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.
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He dresses kind of funny, but I think we can trust this guy.
Simply put, this is a little like reading the fine print in your insurance policy – it doesn’t seem to be that important – UNTIL IT IS. If any of the terms sounds odd – overly complex or highly manufactured – it’s likely they are AND it’s important that you take a hard look at this part of the equation. For some great reading on this, visit www.Learnvc.com – it will help educate you on all of this in detail.
#3) The Firm (a.k.a., the “partnership” brand that your company will be associated with going forward)
I remember walking into the offices of various private equity firms and struggling about what to focus on – the art, the view, the long list of past successful investment or a combination of all of the above. All I knew was that their offices looked A LOT different than my work environment back at the “office” – and for good reason: they are in the brand-building business just like every other service provider.
As an entrepreneur, you have to be really careful not to fall into this trap when choosing the firm that is writing the check. Make sure you don’t get seduced by a brand or a perception here – and do your homework on how the firm has supported (or failed to support) entrepreneurs over time.
It is really important to note that most “partnerships” rarely act anything like partners – and in a lot of firms the “partners” can barely stand each other.
Finally, do your own reference checks on the firm, not just the list of names they give you to call on their behalf. Ask other entrepreneurs who have worked with the firm in the past exactly how they helped – and how the firm responded when the sh*t hit the fan. NOTE: the sh*t always hits the fan. Trust me, it does. And you want to know as much as possible about the firm before living through this delightful experience.
#4) The Partner (a.k.a., your new boss)
This is the person or group of people from the firm that will be joining you on the journey, either on the board or as a representative of the firm’s investment. Make sure you know how the partner thinks about your business, what he or she has modeled in terms of returns (yes, you should OPENLY DISCUSS THIS BEFORE THE DEAL IS DONE) and how he or she likes to work with entrepreneurs.
A lot of entrepreneurs waste time because they think they are talking to a VC Firm – and not realizing that each firm has its own power pyramid among the partners. You need to assess if the “partner” you are talking to has enough clout to get something done within the firm (see #3 above).
It sounds simple, but the partner you choose will be with your for a long time (likely longer than you think) – and you will both be in a committed relationship. Like other life partners, it is really important to imagine what it will be like when the courtship is over – or when you miss a quarter (and you will miss a quarter, we all do eventually…). After the bottles of fine wine have stopped flowing and the movers have finished unpacking all your stuff – try to anticipate day-to-day life will be like with your “partner.”
#5 Added Value (a.k.a., you are here to help, right??)
You are working 100 hours a week building an amazing business and this shouldn’t be a one sided relationship. Now is the time to determine what the firms you are considering will bring to the table BESIDES capital. Make sure to really, really dig in because just about every firm – from big to small – will have a slide in their deck about “how they help entrepreneurs build their business.”
NOTE: they will also say they’re entrepreneur-friendly, usually right before they talk about the onerous term described above. But be sure to ask these hard questions:
What exactly will the Firm bring to bear, and how will it help you?
How relevant is the “Added Value” to your business or key strategic issues you are facing?
Do they have an operations team that will partner with you to drive the business forward?
Do they have specific playbooks or examples that you can leverage to jump-start your growth?
Will the partner or firm help you on sales calls, make introductions to key partners, or leverage other aspects of their firm to help you grow?
Make sure you get real clarity here to sort through what is “slideware” from the investor versus where they will actually bring resources to help. Make sure you get clarity (and commitments) BEFORE you take the capital!
Bringing it all together
Choosing a capital provider can be one of the most important decisions you can make as you scale up your business. The right decision can be one of the key differences between success and failure. The temptation is to be blinded by the dollar signs and forget about the rest; don’t let the flattery or charm prevent you from asking the tough questions and really understand your compatibility with a given VC or PE firm.
As you think through these five important aspects of the capital-raising process, I encourage you to break it down this way: the valuation assessed to your business will change as fast as the ink on the legal documents dry, but the provider of the capital WON’T change for quite a long time.
With that in mind, avoid the trap that bad entrepreneurs fall into: seeking only the highest valuation, and making a decision based only on this one aspect.
GREAT entrepreneurs think about valuation and dilution, of course, but like all other aspects of decision-making, they take a long-term view and think about what will be best for the company during ALL parts of the journey ahead.
You have built a superior business (that’s why you can raise capital) so you should command the best valuation under the most mutually agreeable terms. HOWEVER, you should put more weight on the WHO you are taking capital from, WHAT partner will join your board, and HOW the firm can help you in the long run.
Valuation is a single point-in-time measure of the company you have built to date – but WHO you choose to take money from and HOW they will help will make that company even better will play out over and over again over the grand arc of your future.
If you are honest with yourself and keep thinking about the long term and the best interest of your business, you might not end up just taking cash from the highest bidder.
