For non-finance professionals, much of what a CFO does is a mystery and more than a little daunting. Cash flow statements, 409a valuations, tax, audit, treasury, stock options, D&O insurance are among the many topics that strike fear in the hearts of CEOs, especially those new to the role. But more than any other topic in finance, the concept of fundraising is often the most daunting and misunderstood.
How much do we need?
When do we need it?
Where do we get it?
Under what terms?
After 30 years of being a CFO and helping more than 50 companies raise an aggregate of a billion dollars plus in debt and equity, I have some guidelines and advice for how companies should manage their fundraising process.
When it’s you, your partner and your dog working out of your basement, you have a unique opportunity to think about your business before deciding what it is you need to fund your plan. This thinking stage evolves into a more detailed plan, usually in the form of a slide deck (20 – 30 slides, no more!) that follows a traditional outline and describes the product, the team, the market, the opportunity and the underlying financial plan.
Based on your assumptions and estimates, you should be able to articulate what it will take to launch the business. The funding required is typically adequate to fund the company for 12+ months and/or to a specific value inflection point. The key is to take the time to do your planning and take as little money as possible to support the launch. Ideally, you should self-fund the business until you’re ready to talk to outsiders.
Friends & Family (F&F)
If you need more time or more money than you can commit to yourself, then the next option is the so-called Friends & Family round. This is where you hit up your parents, siblings, Uncle Joe and others who are willing to invest in you, no matter what your business plan.
Unless you are lucky enough to come from a wealthy, extended family and because there are generally not many of these people in the first place, F&F rounds tend to be relatively small – no more than $1 million. The process is quick and simple, but although these people can be very supportive of you, the risk of failure is still very great, and you should be honest about that. You should know that one’s heart often follows the pocket book.
A step up from the F&F, individual investors or “angels” are your next best option. Angels are high-net-worth individuals and often invest in groups to help streamline the process. Angel rounds can be anywhere from $500k to $3 million and many of these people are experienced entrepreneurs who can add value with their operational acumen or their connections.
The biggest problem with raising angel money is that it is not unusual to have 20 or 50 or even more individuals who have invested. Because angels are often entrepreneurs themselves and want to know what’s happening in the business from day to day, this can be time consuming and expensive to manage. The term “herding the cats” is often used to describe the process of managing your well-meaning, but inquisitive angel investors.
Terms and valuation/dilution
It’s worth pausing here to discuss the mechanics of fundraising. The best advice I can give is to keep it simple and don’t be greedy. For the F&F and angel rounds, I recommend using a convertible note as a way of keeping it simple. This avoids the inevitable fight about valuation and ownership until a later date. Any funds received will be invested as a note payable and will accrue interest until some qualifying event occurs, usually a larger financing round. Upon closing a qualified financing round, the principal and interest will “convert” into the new security, often with some sort of discount for having taken the early risk. The simplest form of such a note is a SAFE or Simple Agreement for Future Equity that can often be as little as 1 or 2 pages.
The ownership / dilution issue is the most difficult for an entrepreneur and I’ve often seen companies ruined because the owners could not accept the terms that were offered and end up with $0. This is your baby and it’s really hard to let go, but you have to be realistic about what investors will expect and what you’ll need to be successful. The best thing to do is to run a process and have more than one option available so you have some leverage. I always tell my clients that you don’t get paid on your Series A (or B), rather you get paid when you sell your company or if you are very lucky, when you go public. So don’t sweat the difference between 5% and 10% ownership. If you have good, patient investors and are successful, it won’t matter.
VCs are the first of the so-called institutional investors and will invest in early stage, high risk opportunities. They will invest anywhere from $2 million to $50 million and often specialize in a specific industry. This is a broad range and there are VCs who focus on the company formation end of this range (typically Series Seed rounds) and those who focus more on later investments (Series A and beyond). These firms are staffed by only a handful of partners, the best of whom have already been successful entrepreneurs. They in turn will have raised money from larger institutions and are responsible for managing and investing huge sums of capital.
From the outside looking in, VCs can seem pretty intimidating with their teams of Harvard MBAs and seemingly unlimited access to capital. And they are tough to reach. The best advice to getting the attention of a VC is to use your network and get a “warm” introduction anyway you can. While many VCs claim to be risk takers, like any good investor, they will be looking for deals with higher rewards and lower risk. If you’re part of a team that has built successful companies or are in a hot space, then your job is a little easier.
As the name implies, growth equity players specialize in investing in mid to late-stage companies that have de-risked their business and need significant capital to grow, either by investing in manufacturing, sales & marketing or just building the team. Unlike VCs who will invest in companies with no revenues or profits, growth equity players are looking for companies with traction, usually $5+ million in sales and if not profitable now, then within sight (e.g. less than 12 months) of achieving profitability.
So-called strategics are companies in your industry who may be interested in investing in your company to nurture innovation or expand into new lines of products. On the one hand, a strategic investment can be a great way to gain valuable knowledge about processes or markets and leverage the might of a larger player for things like sales distribution. However, having a strategic investor can sometimes eliminate a set of buyers because they view the investor as a competitor.
There are numerous government initiatives to support entrepreneurs and they vary widely by industry and design. There are loans, grants or in-kind services that can help you build your business. Of course this assistance comes with certain strings attached, most notably rigorous reporting requirements that can be challenging for small businesses. The Small Business Administration (SBA) is a good place to start to research the various options and how they might apply to your company.
Mergers & Acquisition (M&A)
Unless you go public, M&A is the most likely way to generate liquidity for you and your investors. This is where all your hard work pays off and you reap the rewards of your success by selling some or all of your company. You can do this yourself, but I recommend employing a professional such as a business broker or investment banker.
The inflection points & metrics
Inflection points are the key stages in a company’s life cycle where value increases exponentially. In product companies, examples are the first prototype, the first commercial revenues, market expansion and profitability. For pre-revenue companies such as biotechs, examples include identifying a lead drug candidate, producing the compound and then the various stages of the FDA approval process through to commercialization. For any type of company, inflection points might include hiring a crackerjack CEO or doing a deal with a strategic partner.
Metrics are used to help both the company and investors quantify when these inflection points occur. Companies use metrics such as sales growth, average selling price (ASP), gross margin, earnings before interest, tax, depreciation and amortization (EBITDA) or net income to measure their progress against goals. It’s critically important to establish the right metrics for your team and report on them in an accurate and consistent fashion. Knowing your business’ metrics and being able to demonstrate growth and strength in the company is the best way to support a sales process.
Investors often look at the same metrics but will typically use a multiple of revenues or EBITDA (a good proxy for cash flow) as a way of valuing your business. You should be well-armed with examples of companies that are comparable to yours and how your metrics stack up against your peers. You can then quantitatively demonstrate the worth of your business in a sales cycle.
Closing the deal
Fundraising takes an inordinate amount of your team’s time and it can often feel that you are neglecting your core business in the chase for dollars. Experienced teams will know how much they want to raise and where that money will take them before they have to raise more. They will also cast a wide net, run a process with multiple interested suitors and enlist the help of friends and advisers to augment their team and make introductions.
The process can be nerve wracking and at times, disappointing. But there’s nothing more gratifying to entrepreneurs than closing a deal that can help them execute on their dream.