shut the door, or they are just plain impolite and disrespectful to the entrepreneur.
Ultimately VCs will decide to invest or not invest. If they do, the next step in the process is for them to issue a term sheet.
Closing the Deal
The most important part of all of the fund-raising process is to close the deal, raise the money, and get back to running your business. How do you actually close the deal?
Separate it into two activities: the first is the signing of the term sheet and the second is signing the definitive documents and getting the cash. This book is primarily about getting a term sheet signed. In our experience, most executed term sheets result in a financing that closes. Reputable VCs can't afford to have term sheets signed and then not follow through; otherwise they don't remain reputable for long.
The most likely situations that derail financings are when VCs find unexpected bad facts about the company after term sheet signing. You should assume that a signed term sheet will lead to money in the bank as long as there are no smoking guns in your company's past, the investor is a professional one, and you don't do anything stupid in the definitive document drafting process.
The second part of closing the deal is the process of drafting the definitive agreements. Generally, the lawyers do most of the heavy lifting here. They will take the term sheet and start to negotiate the 100-plus pages of documentation that are generated from the term sheet. In the best-case scenario, you respond to due diligence requests and one day you are told to sign some documents. The next thing you know, you have money in the bank and a new board member you are excited to work with.
In the worst case, however, the deal blows up. Or perhaps the deal closes, but there are hard feelings left on both sides. As we restate in several parts of this book, always make sure that you are keeping tabs on the process. Don't let the lawyers behave poorly, as this will only injure the future relationship between you and your investor. Make sure that you are responsive with requests, and never assume that because your lawyer is angry and says the other side is horrible/stupid/evil/worthless that the VC even has a clue what is going on. Many times, we've seen the legal teams get completely tied up on an issue and want to kill each other when neither the entrepreneur nor the VC even cared about the issue or had any notion that there was a dustup over the issue. Before you get emotional, just place a simple phone call or send an email to the VC and see what the real story is.