If you’re considering going out for your first round of institutional venture capital funding, you probably have questions: Is it the right time to fundraise? Is VC really the right choice for my startup? How do I assess terms to determine if they’re favorable? Why would an investor choose to invest in my company versus another? Do I want this particular firm as my lead investor and their particular partner to join my board and help steer my company?
These questions are beyond normal. Raising capital is challenging, in large part because the knowledge symmetry of a founder and an investor is non-existent. Even if you, as a founder, have raised capital before, you may have a few experiences, whereas the investors you’re working with have made investment decisions hundreds (or even thousands!) of times.
Before you go out and pitch your startup to venture capitalists, you’ll want to prepare. Laying a foundation before you seek funding will help ensure that you partner with the right investors who will offer support for the long haul.
At LTSE, we’ve helped over 36,000 startups manage their cap table from top investors like YCombinator, a16z, 500 Global, Techstars and more. We’ve also taught hundreds of startups on how to model their fundraising and have seen how a little preparation can go a long way. Here’s how to prepare for your first round of funding.
Understand what it means to raise institutional capital
If you live and work in Silicon Valley and go to a coffee shop, you’ll hear founders talking about angel investors, VCs, and fundraising. While raising this type of capital is definitely a viable way to build and grow a business, it’s not the only one. For example, European startups tend to have more government grants available to them while Canadian startups can stretch their dollars further due to SR&ED tax credits. There’s also private equity, corporate incubators and bootstrapping to profitability.
The way you grow your business is entirely dependent on what you’re trying to do. And, not every business model is right for backing by a VC. Most people who are considering raising venture capital don't understand the trade offs.
For example, many founders want to go into accelerators or special programs such as Techstars or YC, but don’t realize that this is a path for raising institutional funding. If you’re going down this path, you really need to understand what that means for the profile of your company, the growth rates that you're going to have to show, the market size, and your ownership and independence down the road.
Those that will do well with VC capital not only see the potential to grow very quickly, but also see how VC capital would accelerate that growth and how their business fits the VC expectations.
Nail down your expected return
Startup founders can think of capital in terms of how much they need to build their product and grow their company. But what’s often overlooked is that VC capital has a horizon on which it expects a return. That horizon can vary, but it’s usually about five years.
Not only that, but VCs don’t expect a 2X, 5X, or even a 10x return. The first VC money in is likely going to push for a 100x return. Of course, most seed stage investors– those who invest in the very first round (outside of friends, families, and angels)– have portfolios of dozens or even hundreds of startups across a few different funds. A typical fund has a five year operating horizon after an initial capital deployment phase when they invest into the startup. VCs assume that 70-80% of startups in each fund will produce zero return or simply give them their money back. It’s usually just a few startups per fund that generate enough outsized returns to pay for those that didn’t result in anything and then some.
Good seed funds are looking at overall returns of 5x or more. Founders need to understand that if you're talking to a $100M fund, the partners operating that fund are looking to return more than $500M to their own investors. And if your startup is one of the few outperformers, they’re looking at $100M+ returns just from you. That’s a lot of pressure on both sides.
This knowledge is important, but in practice it means that founders need to model out expected returns, not just for the round they’re raising but for two subsequent rounds that are likely to take place over those next five years of your joint horizon. This is what investors will be considering when they’re deciding whether to invest.
Use your cap table as a business planning tool
Most founders don't spend enough time modeling things that can happen to their cap table or how a different-than-planned business performance or an evolving business plan can impact the future cap table - from fundraising to staffing . Rather than using it as a strategic forward-looking business tool, the cap table becomes a record of what has already occurred.
It’s tempting to set up a cap table and leave it alone, but this is a mistake. You’ll want to use your cap table for scenario modeling, but this can’t be done in a day. Managing your cap table health is like going to the dentist – it takes ongoing hygiene and the longer you delay dealing with it, the more painful it’s going to be when you get around to it.
When it comes to the cap table ahead of an expected fundraise, you need to assess what your hiring plan is going to be and if you have the right option pool for that. You also need to understand how much cash you’ll need and what minimum performance results can unlock another fundraising in future. This helps you understand how you’re going to construct your round and what terms you’ll be looking for.
Early on, start playing with the cap table to determine what your business needs are. Is it fundraising? Is it option pool sizing? Is it a new 409a? You need to get up to date and you need to understand it. Then, you need to regularly start to use it in your strategic business planning meetings.
Understand what the market looks like in your specific business domain
Most investors deal in volume. They meet with hundreds of startups to invest in dozens. Because of this volume, most institutional investors look for patterns. When they hear from a founder, they begin to compare the story to previous experiences and other companies, be it consciously or subconsciously. Some investors are very deliberate about this and search for specific profiles.
Point being, investors will compare you and your business to other companies they consider investing in, no matter how novel your offering is. But if you go into fundraising knowing this, it can be a superpower, particularly if you have an extremely deep understanding of the market in your specific business domain.
Demonstrating to investors that you understand where you sit in the market and relating your approach to a known powerful business model will inspire confidence and help them make associations between you and top investments. This will also prepare you for understanding what investment terms you can expect.
Run your terms by a trusted expert
If you reach the point where investors give you an offer, congratulations! But don’t blindly accept the terms in front of you even after your legal due diligence. You’ll need to run the terms by a mentor or trusted advisors.
Talk with somebody who has a finger on the pulse to understand if what is in front of you is relatively common in today's market or not. They’ll be able to tell you if a clause is unusual or if what you’re looking at is fairly standard. They’ll also be able to explain the “why” behind the terms.
Good options for mentors and advisors include senior partners at startup law firms who see high volumes or a friendly VC who is not conflicted and willing to be an advisor. The key is to find someone who reviews term sheets all the time.
Preparing for fundraising is worthwhile
Raising institutional funding is one of the most important things you’ll do as you grow, so you want to be prepared. The very process of fundraising is grueling and an all-consuming effort that is often underestimated or often grinds the rest of business to a halt. Most startup founders feel tremendous relief when it’s done. Yet, this entire process can help you hone your story, your business model, and secure you partners who are intent to help you build your vision. By taking time to understand the fundraising process and expectations that come as a result of it, you’ll have a better chance of gaining terms that are favorable to you and entering into a partnership with an investor who is right for you.