The 5 Golden Rules of Raising Capital
To any seasoned entrepreneur, it’s a known fact that raising capital is not only hard, but it is also a process that is time consuming and takes longer than expected.
There are countless examples of entrepreneurs with proven track records struggling to secure investment. Even Steve Jobs had to call 200 investors just to find one, Mike Markkula, who was willing to invest in his vision. The rest of that story is history.
I’ve been wondering how best to explain to young entrepreneurs the lessons in raising capital. I settled on 5 Golden Rules.
Rule #1: Prepare
Yes, this sounds really obvious, but raising capital takes a lot of preparation. Once a founder meets an investor, they have a single window of opportunity to close the investment. Every outcome must be anticipated, and every question an investor could ask countered with a prepared response.
Investors need three things from founders besides the high level of confidence they will look for when watching a pitch. They will need a slide deck, a financial model with 3 years of projections (also known as a hockey stick graph for the way the growth of a business tends to spike up at some point in the future), and finally a capital table of the company.
These materials must be prepared with a lot of thought and made to look as professional as possible. Founders may need some help from a financial modeler and also a graphic artist. The rest falls to the founders and their vision.
Tip: make sure to know the competition because investors may have heard another pitch and want to know your opinion on another company.
Rule #2: Always Be Raising
Entrepreneurs have two jobs: run a business and raise capital to run that business. I have met a lot of entrepreneurs who focused on raising a funding round that gave them 18 months of runway on paper (runway is the amount of time a company has until it has depleted all of its cash).
Only once they had completed the funding round did they then focus on building the business. Then once their reserves are down to 6 months of cash left, the entrepreneur changes gears and goes back out on the road to raise more money. This is a big mistake.
First, having 6 months of cash is a position of weakness. Investors can take advantage of the situation and demand harsher terms, knowing that your runway before going broke is short. For example, they can demand a 4X return guarantee before common shareholders get anything. They can also lower the valuation and trigger anti-dilution provisions, which dilutes the common shareholders as well as the junior preferred investors.
Second, it almost always takes longer to raise capital than an entrepreneur anticipates. If you only have 6 months left and are just starting to raise, you can be left in a position where you only have 3 months left, or even two. That’s when the hard decisions start.
The best solution is to always be raising money. As soon as you close your Series A, you are off, hitting the road to either extend the round with another investor or begin raising a Series B. There is no time, or reason, to wait.
The real question is whether this hurts the business because of the financing distraction. Can an entrepreneur be as effective leading and growing a company if they are also meeting with investors? The answer is yes. Remember: entrepreneurs have two jobs, not one.
Rule #3: Terms Over Valuation
What? This makes no sense. After all, entrepreneurs are always chasing the highest valuation they can get. There’s always fuss over the next unicorn, a startup that reaches a $1B valuation.
However, venture capitalists are smart, and they know what the entrepreneur does not. They will easily agree on a higher valuation, but in exchange they will not compromise their harsh terms. For example, they will want either a full ratchet dilution or a pro-rata ratchet version.
This protects them from investing at a high valuation because should the company raise money at a lower valuation in the future, their shares (as well as anyone’s shares who invested at the higher valuation) will get reset to the new valuation.
Another term is liquidation preference. Whoever has liquidation preference gets their money back first before the common or junior preferred shares are paid out.
Adding some icing on the cake for VCs is requiring a participating preferred, which is a double dip. With this arrangement, venture capitalists get their money out and then participate in the rest of the payout equally with the common shareholders. Or instead, they can simply asking for a 4X return before anyone gets anything.
These terms are not uncommon in the world of VC funding. The more an entrepreneur waits and the less time they have to negotiate, the worse the terms they end up with will be.
Rule #4: Line Up More Than One Investor
The only way to get fair terms and a fair valuation is to get more than one investor to offer you a term sheet. This creates competition amongst investors and allows a price and terms discovery to take place.
Investors may not like this, but they will respect it. After all, they want to see the entrepreneur behave as a good business person. Testing the market and finding out what people are willing to offer is a key part of getting the best terms.
Rule #5: Keep Control
Control is the root of the biggest nightmare situation an entrepreneur can experience. Sometimes, venture capitalists will invoke the “recap” rule when they are approached to invest more money into the company. What is this?
“Recap” means recapitalization, which is the process of restructuring the preferred shares the investor owns and reducing the value of common shares to little more than pieces of paper. This happens when the entrepreneur cannot raise money from another institutional investor or VC and has to go back to the existing investors and beg.
This recapitalization usually ends with the entrepreneur being fired and a new CEO being put in place with a new ownership structure. This structure benefits the new investors and generally no one else.
Entrepreneurs reading this will ask how this is possible, given that they control a majority of the board as well as the shares. That may be true, but do not forget to read the fine print in the terms in the investor rights agreement.
Surprise: investors can be minority shareholders who can basically do anything they want if the company’s survival is at stake. They can block new investors who are interested in a senior or pari-passu (meaning equal) set of shares. Sometimes minority shareholders can block any issuance of debt and even the sale of the company.
Keeping control of the company is essential, but usually control is a luxury that venture capital does not supply. Only equity crowdfunding capital raises offer security in control because investors in these cases are usually large groups of retail investors who are not looking for VC terms. They just want in.
Raising capital is a key task for entrepreneurs. It is not easy, but thanks to the new JOBS Act, entrepreneurs can use equity crowdfunding to raise capital. This model promises to help entrepreneurs get the capital they need from the people who care most about the business (friends, family, users, clients and more) while keeping control in the hands of the founders.