This article was originally written by YES!Delft. You can find more information on YES!Delft here. If you want to see the original article, click here.
After discussing general startups and validation theories in the previous 3 blogs (read the last one here), it is time to take a look at the most magic part of startup life: venture capital deals. Why is it magic? Because this is the moment when unicorns are created.
Our constant focus on the valuation of a company puts the investment rounds in a strange spot. It sometimes seems it is not so much about the money to grow the company, as it is about the valuation of the company itself. Combine this focus on valuation with the fact that every deal has two dynamics: economics (valuation) and control and this will be an interesting read!
When I first started at YES!Delft I remember looking at entrepreneurs that were raising money and couldn’t help but feel sorry for them. Here they were, 25ish years of age, sitting opposed to (hopefully) multiple VCs who are twice their age, who have an entire team to back them up and who have done it time and time again.
For the entrepreneur, an experienced lawyer who understands VC financings is invaluable.
For the entrepreneur, an experienced lawyer who understands VC financings is invaluable, not because of their legal knowledge (which is nice) but because they have been where you are now multiple times.
I think it’s not so much about the lawyer, as about getting a team around you who have done it multiple times. The nice thing about lawyers is that you pay them per hour, and not in equity (yes, this really is a nice thing, opposed to what you might feel when you get the bill). Therefore they are the only ones at the table who have nothing at stake (opposed to, for instance, your angel investing advisors or advisory board members).
Do, or do not. There is no try.
When you get the option to quote Yoda, you should always take the opportunity! What works for Yedi’s also works for founders. When you’re raising a funding round there is no “try”. This goes for the funding round itself, but also for running your business in general (and perhaps even life). Why might you ask? The answer is simple: attitude impacts outcome.
You must start out with an attitude of success, or perhaps I should rephrase: with an attitude as if you believe in what you are doing. Make business decisions before meeting anybody. Investors (and customers, suppliers, and other stakeholders) will smell the uncertainty and if you do not believe in what you are doing, then why should they do?
I’m not saying you should not prepare to fail (always have a back-up plan when you’re raising a round, you do not want to be the company on the verge of bankruptcy because the deal is taking a bit longer than scheduled), just that your attitude will have an impact on the outcome.
I do recommend to start talking with VCs before you’re actually raising a round. It’s much easier to create some relationships while there is no timeline and accompanying pressure yet. But be clear to everyone: you’re not raising, you’re also not trying to raise a round, you’re just casually chatting. If you do this consistently you can be sure that everyone will be awake the moment you really are raising!
As a bonus it also creates a clear timeline when you are going at it. When you are trying something, it is hard to put a date on when you started trying, and when you stopped trying. Walking into a VCs office and not being able to clearly explain when you started raising and when your deadline is, is a poor start of the conversation.
I have seen this example a lot, and sometimes one which is even worse: “How much are you raising? That depends on how much the VC is willing to spend”. I get it, the future is uncertain, the world is complex, humans are strange beings, you never know what is going to happen, you’ve been growing like mad, every other month your bi-annual plans are outdated again, how could you possibly know how much money you will need?
But you’re asking for someone's money, and you’re going to spend it on your company, so if you don’t know how much you need, then how much confidence gives the parties on the other side of the table? If you don’t know, they will surely don’t know! It appears as if you haven’t given it much thought, or even worse: that you don’t really care if it will be 5 or 7 million.
Next to what kind of message you’re sending with a range, it can also be quite confusing for VCs. VCs are always limited in the cheques they can write, and if the limit in this case is 3 million, they can be a lead investor if you want 5 million, however in a 7 million round they can only be a co-lead or a follower. Although this is not a big problem for you, it is a big difference for a VC and the way your company is pitched internally. This uncertainty on the VCs side is not the worst, but the whole process is already very complex and having a range instead of an exact number only makes it worse.
Everything which is in the term sheet can be brought back to two things: it is either economics, or control (and OK, there is a third category: unimportant things). Economics focuses on the return the investors will get in the sale of the company, or an IPO. Control refers to all the mechanisms that allow investors to exercise control over your company (veto’s, board seats, etc).
If you find a VC which focuses on other things than economics and control you might think you can cash: give in on all the unimportant stuff and take what you want in the economics and control area! Before you go ahead, think about how this VC will act as a board member, will they still focus on all the unimportant stuff? In the end you are much better off with a VC who knows what is important and fights for it, as they will continue to do so when they are on your board.
This also brings me to another interesting point: while your relationship starts at opposite sides of the table, it will continue on the same side. Don’t let a few quick wins in the first months of your relationship overshadow the years to come. You will be much longer on the same side, than you will be on opposite sides!
The valuation of your company is hard to control. It is determined by, amongst others, the stage of your company, the experience of your leadership team, the size and trends of the market and the current economic climate. All of which are hard to control or steer in a certain direction. When you are met with a low offer from your preferred VC, don’t spend too much energy on arguing about their assumptions on the market, the phase of your company or the experience of your leadership team.
Instead, focus on what you can control and make sure that you have multiple VCs interested. Interest of multiple VCs will increase the chances of a good valuation, it will increase your negotiating position in general and it will give you a Plan B when your Plan A with your preferred VC doesn’t work out.
Before startups get their first financing it is not uncommon that they have not yet appointed a CEO amongst their co-founders. The same often goes for responsibilities, rules of engagement and who is accountable for what. As mentioned before, a financing deal is just as much about control as it is about economics. As a VC you want to be sure that the discussion about who ultimately gets to make which decisions is done before the deal gets done. This can be quite frightening for startups, as very often, they don’t know themselves who is ultimately responsible for what.
It is important to realize that the need to eliminate the ambiguity is not because there is a lack of trust towards the startup or the VC, it is an attempt to clarify the rules of engagement and align the incentives for the years to come. Remember that although you might feel a personal connection with someone within the VC that does not mean that the person will be there forever, the same goes for the founding team of the startup.
Although creating trust between founders and investors is a very important aspect of making a deal, remember that the deal is not between the founders and the investors, but between the company and the VC, and you never know who will end up owning the shares of both. Making sure that all ambiguity is gone before the deal is done is therefore, perhaps annoying, but necessary.
Because of the attention of the media on valuations I never realised that every venture deal has two drivers, instead of one: it’s about economics AND about control. If you get your way in one, your opponent is probably getting their way in the other. But this is not the most important lesson. The most important take-away from this book is that, while you might be opposing parties for a short while, you end up with the same goal for a long period of time.
This means that right from the start you have to create a relationship with your deal partner (even though you are on opposing sides of the table). If you do this actively (and most of the time the VC will take the lead) then just remember that the most important thing you can have as a founder, and as a VC is trust in each other, and every step you take in this process has an effect on the trust there is between the parties. If you are not aware of this relationship building, you are on thin ice. Because relationships happen anyway, if you are actively engaged or not. Not being engaged in this process will make sure you end up with low trust in the deal, and this will show itself when the first cracks will come shining through. Therefore I would like to add one more driver to economics & control, which is trust.
The book is kind of American in its tone of voice (and for instance its focus on the role of lawyers in the deal). If you can not handle this you might want to try “Venture Capital Deal Terms” by Harm de Vries, Menno van Loon and Sjoerd Mol (as you guessed this is written by Dutchies and therefore a bit more down to earth) The book basically gives you the same explanation on the VC world and deal terms, but without the American tone of voice (it also makes for a much more boring read). I highly recommend first time founders to give either one a try!