Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist

[Foundry Group co-founders Brad Feld and Jason Mendelson are the authors of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist, published by John Wiley & Sons. This excerpt is from Chapter 2: How to Raise Money]

Your goal when you are raising a round of financing should be to get several term sheets. While we have plenty of suggestions, there is no single way to do this, as financings come together in lots of different ways.

VCs are not a homogeneous group; what might impress one VC might turn off another. Although we know what works for us and for our firm, each firm is different; so make sure you know who you are dealing with, what their approach is, and what kind of material they need during the fund-raising process. Following are some basic but by no means complete rules of the road, along with some things that you shouldn’t do.

Do or Do Not; There Is No “Try”

In addition to being a small, green, hairy puppet, Yoda was a wise man. His seminal statement to young Luke Skywalker is one we believe every entrepreneur should internalize before hitting the fundraising trail. You must have the mind-set that you will succeed on your quest.

When we meet people who say they are “trying to raise money,” “testing the waters,” or “exploring different options,” this not only is a turnoff, but also often shows they’ve not had much success. Start with an attitude of presuming success. If you don’t, investors will smell this uncertainty on you; it’ll permeate your words and actions.

Not all entrepreneurs will succeed when they go out to raise a financing. Failure is a key part of entrepreneurship, but, as with many things in life, attitude impacts outcome and this is one of those cases.

Determine How Much You Are Raising

Before you hit the road, figure out how much money you are going to raise. This will impact your choice of those you speak to in the process. For instance, if you are raising a $500,000 seed round, you’ll talk to angel investors, seed stage VCs, super angels, micro VCs, and early stage investors, including ones from very large VC funds. However, if you are going out to raise $10 million, you should start with larger VC firms since you’ll need a lead investor who can write at least a $5 million check.

Brad Feld

While you can create complex financial models that determine that you need a specific amount of capital down to the penny to become cash flow positive, we know one thing with 100 percent certainty: these models will be wrong. Instead, focus on a length of time you want to fund your company to get to the next meaningful milestone. If you are just starting out, how long with it take you to ship your first product? Or, if you have a product in the market, how long will it take to get to a certain number of users or a specific revenue amount? Then, assume no revenue growth; what is the monthly spend (or total burn rate) that you need to get to this point? If you are starting out and think it’ll take six months to get a product to market with a team of eight people, you can quickly estimate that you’ll spend around $100,000 per month for six months. Give yourself some time cushion (say, a year) and raise $1 million, since it’ll take you a few months to ramp up to a $100,000-per-month burn rate.

The length of time you need varies dramatically by business. In a seed stage software company, you should be able to make real progress in around a year. If you are trying to get a drug approved by the Food and Drug Administration (FDA), you’ll need at least several years. Don’t obsess about getting this exactly right—as with your financial model, it’s likely wrong (or approximate at best). Just make sure you have enough cash to get to a clear point of demonstrable success. That said, be careful not to overspecify the milestones that you are going to achieve—you don’t want them showing up in your financing documents as specific milestones that you have to attain.

Be careful not to go out asking for an amount that is larger than you need, since one of the worst positions you can be in during a financing is to have investors interested, but be too far short of your goal. For example, assume you are a seed stage company that needs $500,000 but you go out looking for $1 million. One of the questions that the VCs and angels you meet with will probably ask you is: “How much money do you have committed to the round?” If you answer with “I have $250,000 committed,” a typical angel may feel you’re never going to get there and will hold back on engaging just based on the status of your financing. However, being able to say “I’m at $400,000 on a $500,000 raise and we’ve got room for one or two more investors” is a powerful statement to a prospective angel investor since most investors love to be part of an oversubscribed round.

Finally, we don’t believe in ranges in the fund-raising process. When someone says they are raising $5 million to $7 million, our first question is: “Is it $5 million or $7 million?” Though it might feel comfortable to offer up a range in case you can’t get to the high end of it, presumably you want to raise at least the low number. The range makes it appear like you are hedging your bets or that you haven’t thought hard about how much money you actually need to raise. Instead, we always recommend stating that you are raising a specific number, and then, when you have more investor demand than you can handle, you can always raise more.

Fund-Raising Materials

While the exact fund-raising materials you will need can vary widely by VC, there are a few basic things that you should create before you hit the fund-raising trail. At the minimum, you need a short description of your business, an executive summary, and a presentation that is often not so fondly referred to as “a PowerPoint.” Some investors will ask for a business plan or a private placement memorandum (PPM); this is more common in later stage investments.

Jason Mendelson

Once upon a time, physical form seemed to matter. In the 1980s, elaborate business plans were professionally printed at the corner copy shop and mailed out. Today, virtually all materials are sent via e-mail. Quality still matters a lot, but it’s usually in substance with appropriate form. Don’t overdesign your information—we can’t tell you the number of times we’ve gotten a highly stylized executive summary that was organized in such a way as to be visually appealing, yet completely lacking in substance. Focus on the content while making the presentation solid.

Finally, while never required, many investors (such as us) respond to things we can play with, so even if you are a very early stage company, a prototype, or demo is desirable.

Finding the Right VC

The best way to find the perfect VC is to ask your friends and other entrepreneurs. They can give you unfiltered data about which VCs they’ve enjoyed working with and who have helped build their businesses. It’s also the most efficient approach, since an introduction to a VC from an entrepreneur who knows both you and the VC is always more effective than you sending a cold e-mail to vcname@vcfirm.com.

But what should you do if you don’t have a large network for this? Back in the early days of venture capital, it was very hard to locate even the contact information for a VC and you rarely found them in the yellow pages, not even next to the folks that give payday loans. Today, VCs have web sites, blog, tweet endlessly, and even list their e-mail addresses on their web sites.

Entrepreneurs can discover a lot of information about their potential future VC partner well beyond the mundane contact information. You’ll be able to discover what types of companies they invest in, what stage of growth they prefer to invest in, past successes, failures, approaches and strategies (at least their marketing approach), and bios on the key personnel at the firm.

If the VC has a social media presence, you’ll be able to take all of that information and infer things like their hobbies, theories on investing, beer they drink, instrument they play, and type of building or facility—such as a bathroom—they like to endow at their local universities. If you follow them on Foursquare, you can even figure out what kind of food they like to eat.

While it may seem obvious, engaging a VC that you don’t know via social media can be useful as a starting point to develop a relationship. In addition to the ego gratification of having a lot of Twitter followers, you’ll start to develop an impression and, more important, a relationship if you comment thoughtfully on blog posts the VC writes. It doesn’t have to be all business—engage at a personal level, offer suggestions, interact, and follow the best rule of developing relationships, which is to “give more than you get.” And never forget the simple notion that if you want money, ask for advice.

Do your homework. When we get business plans from medical tech companies or somebody insisting we sign a nondisclosure agreement (NDA) before we review a business plan, we know that they did absolutely zero research on our firm or us before they sent us the in- formation. At best, the submission doesn’t rise to the top compared to more thoughtful correspondences, and at worst it doesn’t even elicit a response from us.

A typical VC gets thousands of inquiries a year. The vast majority of these requests are from people that the VC has never met and with whom the VC has no relationship. Improve your chances of having VCs respond to you by researching them, getting a referral to them, and engaging with them in whatever way they seem to be interested in.

Finally, don’t forget this works both ways. You may have a super-hot deal and as a result have your pick of VCs to fund your company. Do your homework and find out who will be most helpful to your success, has a temperament and style that will be compatible with yours, and will ultimately be your best long-term partner.

Finding a Lead VC

Assuming that you are talking with multiple potential investors, you can generally categorize them into one of three groups: leaders, followers, and everyone else. It’s important to know how to interact with each of these groups. If not, you not only will waste a lot of your time, but also might be unsuccessful in your fund-raising mission.

Your goal is to find a lead VC. This is the firm that is going to put down the term sheet, take a leadership role in driving to a financing, and likely be your most active new investor. It’s possible to have co-leads (usually two, occasionally three) in a financing. It’s also desirable to have more than one lead VC competing to lead your deal, without them knowing whom else you are talking to.

As you meet with potential VCs, you’ll get one of four typical vibes. First is the VC who clearly is interested and wants to lead. Next is the VC who isn’t interested and passes. These are the easy ones—engage aggressively with the ones who want to lead and don’t worry about the ones who pass.

The other two categories—the “maybe” and the “slow no”—are the hardest to deal with. The “maybe” seems interested, but doesn’t really step up his level of engagement. This VC seems to be hanging around, waiting to see if there’s any interest in your deal. Keep this person warm by continually meeting and communicating with him, but realize that this VC is not going to catalyze your investment. However, as your deal comes together with a lead, this VC is a great one to bring into the mix if you want to put a syndicate of several firms together.

The “slow no” is the hardest to figure out. These VCs never actually say no, but also are completely in react mode. They’ll occasionally respond when you reach out to them, but there is no perceived forward motion on their part. You always feel like you are pushing on a rope—there’s a little resistance but nothing ever really moves any- where. We recommend you think of these VCs as a “no” and don’t continue to spend time with them.

How VCs Decide to Invest

Let’s explore how VCs decide to invest in a company and what the process normally looks like. All VCs are different, so these are generalizations, but more or less reflect the way that VCs make their decisions.

The way that you get connected to a particular VC affects the process that you go through. Some VCs will fund only entrepreneurs with whom they have a prior connection. Other VCs prefer to be introduced to entrepreneurs by other VCs. Some VCs invest only in seasoned entrepreneurs and avoid working with first-time entrepreneurs, whereas others, like us, will fund entrepreneurs of all ages and experience and will try to be responsive to anyone who contacts us. Whatever the case is, you should determine quickly if you reached a particular VC through his preferred channel or you are swimming upstream from the beginning.

Next, you should understand the role of the person within the VC firm who is your primary connection. If an associate reached out to you via e-mail, consider that his job is to scour the universe looking for deals, but that the associate probably doesn’t have any real pull to get a deal done. It doesn’t mean that you shouldn’t meet with him, but also don’t get overly excited until there is a general partner or managing director at the firm paying attention to and spending real time with you.

Your first few interactions with a VC firm will vary widely depending on the firm’s style and who your initial contact is. However, at some point it will be apparent that the VC has more than a passing interest in exploring an investment in you and will begin a process often known as due diligence. This isn’t a formal legal or technical diligence; rather it’s code for “I’m taking my exploration to the next level.”

You can learn a lot about the attitude and culture of a VC firm by the way it conducts its diligence. For example, if you are raising your first round of financing and you have no revenue and no product, a VC who asks for a five-year detailed financial projection and then proceeds to hammer you on the numbers is probably not someone who has a lot of experience or comfort making early stage investments. As mentioned before, we believe the only thing that can be known about a prerevenue company’s financial projections is that they are wrong.

During this phase, a VC will ask for a lot of things, such as presentations, projections, customer pipeline or targets, development plan, competitive analysis, and team bios. This is all normal. In some cases the VCs will be mellow and accept what you’ve already created in anticipation of the financing. In other cases, they’ll make you run around like a headless chicken and create a lot of busywork for you. In either case, before you jump through hoops providing this information, again make sure a partner-level person (usually a managing director or general partner) is involved and that you aren’t just the object of a fishing expedition by an associate.

While the VC firm goes through its diligence process on you, we suggest you return the favor and ask for things like introductions to other founders they’ve backed. Nothing is as illuminating as a discussion with other entrepreneurs who’ve worked with your potential investor. Don’t be afraid to ask for entrepreneurs the VC has backed whose companies haven’t worked out. Since you should expect that a good VC will ask around about you, don’t be afraid to ask other entrepreneurs what they think of the VC.

You’ll go through multiple meetings, e-mails, phone calls, and more meetings. You may meet other members of the firm or you may not. You may end up going to the VC’s offices to present to the entire partnership on a Monday, a tradition known by many firms as the Monday partner meeting. In other cases, as with our firm, if things are heating up you’ll meet with each of the partners relatively early in the process in one-on-one or group settings.

As the process unfolds, either you’ll continue to work with the VC in exploring the opportunity or the VC will start slowing down the pace of communication. Be very wary of the VC who is hot on your company, then warm, then cold, but never really says no. While some VCs are quick to say no when they lose interest, many VCs don’t say no because either they don’t see a reason to, they want to keep their options open, they are unwilling to affirmatively pass on a deal because they don’t want to have to shut the door, or they are just plain impolite and disrespectful to the entrepreneur.

Ultimately VCs will decide to invest or not invest. If they do, the next step in the process is for them to issue a term sheet.

Closing the Deal

The most important part of all of the fund-raising process is to close the deal, raise the money, and get back to running your business. How do you actually close the deal?

Separate it into two activities: the first is the signing of the term sheet and the second is signing the definitive documents and getting the cash. This book is primarily about getting a term sheet signed. In our experience, most executed term sheets result in a financing that closes. Reputable VCs can’t afford to have term sheets signed and then not follow through; otherwise they don’t remain reputable for long.

The most likely situations that derail financings are when VCs find unexpected bad facts about the company after term sheet signing. You should assume that a signed term sheet will lead to money in the bank as long as there are no smoking guns in your company’s past, the investor is a professional one, and you don’t do anything stupid in the definitive document drafting process.

The second part of closing the deal is the process of drafting the definitive agreements. Generally, the lawyers do most of the heavy lifting here. They will take the term sheet and start to negotiate the 100-plus pages of documentation that are generated from the term sheet. In the best-case scenario, you respond to due diligence requests and one day you are told to sign some documents. The next thing you know, you have money in the bank and a new board member you are excited to work with.

In the worst case, however, the deal blows up. Or perhaps the deal closes, but there are hard feelings left on both sides. As we restate in several parts of this book, always make sure that you are keeping tabs on the process. Don’t let the lawyers behave poorly, as this will only injure the future relationship between you and your investor. Make sure that you are responsive with requests, and never assume that because your lawyer is angry and says the other side is horrible/stupid/evil/worthless that the VC even has as clue what is going on. Many times, we’ve seen the legal teams get completely tied up on an issue and want to kill each other when neither the entrepreneur nor the VC even cared about the issue or had any clue that there was a dustup over the issue. Before you get emotional, just place a simple phone call or send an e-mail to the VC and see what the real story is.

Reprinted with permission from Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. Copyright © 2011 by Brad Feld and Jason Mendelson. All rights reserved.

  • http://eyejot.com/users/davidg davidgeller

    Bought it yesterday (pricey for an electronic book) and I’m almost through it. Fast read. Very well written with great examples. Don’t go out fundraising without it!

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