Lessons learned from my experience taking two companies from startup to IPO about capital raising and how experienced entrepreneurs think about the process.
Entrepreneur #1: Wow, I can’t believe I just got a term sheet from XYZ ventures – they are such a great firm!
Entrepreneur #2: That is fantastic. What is the valuation?
Entrepreneur #1: Big. Not like Uber big. But big.
Entrepreneur #2: Man, that is awesome – you must be thrilled. You are so lucky…
Entrepreneur #1: I know. All my dreams are coming true – I can’t imagine what could go wrong from here…
During my entrepreneurial journey, I was incredibly lucky to work with several great private equity firms – including venture, growth and late-stage investors – before taking two companies to the public markets (Loudcloud / Opsware and ServiceSource). As a result, I’m often asked by entrepreneurs building amazing companies a seemingly simple question: how do I get XYZ (insert any VC or PE firm name here) to invest in my business?
My answer is likewise pretty simple: I think you are asking the wrong question.
And then, channeling the great Alex Trebek (Jeopardy guy, for those under 30), I come back with the answer in the form of a question, and it goes like this:
“What aspect of raising capital do you think will have the GREATEST impact on your ability to build a superior business?”
This can be hard to grasp, regardless of whether you’re getting lots of calls from all the top VC/PE firms – or if you’re simply looking for any source of cash to keep your business dreams afloat. But it’s incredibly important for an entrepreneur to step back and consider all aspects of the capital-raising process to maximize success for the future.
There are five primary aspects of the capital-raising process that really matter – and most entrepreneurs get seduced by ONLY ONE OF THE FIVE. And by doing so, they miss out on the opportunity to add MORE than cash to the balance sheet.
Here are the five key considerations that an entrepreneur needs to consider when raising capital:
#1) Valuation (a.k.a. show me the money)
The easiest component and the one that gets all the headlines – this is also the easiest to get your arms around. Simply put, this is the pre-money (when raising capital for your balance sheet) price at which you are selling stock in the company. Note: when selling secondary shares (i.e., no new money coming into the business) the pre-money and post-money valuations are the same.
Determining how your company is valued – i.e., what metric is driving the price – is a very different topic and well documented in various blogs. It’s worthwhile to do this research and understand what the key drivers are to get to the valuation, but I’ll assume you already know that and focus on the “other” four attributes that great entrepreneurs need to take into consideration.
#2) Terms (a.k.a., bring out the gimp)
You have to understand the key terms attached to the security you are selling and the private equity firm is buying. This is the gritty stuff that is very tempting to offload to your CFO or Legal team. Most of the terms are frankly simple or standard and therefore don’t need a lot of your attention, but a few really matter and here is where you need to be aware…be very aware.
Private equity guys tend to use the term “security” when talking about your life’s work (see my post Investors are from Mars, Entrepreneurs are from Venus) – try not to be offended when the two get intermingled.
I won’t go into too much painful detail here, but I do want to insist that you (as the entrepreneur) really do need to understand the few key terms associated with the capital raise. Don’t consign this to your CFO.
Most important for you to understand is that the investor’s #1 goal is to is to shield their investment from a loss, so key terms are usually focused on giving the investor DOWNSIDE protection (aka: when things go wrong).
Investors will happily give you a higher valuation in exchange for more AGGRESSIVE TERMS to protect against the downside. All valuations are not created equal!
And trust me: when things go wrong is NOT the time you want to learn what terms like “2x liquidation preference” mean.