I was on a panel to talk about capital options for startup as part of the Startmate 2017 roadshow. My extended answers are included below for those who can’t attend.
Q: What is the biggest challenge when you are fundraising?
I think the biggest challenge is the search for someone who truly understand and believe in what you are building, the true believer. Everything else will fall into place when you find this lead investor who can provide reference to his/her peers and get the funding round together.
Q: What is one thing that is not obvious to the entrepreneurs when it comes to fundraising?
When founders work on their first startup, they only have reference points to 1 business. When they are part of an accelerator program, they work closely with 7 other teams so they have reference points to 8 businesses.
Professional investors evaluate 100+ businesses every year, so you only have a 1/100+ chance to be the best deal they have seen this year.
Don’t be surprise if investors don’t fall in love immediately, even though you think your startup is super awesome. The competition is actually the other awesome teams with better metric and traction, out there raising funds the same time as you.
Q: Should I raise from angel investors, venture funds or strategic investors in my industry?
It depends on your stage and how much you are looking to raise.
Asking me if you should raise from an angel investor is like asking a barber if she thinks you need a haircut. I definitely want to invest in the best “out of my league” companies. Here’s why you should take my money in an over-subscribed round:
Good venture funds are aligned with your business to make it a successful one. They make 2% on management fee but 20% on positive outcome. In addition to capital, they can add value by introducing you to customers, employees and later stage investors.
Strategic investors are useful for their distribution channels and industry insights. However, you should watch out for terms that could potentially limit your future growth/options:
- exclusivity (you can’t sell through their competitors’ channels, or service their competitors),
- information rights (they can track very sensitive data), and
- veto rights (you can’t be acquired by or raise money from their competitors).
Q: Should I raise on a crowdfunding platform?
Crowdfunding can be a good option as a “round closer” in some cases. Say you raise 80% of your investment round and you allocate the final 20% to a crowdfunding platform. You can direct smaller investors (<$20k) there and keep your cap table clean.
Some founders don’t like to circulate their business plan and investor update to a “huge crowd”, you can balance this by negotiating a more limited information rights.
Finally, crowdfunding platform charges a fee and carry interest for the work and visibility, make sure you understand how that works.
Q: What about government grant and other non-dilutive funding sources?
Your most precious resource at the very early stage is time. You should consider the effort required to navigate the process and paperwork, and weight it against the potential reward. Paying a professional based on success often makes more sense in this case, so that you can focus on your business.
Don’t optimise your strategy around the requirements of a grant, the opportunity cost could be huge if you miss the window to launch or gather valuable feedback. At the end of the day, the best non-dilutive funding is always the money from your happy paying customers!
Talk to other founders who have secured a grant you are applying for, to get their insights. You can start the research here: http://www.grantready.com.au/
Q: Someone is offering me help to raise my round for a fee, is this a scam?
Established companies usually appoint a CFO and engage a corporate advisory firm or a brokerage firm when they IPO. You will often need to pay for their professional services in order to help you tell your story the right way to the right people, especially when you are raising an institutional amount of money (>$10m).
It is usually a red flag to me when the founders couldn’t raise the first 2 rounds (up to $5m) themselves. If you can’t tell your story right, how can you close big contracts from your customers and attract superstar employees to join your cause?
I have helped many teams raise their funding rounds for free (I even pay for coffee sometimes). So you should definitely talk to me first right?
Q: When is the right time to talk to investors?
You can start the conversation anytime, but that doesn’t mean that you will close an investment round. Start talking to the friendly mentors and founders, warm introductions from them to the investors are usually the best.
Make sure you are making good progress every time you ping an investor. Promise and deliver, build rapport and nurture the relationship. Many teams send me regular email updates (the good, bad, ugly and the ask) and I often chime in if I can help with the ask.
Q: What do investors look for?
Different people look for different things.
I generally look for the 3R: revenue validates the pain point, repeat sales demonstrates the quality of the product/service, referral means happy customers. Here’s my blog post on this topic:
Q: Solo founder or co-founder?
Solo works if you are immune to procrastination and have military grade discipline.
Your co-founder should bring extra accountability out of you, you will push harder because you don’t want to let your teammate down. Your co-founder should also bring complimentary skill set to the table, 1 + 1 > 2.
You may also achieve accountability by having good mentors/advisors around you. But they don’t sit next to you everyday on the roller-coaster ride.
Q: What is your view on technical due diligence?
Code usually gets rewritten for early stage businesses, so I don’t spend too much effort on technical due diligence. I look for the following:
- Are you deriving your key piece of work based on an open-source project with a viral copyleft license? Huge risk.
- Is there a major skill gap in the tech team? For example, a machine learning startup without a machine learning person in the team. “Vapour-ware alert”.
- What is the tech and reporting stack, and their associated cost? An exponential increase in cost when you scale up 10x in capacity is usually very very bad.
- When will the startups hit their bottleneck/capacity? e.g. 10,000 concurrent actions per second.
Q: How do I set a valuation?
Later stage companies are usually valued at an EBITDA multiple when they are acquired or listed on the stock exchange. This is how VCs look at Atlassian (SaaS) and Etsy (Marketplace).
I invest mainly in early stage companies without much revenue. If we use the EBITDA multiple, next-twelve-month revenue multiple or the discounted cash flow model, the startups will be valued at very close to zero dollar. So how do we set a meaningful valuation? Some rules of thumb:
- You want to sell 15–30% per round to keep the dilution in check, investors often prefer the founder-operators to have enough skin in the game going forward.
- You and your co-founders will draw a modest salary to have a peace of mind on the personal finance side, so that you both can focus on the business 100%.
- You want to raise enough money to hire a talented team, build a great product/service and grow your happy customer base for the next 12 to 18 months.
- You have a rough plan to get to the next level, in order to attract later stage investors or to get to positive cash flow, to keep growing.
If I believe in the team, the idea and the plan, I will pay a “markup” price because I believe the team can “backfill” the valuation gap.
At the end of the day, one key definition of a “startup” is epic growth. If the startup can’t grow 10-20% monthly or 5-7x yearly (especially off a small revenue base), then that is a borderline lifestyle business. A portfolio company of mine went from $60k ARR to multi million ARR within 24 months, that’s a good startup.
Depending on how many pieces of the puzzle you have figured out and what premium you are able to command (e.g. founders with previous successful exits = extra premium). The common theme I have observed in the market:
- $250k at $1m pre-money valuation
- $500k at $2m pre-money valuation
- $1m at $4m pre-money valuation
The key is to articulate a well thought out plan on how you will use the $1m to build your company towards a $8m valuation (double). Then the diligence work will be mainly about your plan so you won’t spend 6 months doing data room😉.
Q: What key metrics should I track and pitch?
The answer is in this book.
Q: How can I learn more about fundraising?
The answer is in this book.
Q: Priced equity round or convertible notes?
Personally, I dislike convertible notes. Mark Suster explains the “why” really well. If you really need to use a note, make sure you read this. I have seen horror story that resulted in a 7x liquidation preference upon conversion due to carelessly worded convertible notes (meaning the founders will need to return 7 times the money to their investors first, before they will receive anything).
I am not a lawyer. But generally you can achieve the same speed and flexibility with a priced equity round in Australia. Like by adding the clause below after closing your lead investor. Ask your lawyer what a “deed of accession” is.
You close your first capital (say $500,000) and put in the docs that you have up to [90] days to raise an additional $1 million at the same price (and on the same terms) at your discretion.
If you really want to use a convertible or SAFE note, set a limit on the amount you can raise. Sometimes founders would raise $2m on a note, and then find out they can only get a $2.5m valuation later (like, sold 80% of their business, very very sad for everyone involved).
Q: Closing remark?
Do your own research.
Talk to the alum companies if you are applying to an accelerator. Talk to the portfolio companies if you are planning to raise capital from an angel investor or a venture fund. Those are the best source of references you won’t read on the news.
Good luck.
