Raising capital is a sales job. And for most of us, selling is hard. But with the right approach—the knowledge, tools, and mindset—it doesn’t have to be. Even if you’ve never sold a thing and the idea of it unnerves you, you can learn to sell investors on your idea, your team, and yourself.
This is a guide to raising capital drawn from my first- and second-hand experience, and from the experience of veteran investors and entrepreneurs. I’ve done a lot of deals and seen and read about a lot more. There is great stuff on raising capital all over. I’ve highlighted a few excellent sources at the end.
Here is what the process of raising capital looks like. First you need to figure out how much to raise. Then you can think about where to find it and how to find it. This is where the sales process really comes in. Once you’ve found potential investors, it’s time for due diligence and with luck a term sheet. If that goes well you’ll be negotiating deal docs, closing the deal, and getting down to the real business of putting that capital to work building something great.
Let’s go a little deeper.
But First, a Few Words of Warning.
Just because you can doesn’t mean you should.
Raising capital will change your business so make sure it’s what you really, really want. Make sure it’s what you need. I’ve seen good businesses destroyed by bad investors.
More often, though, the business isn’t destroyed, the founders just end up living a lifestyle they never wanted. When you take money you commit to working like hell to generate a massive return for your investors in a relatively short amount of time—like, five to seven years.
Make sure this is what you really want to do and really need to do because there is no going back. And there is a lot to be said for bootstrapping a sustainable business that supports you, your family, and your team. If things go well, you can choose to raise capital and scale later. Yes, you’ll probably grow slower. But with no strings attached. On your terms.
Now Let’s Figure Out How Much You Should Raise.
If you’re still moving forward with raising capital, your first question should be: How much?
Related to that is another question: How much of my company should I give up?
Before pitch decks and term sheets, you need to decide how much money to raise. That will largely—but not entirely—determine how much of your company you will give up and who you are likely to raise money from.
How much money should I raise?
There is no “right” answer to this question. Your company’s future can play out in different ways. Pick the future you prefer and try to back into the math.
By this stage you should already have some kind of a business plan. At least a business-model canvas. So consult that. Your plan should include reasonable assumptions about revenue and expenses over the next three to five years. It will be wrong. That’s okay. If you take the business-plan exercise seriously, it shouldn’t be so wrong that you can’t come up with a low-resolution idea of your burn—that is, the amount of money you’ll be losing, net, on a monthly basis until your company is self sustaining.
So not only is there no “right” answer in terms of how much you should raise but even when you decide on the amount, it will be wrong because your projections are wrong. Again, that’s okay. Nobody but the most inexperienced of investors expect you to get this anything more than roughly correct.
(If a potential investor wants to spend a lot of time dissecting your year-five revenue figures, run.)
Generally that means you need to calculate 12 to 24 months of burn and that’s your number.
If you think that you will be cashflow positive inside that period—and many new businesses can be, though high-growth startups rarely are—you can just raise enough to become cashflow positive. In other words if you expect that all you need is $200,000 of seed capital to reach profitability in nine months, then raise $200,000 of seed capital. (Actually, raise $300,000 of seed capital, because nothing ever goes according to plan.)
If you can’t find 12 to 24 months of capital on tolerable terms, then raise as much as you can—just so long as you can raise enough to execute on some version of your plan. Ideally you would raise as much as you can and modify your plan to make it last 12 to 24 months. Cut your burn. Bootstrap. De-risk your company. Then go raise more. Just because you want 18 to 24 months of capital, doesn’t mean it will be there.
The critical thing is to raise enough to hit a substantial milestone—like landing a paying customer (who isn’t your mom)—that will make investors more interested the next time you pass around the hat.
“the advice we often give to entrepreneurs is to think about your next round of financing when you are raising the current round of financing. What will you need to demonstrate to the next round investor that shows how you have sufficiently de-risked the business, such that that investor is willing to put new money into the company at a price that appropriately reflects the progress you have made since your last round of financing?”
Make sure that you raise at least enough capital to do that.
That said, 18 to 24 months is a standard ask. And as you’ll learn, startup financing has become relatively standardized. If you pitch an investor and you’re asking for three or more years of burn, don’t expect a second meeting. Veteran founder/VC Mark Suster’s take is that asking for too much capital is a warning sign to potential investors that you don’t know what the hell you’re doing.
Investors are always looking for warning signs. Experienced, successful investors particularly. They see an unreasonable number of deals so they’re looking for easy ways to say “no” and move on. Don’t make it easy on them.
Here are two wise but seemingly contradictory pieces of advice: Ask for less than you want; Raise more than you need. You can always increase the round size without losing face. It doesn’t work the other way around. And since nothing after the raise ever goes according to plan, if you do have the opportunity to raise more money without crippling dilution or onerous terms, do it.
How much of my company am I going to give up?
Raising 12 to 24 months of capital should typically cost you 20 to 30 percent of your company.
Your situation might be different. Sometimes you have a hot brand or insane growth and you can get 24 months of capital for 10 or 15 percent of your company. Other times you’re struggling, or you’re aiming for a small market—or maybe you’re raising a seed round in a city without much capital (hi, Midwest!)—in which case you’ll give up 35 percent of your company for 12 months of burn.
Fred Wilson recommends keeping dilution below 20%, particularly where you’re going to be raising multiple rounds. Dilution adds up.
As a lawyer I can’t help but mention that the amount of equity you give up in a deal will also depend on the actual terms of the deal. Go figure. So for example you’ll probably be able to keep more of your company if you offer a preference higher than 1x. (But don’t do that. Seriously.)
We’ll get into specific terms a little later.
What you really do not want to do is give up 50 percent (or more) of your company in exchange for any amount of runway. I can’t think of a single client who has accepted these terms. But I have seen a lot of investors ask. (This is more common in places outside the coastal capital hubs where tech returns are still not intuitive, and investor still think in terms of cash-flow laundromats and landscaping companies.) There are other important terms for maintaining control, like permanent board seats, but the quickest way to lose control of your company is to sell a majority stake.
To illustrate how all of this works, let’s say you previously raised a $500,000 seed round at a $1,500,000 pre-money valuation (the value of your company before raising capital.) Post-money the company is worth $2,000,000. You sold 25% of your company and still own 75% of it. Now let’s say you’ve burned some of that $500,000 and you think that’s what’s left will last you another six months. At this point you should be all in on raising your next Series A. It will almost certainly take you at least six months.
To keep it simple, we’ll assume that you’re projecting a fixed burn of $150,000 per month after the Series A. (You’ll be scaling up your sales team, marketing, ops, and maybe even legal compliance!) So you should be looking to raise $1,800,000 to $3,600,000.
(Because $150,000 per month over 12 months is $1,800,000 and over 24 months it is $3,600,000. That gives you your range.)
If you give up 20% of your company for this that means your pre-money valuation will be in the range of $7,200,000 to $14,500,000.
(Because $1,800,000 / 20% is $9,000,000, subtract out the investor’s $1,800,000 to get a pre-money valuation of $7,200,000. And $3,600,000 / 20% is $18,000,000 or $14,500,000 pre-money.)
But for 30% of your company your pre-money will be in the range of $4,200,000 to $8,400,000.
In other words if you’re raising $1,800,000 to $3,600,000 in this situation you can expect a pre-money valuation of $4,200,000 to $14,500,000. Quite a range.
How do you decide what to actually ask for? You start with the best terms you can realistically pitch. Here, on paper, that would be $3,600,000 for 20% at a $14,500,000 pre-money valuation. But the best realistic terms on paper are not necessarily realistic in real life.
Be careful about how your valuation jumps from round to round. A $2,000,000 post-money Seed round to a $14,500,000 pre-money Series A is aggressive but not unprecedented. Particularly if you’ve nailed product/market fit. But I recommend against jumping to, say, a $30,000,000 pre unless you’re truly killing it. I have seen it work, but you make the sell much harder—the huge leap doesn’t line up with investor expectations—and you also put yourself in a position where if you don’t absolutely crush your projections you may be forced to raise a down round in the future and that’s all kinds of bad news.
If you’re a solo founder, then at this point your company has raised around $2,000,000 to $4,000,000, including the Seed and Series A rounds, and you’re left with 55 to 60% of the equity. If you have one other co-founder and you split equity evenly—which, don’t do that—then you’re each down to just 27.5 to 30% and you’re only through the Series A.
Remember what I said about maybe not raising capital?
Of course, that 55 to 60% is now worth something like $3,000,000 to $10,000,000. On paper. Your slice shrinks but the pie grows. So you’re still better off. On paper.
Important note here. In my experience, angel rounds are typically priced by the entrepreneur and negotiated by the investors. In venture rounds, from institutional seed to A, B, etc, the investor prepares a term sheet and prices the round, and the entrepreneur negotiates.
Where Do I Find Startup Capital? Sources of equity capital by need, stage, and growth strategy.
The amount of capital you intend to raise and the growth stage of your company will determine who you should be talking to. Expect your first money to come from your own pocket and from friends and family. Start by investing your own funds to get the company moving (or at least investing your own time, if you don’t have money). Then look for angel investors—what your grandparents called rich people—or seed funds, or launch a crowdfunding campaign, or join an accelerator. Today there are professional venture-capital funds doing everything from seed-stage to late-stage investing, so you may be talking with a VC seed fund early on. At the far end of this journey banks will lend you non-dilutive capital, but apart from credit cards and lines of credit that kind of capital is a long way off.
Yourself, Your Friends, and Your Family
Who knows you better than you? Maybe your friends and family. That’s why your first capital—the highest-risk capital—will come from your own pocket and the pockets of people you already know.
These people (hopefully) trust you. They are investing based on shared history. Your big idea is secondary.
Trust makes the family-and-friends round possible. It also creates two potential problems.
First, it’s hard to set fair terms. You can easily take advantage of your relationships by pushing terms that would be unacceptable to a stranger. You’ll probably be setting terms with little pushback. Resist the urge to overplay your hand. Terms in your favor are okay, but be reasonable. But don’t go too far the other way, because if you give your friends and family outsized positions on your cap table it will be a turnoff to potential future investors. Set terms that loosely simulate an arm’s-length negotiations.
The second problem is that these people are investing in you so they typically spend very little time vetting your idea or your business plan. Your grandmother takes it on faith that you know what you’re doing. Which means that you run the risk of breaching that faith and harming your relationships if the business fails. Do not take money from friends and family who cannot afford to lose it. And be sure to explain that no matter how much they might believe in you, your business is still a risky venture that may very well fail and that even in the best case their money will be locked up for a decade or more.
I consider friends-and-family money to be by far the most expensive in the stack. It’s relatively easy to get (depending on your friends and family). But your name, your word, and your relationships are always, always worth more than your venture. Don’t throw them away for a few dollars.
Also bear in mind that your friends and family may help you out of obligation, but they won’t have the fire of a true believer. So don’t expect help beyond that initial check and a few Facebook likes. The time and advice you’ll get from a motivated, true-believer angel is worth a whole pile of friends-and-family money.
One step removed from friends and family is an amorphous group that we call angel investors. Anyone with capital to invest can be an angel, but the prototypical angel has some experience in your industry, with running a business, or both.
Angels will be more demanding than friends and family because there is no reservoir of trust. Some angels will invest casually while others demand a ton of due diligence, a detailed business plan, and intricate financial projections. As we discuss below on due diligence, it’s best to have a basic packet of information ready to present to these investors.
In my experience, angels who work in your industry typically ask for less diligence than angels who are or were business owners. That’s probably because business owners know what to ask for. Industry insiders are more likely to understand the value of your idea intuitively, but less likely to anticipate the risks that you can only learn from running a business.
Crowdfunding is a relatively new concept. First there was Kickstarter-style non-equity crowdfunding—raising money for a project through pre-sales and the like. Then equity crowdfunding was legalized by the JOBS Act and Regulation Crowdfunding.
The basic idea of equity crowdfunding is that a company can raise capital by selling small pieces of equity to a large crowd of ordinary people. The dream for many entrepreneurs—particularly introverted entrepreneurs—is raising capital without having to pitch any individuals. Marketing instead of sales.
Unfortunately the dream rarely materializes. It is difficult for campaigns to stand out. They take considerable effort to market and can chew up precious company resources, including time that could be better spent pitching individual investors who have the ability to fully fund a round with a single check. Often you’re going to end up paying a consultant to help run your campaign or spend all of your time on it.
If you go the crowdfunding route, approach it as part of a broader marketing campaign. Use it to create brand recognition.
Even if you’re successful, if you don’t structure terms properly crowdfunding creates more problems than it solves. You will have dozens or hundreds of small investors on your cap table. Each of them is entitled to some degree of ongoing disclosure and hand holding. There are ways to mitigate this problem, but it can’t be eliminated entirely.
Seed Funds and Venture Capital Funds
Professional investors form funds that invest in multiple opportunities. These funds run the spectrum from Seed funds cutting checks of $500,000 or less to Series A-focused funds that invest $1,000,000 to $10,000,000, and growth funds that invest larger amounts in more-established companies up to the point of IPO. At the later stages venture-capital funds really become indistinguishable from private-equity funds and even banks.
Corporate Venture Capital
Here’s something to be careful with.
A lot of large corporations now have in-house venture capital funds. Startups are all about innovation. Large companies, which often have problems with effective innovation, see startup investments as an opportunity to get in early on important innovations.
It’s a good idea in theory, but rarely well executed.
For most startups, CVC is a treacherous siren song. The CVC promises access to vast corporate resources, perhaps the corporation can be a large buyer or even an exit opportunity. The startup is lured in only to crash on the rocks of reality.
It’s rare that a corporate VC operates like a traditional VC. Most corporate investors aren’t interested in a straightforward home-run return that would satisfy a traditional VC. Instead they want access rights, exclusivity, rights of first refusal on future funding rounds or on acquisition. But the more hooks the corporation has into your startup, the less appealing your startup is to competing corporations—who may be important customers or potential exit opportunities themselves.
The right of first refusal on acquisition is a real problem.
If you give a ROFR on acquisition to a CVC, anyone looking to buy your company knows that the deal could be scooped. Nobody wants to be a stalking horse. So a ROFR scares off potential buyers. Which means—supply and demand—fewer buyers and a lower exit price. Rights of first refusal are not innocuous. Do not give them.
CVC done right can definitely work. The industry seems to be improving gradually. But be incredibly cautious.
A Strategic Approach to Finding (the Right) Investors
Expect to spend time finding the right investors. It’s a process. There are different approaches, but I like Mark Suster’s recommendations in What’s the FIRST thing you need to do before fund raising?, summarized here with a few changes:
- Create a list of potential investors who you’d like to work with.
- Rank the investors by opportunity and likelihood to invest (A, B, C, Passed).
- Qualify the investors to make sure they’re a fit.
- In the case of VC, know all about the firm, but also know the individual partners and know which partner leads deals like yours.
- Research the partner’s connections to find a strong intro. Never talk without an intro.
- Stay at it. Follow up. Do not forget that this is a sales campaign.
Most of you will need to flip his first and third steps—you’ll need to research investors, narrow down prospects, then create a list. There are a ton of resources available to find investor information. As Suster says: “There are enough data sources that if you can’t figure out the basics then don’t run a startup.” Crunchbase and AngelList are good places to start.
Narrow Down Your Search to the Best Fits
Start by narrowing your search to investors who invest at your stage—Seed, Series A, Series B. Sometimes this is explicit. Sometimes it can be inferred from fund size. Small funds do seed rounds; bigger funds do A rounds; massive funds do B, C, D, and later rounds. Though this dynamic has been skewed somewhat as larger firms look to get into investment early and fund through multiple rounds—A rounds and later have become too competitive for most firms to start there.
Next look for industry fit. Does the investor do deals in your space? This is particularly important if you’re looking for a lead investor. But industry expertise can be a big help from any investor. Not only should the investor be doing deals in your general industry, but ideally they’re doing deals in your specific industry space. But—and this is really important—filter out anyone who has invested in your direct competitors. They won’t invest in your company (if they’re willing to, that is concerning) and they may take what you tell them back to your competitor. (This could happen in any case, so don’t fill your pitch deck with secrets.)
You also want to make sure that the investor does deals in your geographic area. It is of course possible to raise outside your neighborhood and hold future board meetings by phone or video conference. But that’s not ideal. If you go that route, make sure that your investor visits for an in-person meeting at least a couple of times a year.
Look for investors who have invested in companies that you respect and that share your outlook and philosophy. If you know the founders of those companies ask for insight. There’s no better intro to a VC than one coming from the founder of a portfolio company.
The Right Investor Shares your Vision, Objectives, and Moral Outlook.
Taking money for money’s sake from an investor who you don’t align with on vision, objectives, and morality is a mistake. I’ve seen it happen. I’ve seen it destroy perfectly viable businesses and create unnecessary, life-draining stress.
Here’s the reality. You’re better off raising nothing than raising from bad investors. Entrepreneurship is damn hard when everyone is rowing in the same direction. It’s immeasurably better to fail, take a nine-to-five job for a while, and try again later than to give the next 10 years of your life to an investor who will make them unbearable.
Find investors you align with and walk from everyone else.
Rank Your List
At this point you’ll have a list of potential investors who are, at least on paper, a good fit for your company. Plug that list into a spreadsheet and rank each opportunity. Opportunities that are both a great fit and reasonably likely to succeed get an A, those less of a fit or less likely to close get a B, and so on. Scratch off firms if they pass.
Keep each tier relatively small. You can only focus on so many opportunities at once before you’re spread too thin. Suster recommends about 8 to 10 in categories A, B, and C—with maybe a few more at the bottom end. Try to cap the list at 50 opportunities. You can always add new opportunities as they come up. And if you’re talking with angels that list might be a little larger. You might end up with a long cap table.
Now Work Your List
You do not want to meet with a potential investor without getting a proper introduction. You want warm introductions from trusted resources. This can be a little harder to dig up, but start by combing over the investor’s social media and reach out to the founders of other companies the investor has funded.
Talking with other founders is also a great way to qualify a prospective investor. Better still if it’s a founder of a failed venture. You can learn a lot about what the investor is really like.
Work your list to get intros. It may take a couple hops if you’re not already well connected.
Remember that this is a sales campaign, so you need to stay in touch and keep investors interested.
“If you’re not able to find ways to keep a prospect engaged during your sales process then you have no hope as an entrepreneur when you eventually need to run sales campaigns, sign business development deals or one day sell your company in a large transaction. The key to all success in life is follow through and what separates out the truly successful people from the less successful people in funding is often follow through and follow up.” Mark Suster.
Don’t Get Discouraged.
This can be a grueling process. Plan to spend most of your time over the next six months on this project. Plan to hear “no” a lot. Keep in mind that you only need one investor (or maybe a handful) to fund your company.
I love this graphic from the Anatomy of a Seed Round. Just look at the number of dead-end meetings. But also look at how a few meetings spawned more meetings and led, ultimately, to $1,000,000 of seed funding. You won’t know in advance which meetings will work out and which will be dead ends, so take them all and be persistent. When in doubt, remember this graphic.
Shooters shoot. Entrepreneurs sell. It’s a volume game.
For what it’s worth, later rounds tend to be simpler than this—unless you happen to be raising in a recession. But unless you have an investor willing to take all follow-on rounds, which isn’t likely, the same general pattern holds.
Thinking ahead a few moves.
Most startups raise several rounds of capital before an eventual acquisition or IPO. Each consecutive round should be raised at a higher pre-money valuation than the last round’s post-money valuation. Ideally a fair bit higher. Your odds of success go way up if you start thinking now about how you will accomplish this.
As I mentioned above, down rounds are bad. “Down round” means that you’re raising capital at a lower valuation than your last round. Down rounds send a negative signal to your investors—investors expect growth and you’re going in the opposite direction. They also tend to have draconian consequences for you, the entrepreneur, as a result of anti-dilution protection that’s found in most deal documents.
To minimize the chances of a down round, you need a strategic, long-view approach. Do not focus on maximizing the valuation of your current round. You might be able to squeeze your new investors for a few extra dollars of valuation, but you’ll typically pay for it with tradeoffs in other terms, and you’ll always pay for it in heightened growth expectations. If you don’t meet those heightened expectations before you run out of capital your current investors won’t be happy, new investors won’t be impressed (or won’t exist), and you’ll have a hard time raising at a respectably higher valuation—particularly after being so aggressive with valuation in the last round. You may be forced into a down round. It’s far better to accept a reasonable valuation—on the upper end of the available spectrum, of course—and step up from there.
Keep in mind that once you take venture capital, your investors have their own investors. Help your investors look good with their investors by pricing your rounds for steady upward growth.
Are You Still an LLC?
Quick aside here. If you raised a seed or pre-seed round as an LLC you should consider converting to a C corporation before your next round. Most VCs won’t touch you as an LLC. Some angels won’t either. Jason Calicanis, for example, is adamant that angels should never invest in an LLC. You won’t find that rigidity in most parts of the country. But even so you should probably convert to a corporation if you plan to step from angels to VCs.
(I say “probably” because every situation is a little different and there are rare cases where the tax advantages of an LLC outweigh the structural simplicity, familiarity, and other tax benefits of a corporation. But in the world of high-growth startups that’s rare.)
If this is your path, plan from day one to create an equity structure that converts efficiently. This is easier said than done. But you can set yourself up well by creating a membership-interest structure that mirrors the common-stock/preferred-stock division you’ll be converting into. And make sure you have the authority—even the explicit authority—to convert. We often mention the plan to convert in early term sheets to set expectations. Don’t leave conversion up to a future vote of your friends, family, and local angel investors.
You also want to convert sooner rather than later. It only gets more complicated over time. The primary benefit of an LLC—pass-through, single-tax profits—may matter to some angels who want to take losses but that’s irrelevant to later stage investors. And perhaps the biggest benefit of investing in a corporation—the Qualified Small Business Stock 100% exclusion of capital gains—requires a five-year holding period. If you convert too late, you may miss this opportunity by exiting before you hit five years.
Your Pitch Deck and the Pitch
In the world of startups you’ll be expected to provide investors with a pitch deck—a set of powerpoint slides that explains who you are and what you’re doing. Nobody looking at startup deals wants to read a one-hundred-page private-placement memo or a prospectus. Don’t waste your time preparing one. Stick to a high-quality deck. If a potential investor asks for your PPM that’s a good indication that she isn’t familiar with startup investing.
There’s a lot of great stuff out there on creating a compelling pitch deck. Andy Raskin has excellent materials on pitch decks and crafting your story. He’s writing as much about sales as fundraising—but remember this is sales. Your pitch deck is a sales tool.
If you search around you can find good pitch-deck examples. Here’s a template recommended by VC firm Sequoia. Here’s the AirBNB seed deck. Here’s Foursquare’s seed deck. YouTube’s Series A deck. Uber’s seed deck (gated). And eShares’ (now Carta) Series A deck.
There is no one way to create a pitch deck. But if you look over these examples you will see patterns. Make sure you present the problem, the market, your solution, your team, explain: why you and why now. Get your story tight. And make it crystal clear how you plan to make a ton of money for your investors.
From an aesthetic standpoint, make your deck easy to skim, with the main points standing out in headings and clear graphics. A potential investor is likely to skim through your deck before reading in depth. Be sure they’ll get the idea. If you need to get into the weeds or have detailed financial projections, put those in an appendix section after your last presentation slide.
Once you have a deck together, practice pitching. Pitch your friends. Pitch your spouse. Pitch your phone. Pitch your cat. Use every opportunity you can find to practice pitching so that when you’re doing it live in front of your ideal investor you come off as confident and professional. Practice. Practice. Practice.
Preemptive Due Diligence — Get Your House in Order
Before you start reaching out and pitching investors, consider what will happen if you’re successful. Most investors will want to dig a little deeper into your company before cutting a check. That digging is called due diligence.
Make this easy and you’ll look like a pro. Diligence will move quickly. And you’ll get out in front of any negative stories or unappealing parts of your business.
On that last point—go ahead and clean up your social-media history. Investors will search for you. Take down anything that will be offensive to a reasonable investor. Take down anything idiotic you posted in high school. You don’t need a clean slate. You don’t need to be milquetoast. Your idiosyncrasies make you interesting. But at the same time ask yourself, would you trust your money to the person you play on social media?
Proactively, when an investor is ready to move forward have a diligence packet ready. This should include a current cap table, basic corporate documents (certificate of incorporation, bylaws, investors’ rights agreement, and that sort of thing), bios of you and your key team members (including background checks if you have them), IP assignment agreements, key person employment agreements, patents, any licenses your company needs to operate, and other major contracts.
Typically you will provide this information to investors by email, Dropbox link, or a data room. The last is more common in larger deals. You might think about skipping the data room entirely. But in any case you’ll need to share this information at some point, so have it ready.
Do not expect any investor to sign a confidentiality or non-disclosure agreement. They won’t. Serious investors see many overlapping deals. There’s too much liability exposure for them in signing an NDA. So don’t include anything incredibly sensitive in your diligence packet, like trade secrets or confidential contracts. Save those for later. In some industries—hard sciences, specifically—you might get an NDA closer to investment. But at this stage it’s always too early to ask.
Your diligence packet is intended to keep things moving forward. Don’t go overboard putting it together. Just put together the basics. Expect investors to ask for more information than you provide. Get it to them quickly.
The Term Sheet
You aren’t seriously negotiating until you’re working on a term sheet. A term sheet is a short document—usually two to four pages and sometimes called a letter of intent—that summarizes all of the major terms of the investment deal. Term sheets are typically not binding, meaning either side can walk at any time, but they signal intent to do a deal and carry moral and reputational weight. Investors do not want to be known for signing term sheets and walking away. (Hopefully in the search phase you weeded out any investor with a reputation for walking from deals.)
Either side can propose a term sheet. If you have a lead investor in an investment round, that investor will typically create the first draft of the term sheet. In early rounds involving friends and family or a group of angels, the term sheet is usually written by the issuer.
Once a term sheet is proposed it will be negotiated until agreeable and then signed. All investors will be expected to sign the same term sheet for the same terms. (In some cases an investor bringing more to the table will get a “side letter agreement” providing some additional rights, like a board seat or board-observer seat.)
Some Basic Terms
This isn’t the place to deep dive into terms. If you want to go into specifics on the terms that will be in your term sheet, we’ve written a lot more about it elsewhere.
The fundamental things you’ll need to have figured out at the term sheet stage are valuation—which is covered above—and what kind of investment vehicle you are selling: equity (equity or membership interests), convertible debt, or a SAFE. If you haven’t already decided, you’ll also need to figure out whether your company is going to be a limited-liability company or a corporation. Though as noted, plan to convert to a corporation at some point.
Convertible debt is a standard promissory note—like a stripped-down version of the note you sign to buy a house or a car—with the added right to convert the principal and accrued interest on the note to equity at the company’s next financing round. If you don’t plan to raise another investment round, the note can convert automatically on fixed terms on a specific date, like three years after issuance. But if you don’t plan on raising another round, a convertible note might not be the best vehicle.
The SAFE—simple agreement for future equity—is an option to purchase equity in a future financing round at no additional cost. It is triggered automatically when the company raises another round on pre-defined minimum terms. A SAFE is essentially a convertible note without interest or a maturity date.
The term sheet will cover other major terms like participation and liquidation preferences (pro tip: you want non-participating with a 1x liquidation preference—your investor either gets its money back, if things go poorly, or converts to common and enjoys the upside with you), conversion rights (preferred to common), drag- and tag-along rights, information rights, board participation (a director seat or observer rights).
After a term sheet is signed, the lawyers will get busy writing up the definitive deal documents. The term sheet covers all the major terms at a high level, but these terms need to be expanded into operative legal language. The term sheet usually doesn’t cover any of the nuance.
Lawyers are more directly involved in negotiating deal documents than in negotiating the term sheet. (But definitely do not sign a term sheet before talking it through with experienced counsel! I’ve seen that mistake made too many times to count. It’s hard to walk back a bad term sheet.)
Deal documents are typically based on industry-standard templates, so it helps to have a lawyer with startup experience who is familiar with the document sets. Expect a lot of back and forth on these deal documents before they’re finalized and ready for closing.
When the documents are done and the exhibits complete, you’re ready to close. In seed-fund and VC deals, the company will provide wire-transfer instructions. In smaller deals the investor may just cut a check.
Ideally all investors will close on the same day. This is usually done remotely and electronically. But occasionally you’ll still have an in-person closing on small deals. Some investors may need to close later—because of logistics or because they got on board late—and most deal docs will provide a window of 30 to 120 days after the initial closing for any subsequent closings.
Setting a closing date far in advance can be a useful tactic in angel rounds to pressure investors to fish or cut bait. That won’t work as well in a VC round, but in that case you typically won’t have as many investors to corral.
Expect the closing date to slip once or twice. It’s an unfortunate reality of deals that things come up, people take vacation, diligence takes longer than expected, and the closing date gets pushed. Try not to let this happen too often. Use the closing date as a forcing function.
If the issuer is relying on Regulation D to exempt the securities offering from registration requirements, it will have 15 days from the initial closing to file Form D with the SEC and with all states in which securities were sold.
If the issuer is a corporation it will send out stock certificates. Like everything else, this is increasingly done electronically through sites like Carta. If the round is small enough the company may still issue paper certificates. LLCs typically do not issue certificates for membership interests, electronic or paper, but keep an updated table of investors at the end of their operating agreement.
Ongoing Reporting to Investors
Investors don’t like being left in the dark. Very early stage investors may tolerate it because they don’t know any better or because they follow you on Instagram and can literally see what you’re up to. But don’t count on it.
Professional investors are going to insist on information rights and regular updates. If you raise from a group, the lead investor will usually take a board seat. But everyone in the round is going to ask for quarterly or monthly updates on the state of the company’s financials, growth, and strategy.
If you raise money from a state-backed incubator—any investor deploying government funds—you will need to satisfy reporting obligations regarding the number of people you employ, salaries, and that sort of thing. The things that elected officials want to know, so they can brag about all the good they are doing.
Beyond the raw data, good entrepreneurs provide their investor with regular, substantive updates. You want your investors to keep you top of mind. You want them to keep believing in you. You want them to fund future rounds. And you want them to hype your company at every opportunity. Your investors are owners. Treat them like owners.
Raising the Next Round Starts Now
If you successfully raised a round and expect to raise another in 12 to 24 months, start laying the groundwork immediately. Go through the process of creating a potential-investor list, narrowing down the VCs that you’d like to work with. Start learning about them. Start networking and building relationship before you get close to raising your next round. It will help tremendously. This will not be a full-time endeavor like it is while you’re actively raising. But do set aside time regularly to work on meeting and staying in touch with potential future investors.
Three other things to be aware of on the technical side.
First, in order to raise your next round you will need investor consent—or at least a majority vote to authorize amending the company charter and issuing new stock. (Or membership interests if you’re still operating as an LLC.) Make sure it’s not a surprise when you go to ask for authorization.
Second, your investors may have preemptive rights to take some or all of your next round. Professional investors usually insist on this—VCs make their money by doubling down on the winners; preemptive rights ensure they can. This creates a problem if you want to bring on a new investor for a specific amount and your current investors have the right to purchase as well. This problem emerges when you’ve been talking with a promising VC who really wants in but “needs” to invest some amount, say $5,000,000, to make it worth the firm’s involvement. You can’t do a $5,000,000 round because your prior investors will preemptively take some or all of it. You can structure around this, but typically you’ll need the original investors on board to either pass on some or all of their rights or to authorize a sufficiently large round to accommodate everyone.
Third, whatever the size of your round, keep a close eye on dilution. Dilution creeps up on founders. You go a couple rounds. You have an equity pool. And suddenly you’re down to 10% of less of the company that you started just a few years ago. That’s not necessarily a bad thing if the pie is getting much bigger. But it can be, so be careful.
Get At It
This should be enough information to get you started. I’ve included some additional resources below. If you still have questions reach out to me at email@example.com and I’d be happy to talk with you.
Remember that raising capital is a sales campaign. Organize yourself accordingly and plan for a sustained effort. As founder your most important job is ensuring that your company has the resources to survive and thrive. Treat your capital-raise efforts accordingly.
There are many good resources on raising capital. Here are a few of my favorite articles and books. Be careful that you don’t fall into a blogosphere black hole. You’ll learn more by doing. You need to learn how this works, but progress and momentum matter most of all.
The Big Picture:
Scott Kupor on How to Raise Money from a VC.
Sebastian Quintero on How much runway should you target between financing rounds?
Paul Graham on How to Raise Money.
Y Combinator’s Guide to Raising Seed Funding.
Venture Hacks on How Much Money Should I Raise?
Venture Deals by Brad Feld and Jason Mendelson
The Secrets of Sand Hill Road by Scott Kupor