The Economics of #Fundraising – TNSTAAFL

Raising money?  Read this first.

Dilution, overvaluation, free money, TNSTAAFL, and how to deal with VCs like a pro.

First time founders are typically the most likely to object to dilution when fundraising. They tend to overvalue their companies early, thus creating problems for fundraising later. They do this to avoid dilution, which on the surface seems like a good idea, but can prove deadly to your start up when you get to the A round.

Dilution Is Your Friend

The adage, you can have 100% of nothing, or 50% of something is very true here. Keep in mind that while each round of funding does lower your overall stake in the business, it should increase the value of the company such that the increased pro rata value of your stake grows with each round of funding. This means that an increase in overall value should normally offset the loss of additional equity paid out. So take a deep breath, and, look at the overall economics of the deal.

When properly executed in a funding transaction, dilution should increase the dollar value of founder holdings even though your overall share of the company is less.

Overvaluation Can Kill

When you first get started, figuring out how to value your company is really, really hard. Discounted cash flow models and complex valuations (e.g. monte carlo forecast simulations) are utterly, utterly useless. The fact is, your start up is worth only the value of your future work, and since no one can tell the future, you might as well stop trying.

Despite this stark truth, many entrepreneurs put high values on their companies when they first get started. As a general rule, any company that says they are worth more than $3mm from the get-go, is pretty much overvalued. Unless you have magic beans and geese that lay golden eggs, your day-zero company is not worth more than a couple million.

So, if you raise money from family and friends at a valuation of $4mm, you lose face when six months later a pro VC funds you at $3mm and you have to explain the dilution and write-down to the people you love.  Have fun with that.

How to Avoid Overvaluation

Fortunately, there are two cool methods to avoid the overvaluation trap: SAFE notes and convertible debt. Let’s start with the latter.

Convertible notes are simple debts, convertible into shares of the company at a future date. If you take early funding with a convertible note, your investor becomes your bond holder and doesn’t have to know what you’re worth today. Since the note is convertible, it will become equity in the future and typically does so at a discount due to the increased risk the investor took when giving you the note. In this way you don’t have to worry about valuation until the professional money comes in, and they expect this kind of note will be on your balance sheet already.

The SAFE note was developed by Y Combinator to avoid putting debt on a new company, or to even permit funding an idea before it becomes a company. It works like a synthetic convertible note, except it is just a promise to pay equity in the future for the same discount to the valuation for funds given to develop the idea or company. It isn’t debt, just a promise to provide shares like convertible debt in the future.

Given these options, it is far better to use them for early pre-seed funding than run the risk of over valuation or over dilution.

When to Avoid Dilution – TNSTAAFL

If you need funding, then you’re going to get diluted. TNSTAAFL is economist jargon for, “there’s no such thing as a free lunch”, which definitely holds true here. However, there are some alternative funding sources you can still tap, albeit not free, but typically superior to dilution if you can pull one of them off:

  • Get your customers to prepay for services. You can do this by being honest with them about needing development money and how they can get a deal if they provide it: maybe giving them the finished service for free for a period of similar value. This not only helps you avoid dilution, but can also get you test-beds for product, as well as your first customers. This is often done on Kickstarter also, where you can get money in exchange for product betas. Just don’t become the Coolest Cooler, ever.
  • Look for grant money. This is rare, but most commonly found when your idea benefits the US military in some way. They give out a ton of grant money to develop start-up companies that solve their problems. And they have a lot of problems outside of how to more efficiently kill the enemy, like how to provide emergency relief services, quickly and safely refuel aircraft, feed a million people, etc.
  • SBA loan. The US government may actually give you a loan to start your company. Depending on the type of company you found and your creditworthiness, this may range from a small amount to some pretty large loans. It is worth looking into.  Check out their website to learn more.

However, the easiest way to avoid dilution is by learning to be what I call “ramen lean”. This means that you live so frugally, you basically can’t afford to eat more than ramen (not suggested by any doctor or myself, but it is a good metaphor here). If a start-up can reduce expenditure, every dollar they save is dollar of dilution avoided.

How to Manage Abusive VC Sharks

Sometimes, a VC will pressure you to do a deal that stinks, destroys the economics of your company, and/or is just too greedy. If you find yourself in front of a tough-talking VC who asks for more than her/his fair share, then you need to walk. Don’t talk yourself into a bad deal. Money is commodity, find the right flavor for you. Just be sure when you do walk that the greedy person isn’t you.

Walking away from a deal when you don’t feel good about it, is the best thing you can do when someone is ripping you off. Trust your instincts. It is empowering to turn your back on an offer and walk away. Sometimes, albeit rarely, the VC will come back with better terms, but be careful here too. People tend to be on their best behavior when dating, and you don’t see their true colors until after you marry. So if you see red flags while dating a VC, just move on to the next funding source and don’t waste time.

You can’t manage an abusive VC, but you can leave the room.

This can be avoided if you’re willing to do diligence on funding sources before you approach them. For example, email or talk to the companies in a VC’s portfolio and find out about how the VC is as investors. Did they do what they said they would do? Find out if they even are looking for investments in your sector. Focus on finding good-neighbor funding sources that add value by helping your company to grow in verticals where the angel/VC has both capital and subject expertise.

The 18 Month Rule

Regardless of the amount raised, it is almost a joke among VCs that your funding will last no more than 18 months. As well as you can plan how each penny will be spent, the best laid plans tend to meet reality. Things will be good for 10-12 months, then you’ll realize you’re burning money too fast and the next round is taking too long to raise. So, you’ll start to economize, pinching pennies and perhaps laying off the least productive workers so that you can keep your company alive. This is due to how humans manage according to expectations.

Now that you know this behavioral bias going into a funding round, you need to be cognitive of this bias, adapt your expectations accordingly, and then consciously manage your money more frugally over the full term of the funding round. For example, don’t wait until your funding is almost gone before making hard HR decisions. Let employees go sooner rather than later if they don’t contribute sufficiently or are a bad cultural fit. The best time to act miserly, is as soon as you get funded. Doing so leaves some of your powder dry for when you’ll need additional marketing dollars a year down the road, and would love to have them while fundraising. You’ll have a better product in the future, and will wish you had more money to market that when you’re fundraising and need to show traction. Don’t blow it all now.

Overall, don’t let fundraising intimidate you and be sensible about your choices with equity. A good VC partner like Sputnik ATX (honk, honk) will help you fundraise also. Now, go find that awesome angel or VC, and get started with your plans to change the world.

 

How to Engage #VCs – A Primer for #Entrepreneurs

I’m very surprised at how many founders think that we’re jerks when they, in fact, are acting like wild animals.

Successful entrepreneurs know how to engage VCs. We’re not some elusive species.  We’re human just like everyone else, and yet I’m very surprised at how many founders think that we’re jerks when they, in fact, are acting like wild animals. This primer is designed to help entrepreneurs understand VCs a little better in the hopes that we can have more meaningful interactions and avoid some of the blunders that cost entrepreneurs a funding opportunity. Quite frankly, these aren’t just things that drive VCs nuts, they are basic rules for being a good person.

  1. Don’t talk to VC’s when you’re drunk. OK, this seems obvious; however, you’d be surprised how many times drunk founders approach VCs at mixers. For some reason, there is a lot of booze at start-up and VC events that some people enjoy just a little too much. I’m not sure who thought it was a good idea to mix these two things, but I strongly suggest you avoid the bar if you want to impress anyone. I once had a drunk guy come up to me at SWSW and declare, “so you’re one of those {expletive] VCs I’m supposed to be networking with so I can get my company funded, so lets talk.” Needless to say, I moved on.
  2. If you want funding, ask for my advice, don’t ask me for money. It is surprising how often people lead with the money question, and that is just poor manners not to mention bad communication strategy. If you want me to be interested in what you’re doing, ask me for my advice and let’s both find out if I can help you. Look for smart money that will be able to assist your company to grow, and if I see you doing that, I’m more likely to be interested in you also.
  3. If I don’t answer the phone, don’t keep calling over and over (same for texting). Seems like a simple thing, right? And yet, on one deal we were pretty much ready to sign one day when the founder kept calling and calling until my partner and I were just begging for him to stop. He was pestering us to sign the funding agreement, and we were very preoccupied with a credit facility emergency with a different portfolio company that had to be addressed. Our investment in the other company was very significantly greater, and had to be the higher priority. We realized after many back-to-back calls from him that he didn’t respect our time, that things would only get worse if we did the deal and so we decided to walk away from the deal. If founders are jerky up front, things usually don’t get better after we give them money. So just show some good phone manners and respect my time in the same way you would expect.
  4. Don’t monopolize the conversation. Another no-brainer, but one that is repeatedly violated, most often at events where a VC is in conversation with a group of founders from different companies. Typically, we will try to get to know everyone by asking questions to each person about their company and what they’re doing to change the world. Invariably, one or two people in the group think that this is a competition to see who can one-up, interrupt and dominate the conversation. Instead, introduce what you do and ask others the same. VCs will notice that you prefer to learn than lecture, a good attribute in a founder.
  5. Get value from the “no”. If I turn you down, don’t be a jerk. It is OK to ask why I’m not interested, and even to ask if I know a VC that might be interested, but it is not cool to just roast me. VCs say no 95% of the time or more. It is just a simple matter of supply and demand, nothing personal. However; I’m impressed when someone is thoughtful enough to thank me for my time and consideration, then asks if I can share feedback or suggest another VC that might be interested in the investment. That is smart. If I take the time to listen to fully evaluate your company, I started with the idea that this might work. If it doesn’t end that way, ask me why. I may not always feel like I can share, indeed there may be a confidential reason I can not provide, but it doesn’t hurt to ask me why. If you do, you may get valuable feedback to improve your business model or help you realize how your company is perceived. Furthermore, asking if I know anyone who might be interested in your company may result in a referral to a good funding source. So please resist the urge to assume we’re jerks for not giving you money, and get some value from the “no”.
  6. Avoid superlatives, balderdash and hyperbole. Wild claims and broad statements are usually a sign that the entrepreneur is either overconfident, foolish or dishonest . I went to a pitch once where the founder stated that they were the first company to do something when I knew, for a fact, they were not. I knew because I founded a company based upon that same business plan almost ten years before, and sold it to a strategic seven years later. There were, in fact, a lot of competitors, and by stating they were the first, the best, etc., they just showed that they were ignorant of the real market and totally unprepared for funding. Please know the limits of your technology as well as your competitive marketplace, and be prepared to discuss them with honesty and integrity, avoiding the breathless reporting of meaningless, management jargon.
  7. Don’t turn the one minute elevator pitch into five minutes. If a VC gives you a time limit for your pitch, please observe it strictly, unless the VC invites you to go into overtime. This happens a lot on pitch days when companies exceed their allotted time. Look, I know you have a lot to say, but the ability to concisely deliver a compelling message is one of the best indicators that a founder will be successful. Doing so shows that you know how to sell, and respect the time of the person you’re talking to. If you don’t respect other’s time, it also speaks to a lack of empathy and possibly integrity.
  8. Don’t bring up valuation unless I ask first. I previously stated that you shouldn’t lead with money, but let’s be frank: don’t bring it up unless asked first. Talking about your company valuation is kind of like bragging about how much you paid for your pants. No one wants to hear about it, unless they intend to buy some for themselves. So, don’t waste valuable time talking price, until you’ve sold me on the value of the pants themselves. Once I’m convinced that you have a company worth exploring further, I’ll ask and you’ll know that I’m really interested. That is a good signal for entrepreneurs that my interest is piqued, so make the most of it.
  9. Don’t trash talk other VCs or angel investors. Investing is a team sport. Funds don’t go it alone, and we prefer cooperation more than most industries because it reduces risk and improves returns for everyone. We know that it is in the interest of all to get as many smart people as we prudently can to advise and help a portfolio company. VCs invest in teams, with each round of funding bringing in other VC firms who have value and experience that is relevant to the asset. That means that most VCs are frequently friends and serial business partners. I respect them a lot, and value them highly. If you think I’ll be impressed when you trash talk the last office that said “no” to you, well I’m not impressed. That kind of behavior shows that you may have trouble working with other people, and reading a market, both are very bad traits in founders that we seek to avoid.
  10. Don’t show up at anything personal hoping to connect with me, like my kids athletic event, or heaven help you if you knock at my home. Nobody likes a stalker. I’m more likely to call the cops on you than even consider funding your company. Another no brainer, and yet I have more than one example where people tried to pitch to me while I was trying to watch my kids play sports at school. It is nice if you realize that your kids team and my kids team are in the same league, but please, let’s just enjoy the game. Use this time to show me that you can set appropriate boundaries and allow me to enjoy some precious time with my family. Don’t be a stalker.
  11. Google me, find out what I’m interested in, and engage me in a conversation beyond your company. Some might find this creepy cyber-stalking, but I just consider it good recon. If you know the people you want to meet, you’re more likely to be able to build a foundation of trust. Find a genuine area of common interest and build upon it. I’m impressed with someone who tells me that they googled me and discovered an area of common interest and we can chat about that for a while. An important caveat: don’t try to fake it. Disingenuous interest is easily seen through if you only have a quick, Wikipedia education of something I’ve enjoyed my whole life.
  12. Don’t go on and on about where you attended college. I don’t care if you went to Harvard, please show me what you can do. Your education is nice, but there are a lot of people who emphasize it too much, as if education is some kind of guarantee that they are smart. And let’s face it, Harvard is a nice school, a good fall back if you can’t get into the University of Chicago, but where you go to school is not as important as what you are doing with that education. Remember, a lot of smart people don’t go to top tier schools, and will work you under the table. Hungry, resourceful, hardworking brilliance is something VCs look for in founders. Think smart, gritty and determined, not educationally stunted by virtue of lofty expectations with little substance to back it up.
  13. Smile. Yep, I said it. Smile. It is amazing how by just being happy, and feeling good, you subtly influence others to do the same. Smiling is free, and appreciated by all. Launching a start-up company is a full-contact, extreme sport. So, please show that you enjoy the challenge, and help your founding team to stay positive in the face of their challenges. Changing the world is hard but rewarding, so make sure you enjoy the ride.