In the last year, I have spoken one-on-one with over 800 startup founders.
These conversations center around cap tables since that is the product we offer to startups, but we discuss an array of broader topics, especially around financing and all it entails: fundraising, equity investor relations, valuations, and more.
When I first get on a call, I immediately ask the founder about their company. The passion pours through– the company is their baby and they treat it as such. Nearly all founders have nailed their elevator pitch.
When we talk, it’s also clear how much the founders are struggling. In particular, they want to grow their businesses by finding and securing the right funding without losing ownership. They’re worried about their option pool percentage and their 409a valuation.
I’ve spent 20+ years working in and around Wall Street and founded my own FinTech business, and I’ve seen founders get it right, wrong, and everything in between. I don’t have all the answers (no one does!), but after working in this space and talking to hundreds of founders, there are recurring themes.
Here’s what early stage founders should know about fundraising in today’s market.
Finding the right money is hard given the macro economic climate and the tightening of VC investments
In many ways, early stage startup founders are always looking for funding. Thing is, finding money is the easier part. Finding the right money is the much harder part. It’s a delicate balance for founders. They’re afraid to run out of runway, but they also want to be selective. It’s a challenge that requires a lot of mental gymnastics.
When it comes to meeting and choosing investors, do your own diligence and don't be afraid to ask the tough questions. My recommendation is to ask investors what their advice would be if the worst case scenario came to pass. Most founders know their greatest fear. So, put that fear in front of investors and see how they respond.
When business gets tough (and it will) and you're in a board meeting, you want to be partnered with someone who sincerely has your best interest and the company's best interest in mind and truly buys into your mission and vision. Because if you don't, you may be forced to do things that are against the fabric of your ethos.
Ultimately, when you’re assessing investors, you should ask yourself “who do I want to be working at a whiteboard with– sweating with sleeves rolled up– because something has happened and the trajectory of our business has changed?” Finding that investor, the one who you can work with, is much more important than the one who would be fun to drink champagne with after celebrating a success.
Being a good corporate citizen is paying off
During every conversation, I bring up Impact & Environmental, Social, and Governance (ESG) to find out if the founder knows, understands, and cares about it. Impact and ESG criteria is a set of standards increasingly used by investors to assess a company’s social and sustainability goals and is engrained in everything we do at LTSE.
Regardless of the type of company you’re building, a founder today cannot ignore the trend of the amount of capital or assets flowing into the ESG/Impact Investing sector. This trend means that money is finally getting involved to promote and de-promote companies that do and don't do the right thing.
For example, Larry Fink, CEO of BlackRock, the largest asset manager on the planet, has come out the last several years in his CEO letter and said, "we care very much about ESG." The SEC has recently put out a regulation on greenhouse emissions for organizations which is trickling down into the private equity and venture capital space.
Essentially, if you are a company that builds solid foundations from an environmental, social, and governance perspective, you unlock potentially all of this capital that's been earmarked for ESG/Impact that you would not have access to otherwise.
Regardless of capital flowing into ESG, today’s generation of founders want to be good corporate citizens and build sustainable companies. The struggle is to figure out where to start. I recommend that startup founders incorporate ESG into their mission from the beginning. Take Patagonia: from the beginning, Patagonia has made clear what their terms are, namely that they’ll invest a portion of their profits into sustainability initiatives. The company has taken a hard line stance: either get on board with our ESG strategy or don’t invest.
Integrate ESG into your strategy now because that will be part of your communication with investors, part of your overall strategy, and you will be rewarded with access to capital that you wouldn’t have otherwise. Even more importantly, you’ll attract the right type of mission-aligned people to work for and with your company.
Get your cap table in order early on
Most startup founders manage their cap table in a simple spreadsheet. While this works very early on, you need to get ahead of managing your cap table as soon as possible. Basically, manage your cap table before it manages you. Don't wait until it becomes complex to start managing it.
You want your cap table to be well organized and ready to scale before you grow, as things can scale very quickly and get increasingly complex.
For example, imagine this scenario:
You and a co-founder have raised $35 million. You currently have eight employees and will hire twelve more now that you have an influx of capital. Suddenly, there are tons of transactions needed on the cap table. Shares need to be issued out to the new investor, which is a whole new class of shares that takes preference and has seniority. Then, there's twelve new hires that you need to issue options to. All of these transactions wind up adding up and compounding until you’re left with a complex and hard to manage cap table.
Having a proper cap table platform in place not only helps with managing this complexity, but also helps with strategic planning for equity. If your cap table is in order, you can model out various scenarios to see how it would affect the overall options pool.
When getting your cap table in order, you want everything in the right place from a legal and financial perspective, but you also want to make sure the data is secure. This is why it’s best to use cap table software that offers a login– it’s much better than sharing an unencrypted file over an unencrypted email server with your most sensitive information. Also shows that you truly value your equity.
It's never too late to start managing your cap table, so don’t despair if things have already gotten complex. But if you haven’t gotten it in order, don’t wait. It’s critical to do it now– what’s cheap will become expensive later.
Don’t mistake investor relations for marketing
Most founders mistake investor relations for public relations or marketing. They only tell the good stuff to investors– they share info about new customers, product launches, and new hires but omit the challenges until official board meetings. Although it’s tempting to share only good news, this does not establish credibility and confidence. It’s not a prudent strategy.
If you just deliver really great information all the time, but then every board meeting they're uncovering problems with the business and missing targets, they're going to start to question your credibility as far as being able to communicate effectively to investors on the strategy and how you're going to keep to it.
Investor relations is sharing the strategy, laying out the steps you're going to take to execute the strategy, and then providing updates– good, bad, indifferent, or any time that you veer off the plan. Sharing challenges is important, as your board and investors are support– they’re people in the know whose brainpower can help you succeed.
When you're private, you have a choice of who's on your cap table and who your investors are. This gets you into a good cadence of reporting on everything and just making sure you're keeping them updated. When it comes to IR, practice makes permanent.
If you get into an investor relations cadence early in your evolution, that is going to have a flywheel effect the next time you fundraise because you're going to have a lot of documentation and reporting. You’re also going to wow this new investor with how you communicate. This is especially important when markets are contracting, as we are seeing signs of currently, your IR effort could be the difference in securing that round vs. that capital going to another company. IR is an investment not a cost.
Don’t confuse your 409A valuation with your fundraising valuation
The 409A valuation is an IRS mandated business valuation used for taxation purposes. Whether you're a US based company or a foreign entity, if you want to use options and hire US employees, you must get a 409A done. An analyst will evaluate your business and derive a fair market value (FMV).
Most founders know about 409As, but they do not fully understand the intention of the valuation. Most founders want to see the highest valuation and share price for their company when that is not the purpose of the 409A. You can think of it like buying a house: When you are getting your house appraised for a mortgage you want the highest possible price, but when it comes to the tax bill you want the lowest possible price used. It’s the same thing for a 409A. In the case of a valuation, you want a low price so that you can offer options at an affordable rate to your employees and have them participate in the upside.
When you do your first 409A, pay for a quality one that gives you true fair market value and audit defendability. It will cost you more upfront, but it'll be a worthy investment because if you get a valuation and a strike price that is questioned down the road in an audit and you have to back date options, that'll wind up costing five times more than a quality 409A would’ve. Just like getting your cap table in order, cheap is expensive.
Be savvy about your option pool percentage
Many founders ask about option pool percentage. They wonder the right percentage of options they should set aside. Unfortunately, there’s no generic, end-all answer for this.
Ultimately, determining the option pool percentage requires some homework by the founder. Founders need to understand the key hires they need to make, what total comp looks like for them, and the mix between base and equity.
Just because the option pool percentage varies widely based on your circumstances doesn’t mean you have to go it alone. You want to get guidance on your option pool percentage for your particular scenario, so be sure to employ legal counsel that has experience and can offer advice.
Get the right guidance
When it comes to finding and securing investors, managing your cap table, and determining your option pool percentage, it’s imperative that you get the right guidance from the best possible legal counsel.
Any law firm you hire should’ve worked with companies in your position before. Not only should they have worked with a Delaware C Corp, for example, but they should also have experience in healthcare tech. The more experience they have working with your specific type of company, the better.
Recommendations from other founders count for a lot, too. If they’ve had a good experience, you probably will, too.
All said, legal counsel is expensive, and it’s important to be smart about costs. Most founders would love to work with senior partners at the biggest, most established New York or San Francisco law firms, but this is often too expensive at this early stage. Fortunately, I’ve worked with all the major law firms and many small ones. Often, the smaller ones you’ve never heard of do a fantastic job because they're more specialized.
Fundraising is a worthwhile challenge
Many founders I talk to share how challenging fundraising is. They get through a round of fundraising, raise a significant amount of capital, then lament that they don’t want to do it again. Indeed, the process can be stressful and time-consuming. But if founders stay abreast of changes in the fundraising landscape, tackle their cap table early on, and work hard to choose the right investors, they’ll have a much better experience that will set their company up for success.