The Fundraising Rules

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Author’s Note

Acknowledgements

Disclaimer

 

CHAPTER 1: Background on Venture Capital

The VC Biz

Behind the Scenes

The Exit

CHAPTER 2: Developing a Fundraising Strategy

Big Picture

Overview of Fundraising Stages

Picking the Right Type of Capital

Additional Capital

Concerns & Sources

Your Target Structure

Your Process

CHAPTER 3: Picking The VCs

Finding the Fit

Implications of How a VC is Funded

CHAPTER 4: Preparing Your Materials

You Only Need Three Documents

The Bait

The Presentation

The How

CHAPTER 5: The Pre-Fundraising Process

Get Tactical Before You Get Started

CHAPTER 6: Getting the Meeting

The Approach

What To Expect

Why You Might Get Dinged

Handling Getting Dinged

 

CHAPTER 7: The First Meeting

What To Do in the First Meeting

What VCs Will Be Watching For

VC Presentation Tips

What Not To Do in the First Meeting

How to End the Meeting

CHAPTER 8: After the First Meeting

What Happens Next

If Interest is Not Immediate

Your Next Moves

CHAPTER 9: The Due Diligence Phase

Diligencing You

Diligencing the VC

CHAPTER 10: Doing the Deal

How Deals Get Done

 

CHAPTER 11: Deal Terms: Rights To Future Cash

Valuation

The Cap Table

Preferred Stock

Other Terms

CHAPTER 12: Deal Terms: Control

Governance

Keeping Founders Around

Other Considerations

After the Deal

The VC: Your New Partner

 

Recommended Blogs

Author’s Note

 

SINCE BECOMING A VENTURE CAPITALIST, I have been in awe of the many talented visionaries who have come in to pitch world-changing ideas. Many of these entrepreneurs are world-class business athletes and jacks of nearly every business trade. They’re competent in product development, sales, marketing, finance, strategy and management, making them uniquely capable of weaving concepts and resources into a sustainable business.

 

What is shocking to me, however, is that many of the world’s best entrepreneurs are bad at fundraising. At first, I didn’t understand why, since the skills used in fundraising are many of the same skills used to create businesses. Over time, however, the reason these athletes underperform became clear. They don’t possess a fundamental understanding of the fundraising process. They have the skills, but not the knowledge.

 

To take a step back, I would argue that it’s not the fault of these entrepreneurs. Although they can easily evaluate the markets in which they want to launch their ventures, accessing the internal workings of these enigmatic investment institutions is not as easy. The only way to understand the inner workings of a venture fund is to become a venture capitalist, or to experience the fundraising

process first-hand, multiple times, leaving even the best entrepreneurs to flail through their first few rounds.

 

My mission in writing this book is to illuminate the fundraising process so that engaging these venture capitalists is no longer like walking in the dark.

 

I will provide a detailed account of both the key steps in fundraising and the rationale behind them. The information should help entrepreneurs see through the eyes of the venture capital investor, enabling them to better understand motivations of investors and how best to engage them.

 

While this book does not cover every nuance of the process – entrepreneurs who read this will surely still tread over unexpected ground – this book should help them understand the lay of the land, significantly reducing the number of surprises.

 

While I believe that this book will be useful for entrepreneurs engaging in raising their second or third round of capital, it is primarily designed to assist entrepreneurs seeking their Seed or Series A investment, as they should accumulate a board of experienced investors thereafter which can help them negotiate future capital raises.

I do not view this book as a betrayal of the arcane art of venture investing. Rather, I hope that this tool will make the life of a venture investor easier. Entrepreneurs who understand the fundraising process are more likely to be prepared to answer questions investors will have, provide the materials that investors require and facilitate the process more effectively. In sum, it is my hope that this guide will simplify the role of the investors, taking some of the friction out of the process.

 

My intended audience for this book is the entrepreneur. There are, however, other groups that may find this helpful. Aspiring VCs may use this document to understand many of the nuances of the venture investment process, while agents for startup companies may also be more prepared to serve their clients having digested the knowledge herein.

 

Lastly, this book is written for all skill levels. I attempted to cover most of the topics that an entrepreneur should understand, regardless of how basic the topic may be, to ensure that new entrepreneurs are able to find the foundational information required to prepare for this process. As a result, more experienced entrepreneurs may find that some sections of this book cover topics they already understand. For this reason, I arranged the topics covered into discrete sections, enabling experienced entrepreneurs to quickly navigate to sections of interest, avoiding the more mundane. Furthermore, this structure ensures that this

reference guide can quickly be leveraged to find key information as it becomes relevant to entrepreneurs throughout their fundraising endeavors.

 

Lastly, to the entrepreneur reading this: Go get ‘em.

Acknowledgements

 

I am indebted to my closest VC mentors, the inspirational Jed Katz and the wise Thatcher Bell, for their guidance and support throughout this endeavor. They provided me with numerous topics, context and spellchecking – without which, this would not have been possible (or coherent).

 

This book also owes its existence to the managerial skills of Samman and the overly talented artistic eye of Andrea Goodlin.

 

A special thank you goes to my business partners for tolerating this pet project.

 

Last but not least, to my wife, Laurie. Without her constant forgiveness this book would never have been completed.

Disclaimer

ONCE UPON A TIME, I BUMPED INTO ANOTHER VC who was an avid reader of my blog. He mentioned that his firm’s fundraising process varies in some ways from what I describe in my writing. I wasn’t surprised by this, and I want to make sure readers of this book aren’t surprised, either.

 

Each VC fund is different. Funds have distinct cultures, investment strategies and investment processes. The objective of this book is not to characterize the fundraising process at every VC fund. Not only would that be impossible, it would make for a boring read.

 

Instead, I am trying to describe what I believe is a relatively generic process. I will do my best to highlight areas where I see significant variation. As a result, you should understand that this book provides general guidance and therefore, seek to discover the nuances of the process for each fund.

BACKGROUND ON VENTURE CAPITAL

The VC Biz

WHAT IS VENTURE CAPITAL?

Venture Capital is private capital that is invested in high-growth companies in exchange for equity. Private capital includes the capital of high-net-worth individuals and institutional investors such as pensions, endowments and other highly capitalized organizations. Broadly speaking, the term venture capital includes angel investors, but casually, the phrase venture capital is only applied to institutions that are primarily investing the capital of a third party.

 

VCs generally make investments with the objective of generating significant returns that will be realized when the company’s stock is liquidated through an exit, such as an acquisition of the company or an initial public offering. There are some exceptions to this, however, as 1) venture groups within corporations often invest with the objective of generating both returns and creating strategic value for their parent company, and 2) socially responsible venture firms seek to bundle returns with social benefit.

Venture capital funds are managed by one or more individuals who invest on behalf of the investors mentioned above. The investors that provide capital to venture capital funds are called Limited Partners and the day-to-day managers of the capital are called General Partners. These General Partners identify and select

investment opportunities, negotiate the deal terms, often join the boards of directors of their portfolio companies and assist portfolio companies through development.

 

ACTIVE VS. PASSIVE SOURCING

VCs source deals both actively and passively. Active sourcing entails identifying concepts or sectors that are of interest and then scrubbing the marketplace to identify potential investment opportunities in the relevant sector.

 

In the passive sourcing strategy, investors rely on relationships and reputation to bring investment opportunities to them. You could say that VCs who leverage a passive sourcing strategy don’t always know what they are looking for – they’ll know it when they see it.

 

It’s worth noting that both of these strategies can work for investors. While most investors benefit from some passive sourcing, VCs who invest in earlier-stage companies are more likely than later-stage investors to rely heavily on passive sourcing. There is good reason for this tendency. While sector analysis can identify early-stage investment opportunities, many great startups create new markets or alter industries in ways that are difficult to predict. One must see the company to see the market opportunity in these cases.

By contrast, later-stage investors are more likely to invest in companies that already received an investment from a VC. As a result, these investors (especially in healthy economic environments) must be more proactive in seeking investment opportunities to deploy capital. The passive-sourcing strategy is also used by later-stage investors, but this strategy largely entails developing relationships with early-stage investors.

 

There isn’t a right or wrong sourcing strategy. Investors use both, but the stage at which they invest, along with other factors, informs the strategy they develop.

 

INVESTORS TRANCHE INVESTMENTS RO REDUCE RISK

VCs often prefer to capitalize the company through a series of investments. The two key reasons for this are mitigating risk and optimizing ownership.

 

The first and foremost reason VCs allocate capital through a series of investments is that this strategy enables management to demonstrate ability to execute against a number of operational challenges, before more capital is put at risk.

 

For example, let’s assume a VC intends to put $5 million into a company over its lifetime. Let’s also assume that the major execution risk faced by the company is getting customers to pay for the company’s service. In this scenario, the investor

has two options –  to put all $5 million into the company on day one, or to put in $1 million, just enough for the company to go out and sell a few customers and prove that they are willing to pay for the service. If it turned out that customers are not willing to pay for the service, the investor who chose to tranche their investment has preserved $4 million.

 

It’s generally very difficult to take invested capital out of companies, so it is often better for investors to only put it in as their confidence in the opportunity increases.

 

VC FUND LIFECYCLE: INVESTING

Once a VC firm raises its fund (or has a first closing), it has capital to deploy. At this point, the firm enters the first phase of the fund life cycle: investing.

 

Typically, VCs spend the first three to five years of a new fund investing in new companies. The number of investments made in this period varies based on total fund size and the average amount of capital to be deployed in each company. The length of the investment period varies based on the target number of investments for the fund and the number of investment professionals.

 

While funds usually don’t add new companies to the portfolio after this stage, it

doesn’t mean all capital is deployed. VCs reserve capital for each company in which they invest, so they can provide additional capital over time. This enables the VCs to protect their ownership level of the companies – and enables the companies for future growth.

 

While the amount of capital deployed with new investments varies by fund and by stage, early stage VCs invest 20 – 30 percent of the capital reserved for a given company in the first round. The best VCs have lots of “dry powder” to help each company in the future.

 

VC FUND LIFECYCLE: GROWING

The second stage of the VC fund lifecycle is the growth stage. In the growth stage, the fund’s portfolio companies are working hard to build out operations and create significant revenue streams. While some companies will fail in this phase, others will successfully acquire customers and build scalable businesses.

 

The challenge that VCs face in this phase differs from that of the investing stage. A VC’s focus shifts from identifying winners to managing growth. Managing growth means making sure the company has the right resources at each stage of its development. By resources, I’m referring to both capital and people (e.g., advisers, executives and staff). What complicates matters is that the resources

required for one phase of a company’s development may not be the right ones for another, requiring the management team and the staff to constantly evolve.

 

Furthermore, the best VCs also continue to make important introductions in this phase. If the management team needs to connect with a key customer, partner or potential employee, the board should leverage its Rolodex to help.

 

 VC FUND LIFECYCLE: HARVESTING

The third and final stage of a VC fund takes place when most of the surviving portfolio companies begin to exit. This stage is referred to as the harvesting stage.

 

During the harvesting period, VCs will work with portfolio companies to prepare for acquisition or an IPO. VCs help by working with management to refine operations (e.g. processes and corporate governance), evaluate investment bankers and make introductions to potential acquirers.

In some instances, the portfolio companies may not be poised to realize an exit in a timeframe that meets the needs of investors. Prevailing economic conditions can limit exit  opportunities. In these scenarios, VCs might engage in secondary transactions where they sell their ownership stakes to other investors. These are relatively complicated transactions and not the preferred strategy for VCs, but

they can provide liquidity in a manner that is good for investors and the company.

 

It’s worth noting that exits are typically realized throughout the fund lifecycle (even before the investing and growing phases are complete).

 

 THE J-CURVE: THE EVOLVING VALUE OF A VC PORTFOLIO

The value of a venture capital fund’s portfolio typically falls below the value of the invested capital before increasing to provide a positive return. For example, if a VC invests $100, it’s likely that the VC fund will be worth only $80 (according to the accountants) shortly after the investments are made. Eventually, if all goes as planned, the value of the portfolio will increase be $200 (or more), creating a curve sort of shaped like the letter “J.” As a result, this phenomenon is commonly called the J-curve.

 

This short-term decline in value is caused by two factors. First, historically, accountants only changed the value of portfolio companies when they take a new investment at a new valuation. While, in theory, the value of a successful portfolio company is constantly increasing, the value was only changed on the books periodically – at the time of a valuation event. Since portfolio companies typically raise additional capital 12 – 24 months after their first investment, their valuations

were not updated frequently. More recently, accounting rules for private companies have changed to encourage VCs to adjust valuations more frequently, commensurate with significant developments for portfolio companies. Even so, accountants and VCs tend to be conservative in their valuations of successful portfolio companies.

 

Second, companies that don’t succeed often shut down relatively quickly. They burn  through their cash and are unable to raise more money since they haven’t demonstrated enough progress.

 

As a result, less successful companies are written down or off quickly before the successful companies are written up, creating a distortion that appears to be a loss of money.

 

 

VENTURE FUND ECONOMICS: A FEW COMPANIES GENERATE THE PORTFOLIO’S RETURN

Every time VCs make an investment, they believe the company they are backing will generate a healthy return. In reality, that’s not the case.

 

Even the most successful early-stage investors experience failure rates in their

portfolios, which are probably surprising to people not familiar with the business. A rule of thumb for top-performing investors is that one third of their investments will “go to zero,” one third will return the invested capital and one third will provide a five to tenfold return. Furthermore, in the early-stage model, the few companies that return 10 times or more on invested capital provide the vast majority of the fund’s total return to its investors (who are called limited partners).

 

This reality has implications for entrepreneurs who are raising an early round of venture capital. First, you need to convince investors that your company can generate a big return, since VCs need to make every investment with the belief that it will do so. Second, you should expect the market valuation for your company to be lower than initial intuition tells you. Since two-thirds of the companies which receive venture investments generate mediocre returns for early stage investors, investors likely perceive the riskiness of your venture to be higher than you will.

 

 

VC FINANCIAL PERFORMANCE REQUIREMENTS

I have been asked what revenue and EBITDA are required to receive investment. The answer to this question (as with many others) is, it depends.

First, the sector likely serves as a significant determinant of the necessary revenue and

profit. It typically takes less capital to get an IT company to market than a pharmaceutical company. As a result, it’s likely that financial performance expectations at each round of investment vary. While Series B investments in pharmaceutical companies may be done with no expectation of revenue, most (but not all) healthy IT companies seeking a Series B investment have revenue.

 

Second, within a sector, investment strategies of VC funds vary substantially. There are several funds in the tri-state area that target Series A investments in companies with at least $5 million of revenue. Others will do Series A rounds with companies that do not have revenue.

 

When thinking about the financial requirements of each type of fund, it’s worthwhile to think about the other implied aspects of their investment strategy. A fund’s financial requirements are an indicator of risk tolerance. Funds that invest in pre-revenue companies are generally willing to take bigger risks. Also (because risk tolerances vary), return requirements also vary. Firms that take more risk by investing pre-revenue generally seek higher returns.

 

To give a sense of the relationship between risk and return profiles: VCs who invest in pre-revenue or early revenue companies commonly target 10x plus returns, while VCs investing in companies with at least $5 million of revenue often

seek 3x to 6x returns.

 

You might note that IRR requirements are not so widely variant, but the longer the holding period, the larger the multiple to achieve the same IRR. Revenue/profit are predictors of holding period.

 

In sum, investment strategies vary substantially by fund. Be sure you target VCs who have an investment thesis that is aligned with your company.

 

 DON’T PLAN ON BUYING VCS’ OUT

I have heard entrepreneurs ask if it’s typical for management to buy VCs out of the capitalization table after the company has free cash flow. These entrepreneurs are thinking they could give the VC their original investment plus a fair market return in exchange for their equity.

 

First and foremost, you need to understand that if you take capital from a VC you will typically not have the right to buy out the VCs. While situations in which the company buys the equity from one or more parties (a stock buyback or recapitalization), or where two private parties engage in a transaction (a secondary transaction) do take place, the company (or management) cannot force an investor to shed their holding in a company.

Furthermore, it’s worth noting that VCs typically do not liquidate their investment via stock buybacks or secondary transactions – these arrangements are the exception, not the rule. Most VCs seek to liquidate their investment through a merger or IPO. There’s good reason for this – M&A and IPO transactions usually generate better returns than buyback or secondary transactions. A sale to another company captures a control premium and IPO makes the equity accessible to many more buyers, often driving up the price.

 

The main takeaway here is that if you pursue venture capital, assume that your investors will be involved with your company until the company goes under or until you have an exit.

 

BEHIND THE SCENES

 

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