Funding Your Business: Demystifying Venture Capital

1. Introduction : Hi, I'm Albert Wenger. I'm a Partner at Union Square Ventures in New York. I'm excited to be teaching a class about the fundamentals of raising venture capital. I've been a partner at Union Square Ventures since 2006. We invest in companies and projects that help broaden access to knowledge, capital, and well-being. We're based in New York City, but we invest all across North America and in Europe. Working as a VC keeps me young because I get to work with all these energetic entrepreneurs who are building new things, who are excited about the companies that they have started. We get to see a glimpse of the future and we get to sort of have a front-row seat and be slightly involved in shaping the future by virtue of what we do. I've taken a bit of a circuitous route, I've started a couple of different things, and I was an academic. I was on my path to getting a PhD. I got a PhD at MIT. But while I was there, this thing happened, it was called the World Wide Web. I was sitting there in my cubicle working on my thesis thinking, "Oh, this amazing thing is happening." So, I started a company with two MIT professors, and we raised money, we raised venture capital. But one of the things I discovered in that process is that I was actually more interested in being on the venture capital side and that I wasn't actually a very good operator. I'm excited to be teaching a class on demystifying the venture capital fundraising process. This class covers the fundamentals of whether your business is one that should be raising venture capital, how you get to approach firms and set up meetings, what should be in your pitch, what you should be looking for in a term sheet, and that how you get to a class. In the class, we're not just going to cover the how of venture capital fundraising, but we're going to start with a why, which businesses should raise venture capital. We'll talk about that. In fact, many businesses should not raise venture capital and that there are alternatives to raising venture capital that may be much more appropriate for your business. This class is for anybody who either is the founder of a company, is thinking about funding a company, or is simply intrigued by how innovation gets funded in the form of venture capital. Financing is just a means to an end, the end is building the business itself. 2. I. Why Businesses Need Financing : So, we're going to start this class by talking about whether venture capital is something for you, for your company. And to answer that question, we're going to ask an even more basic question. We're going to answer the question why do you need financing at all for your company? Now, when I ask people that question, they often say, "Well, I need it so I can hire people," or they'll say, "I need the money so I can develop my product." That's all true. But the question is, you eventually going to get paid also, right? So, the real problem that you're facing isn't that you need to develop your product. It isn't that you need to hire. That's not the problem per se. The problem is that, you need to do all those things before you get paid. Businesses need financing when they have cash outflows, for instance, for paying rent and paying employees before they have cash coming in from selling their product. That is why you need to raise financing, but it's not always true, because sometimes you can reverse this problem. To solve this mismatch of cash flows, there are two options other than venture capital financing. One is crowdfunding, and the other is bootstrapping. For instance, you could do a crowdfunding campaign, and you could have customers order a product that you haven't actually built yet. So, at that point, you've got money coming in that you can now spend to make the product. By the way, some really big companies still do that. Tesla gets a lot of its financing from pre-orders for its next series of cars. Another way of dealing with the problem is, to just keep your cost incredibly low initially. So, you get to some point where you can start charging people, and then you hire more people and you do more development out of the revenues that are already coming in. New York City has two great examples of so-called bootstrap businesses. One is Shutterstock, which is now a public company. When Jon Oringer started that, he went out and he bought a DSLR, and he shot 3,000 images, put them up for sale, and then money started coming in, and that's how he built the company. He didn't raise venture capital until he already had 40 employees, and then he raised it to grow much faster. Another example is Squarespace. Anthony Casalena started programming it and didn't take any money, programmed the whole thing, started to launch it, people started building sites on Squarespace and started paying. Again, he built that business to quite a scale before taking venture capital. In both of those cases, what it meant is that, the founders were able to retain much more ownership in the business than they would have otherwise been able to. So, couple of different ways of maybe avoiding financing altogether, they ultimately chose to finance the business, but they could have avoided it altogether. You always remember, the best financing is no financing at all. It is revenue from customers. 3. I. Equity vs. Debt : Now, I suppose you've concluded that you do need financing for your business. There are two fundamentally different types of financing out there, there's debt and there's equity. Debt is something you might get from the bank or you might have on your credit card. It is money that you absolutely have to pay back and it usually is collecting interest rate and it usually has a deadline by which you need to pay it back. Most startups don't raise debt until they've raised traditional venture capital and or have grown and have meaningful revenues. The reason for that is simple; banks tend to be very risk averse and it's very hard to get a bank loan for a very risky venture. There are two ways of having less risk in your venture. One is to be up and running and have customers. The other is to have a balance sheet to have money in the bank from a venture capital firm. Equity, on the other hand, is when you've sold part of your business. Now, you own the business together with investors, and those investors will get their money when you have exit and when you get your money. An exit might be a sale to another company or it might be an IPO on the stock exchange or it might be a capitalization, a recapitalization through a new investor in this secondary sale. Now I lied, there's more than two options for financing. There's not just debt and equity. There's also grants. In some places, you can get grant money from a university or from a government. Grants are great because you don't have to pay them back. That's what makes them a grant. They are hard to come by, and if the application takes a really long time, you might not be worth pursuing it. Okay, I lied again. There is yet another way to raise money. That's a really new way, and it's called ICOs or Initial Coined Offerings. It has to do with cryptocurrencies. That too is a topic for a totally different class. This class is going to talk only about equity, venture capital, investors, invest in equity. 4. I. Why Venture Capital? : So, which businesses should raise venture capital? Well, when you're raising venture capital, you're selling part of your company. That means you now own less of your company. What that means is you better be able to use that money to build a much bigger business than you would have been able to without it. Let me give you some simple math. Let's say you've bootstrapped and you own a 100 percent of your business. If you sell your company for $20 million, that means $20 million come in to you. Now, let's say you've raised a lot of venture capital and you've sold 80 percent of your company to VC investors, that means you only own 20 percent. So now, for you to have $20 million worth of ownership, it means the company has to be worth $100 million. That's five x as much as in the bootstrap scenario. So, very clearly, you should be raising venture capital only if it allows you to build a much bigger business than you would have been otherwise. Let's look at this same question from the lens of the venture capital investor. Venture capital investors take a fair bit of risk. Many startups fail. That means for the remaining successful investments, venture capital firms need to achieve a large multiple on the amounts that they have invested. Often, firms are targeting when they invest at the early stage a 10x return on their money, and at later stages, a three to five x return on their money. In order for that to be possible, your business is to be pursuing a very large market. So, for instance, if your market is professional Philharmonic Orchestras, it's probably not a very large market and you probably should not be raising venture capital. But if your market is all professional musicians, then it might be big enough to raise venture capital. If your market is everybody listening to music, it is certainly large enough to raise venture capital. So, the size of the market is one very important characteristic for venture capital businesses, very large markets are better suited for raising venture capital. A large market doesn't have to mean an existing large market. Your product could be taking something that is small today and making it much larger. For example, take something that was very expensive like a very expensive designed piece of design software. If you can make that much, much cheaper, you could dramatically grow the market. Another criterion that makes firms well-suited for raising venture capital is if by raising capital, you can grow much faster than you could otherwise. So, if you're constrained, for instance, is that you can't hire sales people fast enough because every salesperson first needs to learn how to sell your product, and that means it takes some amount of money to pay that salesperson before that salesperson becomes productive. But if you have a lot of demand for your product, that's the time when you might want to raise venture capital so you can grow much faster. Another characteristic of businesses that do well with venture capital is where having the Venture Capital allows you to build some kind of defensible moat around your business. That could either be some technology that's very hard to replicate or it could be a large customer base or ideally it is some type of network effect. Where as you grow, you can deliver more value to all of your customers. Think of a social network. The bigger it is, the more connections somebody who participates can have. That's called a network effect. If you can use venture capital to build a network effect in your business, that's a very good use of venture capital. You could also have an opportunity where initially you start in a niche market, a small market segment, but one where your product is particularly well-suited. Once you get adapted there, then you start growing into many other segments. An example of that where many of the ride-sharing services that started at the high-end by servicing only Town Cars and then grew to service the entire market all the way down to just ride-sharing. Another characteristic of businesses that do well with venture capital are businesses that have real leverage as they grow, as they scale. So, that means that as you do more, as you add more units of sales or more outlets, your cost doesn't keep piling up. So, at some point, you suddenly have very large margins. There are a couple of ways this can happen. If you think about retail businesses, often they start to franchise and then they can grow in many locations with high margins. If you think about technology businesses, often when they have another stream or another download, it's a 100 percent margin because there's basically no physical cost to making the product. So, if your business has this characteristic that assets scales, there's leverage, and your economics are going to improve, that's another characteristic that makes businesses good for venture capital. So, think about your business. Does your business have these characteristics? If it doesn't, maybe you should be thinking about other ways of financing the business. If it does, still think about whether you want to own a 100 percent of the business or whether you think that the acceleration and the growth provided by venture capital will more than offset your loss of ownership. 5. I. Venture Capital: Pros and Cons : What are some downsides of raising venture capital? Well in addition to selling part of your business, you now have a co-owner who has their own expectations about how you will run the business, how rapidly you will grow the business. And this is a very much a long-term relationship. Most of the time when you raise venture capital, the investor will want to be on your board of directors. That can be a great thing, if you get somebody who is experienced, who can give you advice, who can tell you when things seem to be going great, but also when things seem to be going off the rails. But you're also winding up with somebody who, you may feel, is putting pressure on you. And for some people that's great, they find it wonderful to have somebody who is sort of like, yes, both the cheerleader but also has high expectations and other people really don't want to deal with that. You should figure out who you are before you go down the road of raising venture capital. The relationship with your investors is for a very long time. You can't simply get rid of investors. With that, if you owe debt to the bank or the credit card company, you could just pay it down, but with equity investment, your partner until there's some kind of exit for the investors. In addition to ownership, there's also the question of control. There are two levels of control inside of a company, one is the question of who controls the board of directors and the other is who controls the equity of the company. If you raise multiple rounds of financing, you will very often lose control both of the board of directors and of the equity of the company. This will happen if the investors have more board seats than you do and if the investors have more voting rights than you do. There are companies where founders have retained a lot of control, examples of that are Google and Facebook. In Google, Larry Page and Sergey Brin manage to retain a lot of control of the company. In the case of Facebook, Mark Zuckerberg maintains control of the company. These are largely the exceptions. Most companies, as they go through multiple rounds of financing, the founders do lose control of the companies and this can wind up in certain situations with founders being fired from their own companies. A famous example of that is Steve Jobs being fired from Apple. This is another thing you really want to think hard about before you go down the road of venture capital financing. And it's also something that we'll get back to later in this class when we talk about term sheets, what to look for in term sheets, and how to negotiate them. Having a venture investor on your board can be a very good thing. Many VCs see lots of companies and what's going on in them. They can tell you, based on their experience in those companies and past companies that they've invested in, where you might be making a mistake or what you could be doing differently. A VC on your board can also help you directly with the business. They can help land a customer. They can help recruit talent to your company. They can help make connections for you that turns into business development relationships. So the questions you need to ask yourselves before embarking on this route of racing venture capital are, why does your company need any kind of financing and are there alternatives such as crowdfunding or bootstrapping? Does your company meet the characteristics of a good venture backed company? And are you personally up for entering the kind of ongoing relationship with a venture capital firm that is required? 6. II. Seed Financing : So, now that you've decided to raise venture capital, how do you get started with it? This next section of the class is about questions such as, how do you raise seed financing? What is dilution really? How much money should you be raising? And should you be going for convertible notes, or a priced seed round? So what is seed financing, and how do you get it? Seed financing is the first outside money you raise, and I have a theory which I call the concentric circles theory of seed finance. At the innermost circle are what we call F and. F that stands for friends and family, or as it's more commonly known friends and fools. These are people who know you incredibly well, and who would give you money to do anything. Even if your plan was to be selling ice cream in Antarctica they would say, here's a little bit of money, go do it. The next circle beyond that are people who have a shared interest. There are investors who have specifically indicated in some form, or maybe not even investors maybe just people who are wealthy, who have indicated some interest in the specific thing you're working on. So, this could be you're doing something in healthcare and you happen to know somebody who has made money in healthcare and so, you go explain your idea to them. The next circle outside of this are professional seed investors. These are people whose business it is to do seed investing, they invest at the earliest stages of companies. Now, why did I draw these as concentric circles? Because each time you leave one circle and you go to the next circle, you should assume that it's 10 times as hard to be raising money. Ten times from here to there, and 10 times from here to there. So, what does that mean? You should always get started with friends and family, you should use that to get going, you should then seek out people who might have a shared interest in the specific idea you're pursuing, and only then should you consider professional seed investors. Under most circumstances, you don't immediately go and raise a very large round of financing from a large VC firm. Instead, you raise a little bit of money usually known as seed money, so you can be a little bit further along when you go and pitch for the first big, what's called institutional round from a large venture capital firm. 7. II. Dilution: In the introduction to the class, I mentioned that you should only raise venture capital if it lets you grow a much larger business. The reason for that is that as you raise venture capital, you're selling parts of your business and that means your ownership is being diluted. Now, let's walk through how that really works. Let's say you come to Union Square Ventures, and we decide to invest $2 million in your business. Well, we need to reach some agreement on how much we think your business is worth today before we invest, and that number is called the pre-money valuation. Let's say we agree that your business today is worth $8 million. Now, we're going to give you $2 million as an investment, how much is you're business worth now? Well, we just said it was worth $8 million, now you have in addition to that $2 million in the bank, so your business is now worth 8 plus 2, $10 million. We call that the post-money valuation of the business. Now, how do we determine who owns how much? Well, if you look at the post-money of 10 million, of that post-money 2 million is from us, from Union Square Ventures and 8 million is from you. So, that means we own two divided by 10, or 20%, and you own eight divided by 10, or 80% and that is dilution, you have been diluted by 20 percent. Now, let's say a year or a year and a half later, your business has grown a lot, you think you can grow even faster by raising more money, and you raise a second round of financing, let's say from another venture capital firm, and this time the other venture capital firms says, well we think your business is now worth $40 million, and we want to invest $10 million. So, we're again going to look at the math, the pre will be 40, the investment amount will be 10, the post-money will be 50. Let's assume for a moment, that this new firm puts all of the $10 million in, in that case that firm too will own 20% of the business, why? They put in 10 million, the post-money was 50, 10 out of 50 is 20%. The $40 million of the business will be 80%, but of this $40 million, you only own 80% so you now own 80% of 80%, which happens to be 64%. Conversely, Union Square Ventures, which used to own 20% of the business now owns 20% of 80% or 16%. So, the ownership of the company now after this second round of financing is you, the founder, owns 64%, Union Square Ventures owns 16%, and the new investor owns 20%. Dilution is the process, where your ownership stake shrinks in subsequent multiple rounds of financing, each time the investors coming in are buying a portion of the business, and everybody who's already an existing owner of the business gets diluted, that's you and whoever is an existing investor, dilution applies to everybody who already owns the business today when there's a new round of financing. In every financing, there are four numbers. There is the pre-money valuation, the size of the investment or size of the round, the post-money valuation and the percentage dilution. Now, the way the math works, you get to pick any two of these and then the other two numbers are determined. So, if I tell you for instance that the post-money was $50 million and the financing was 20% dilutive, you can use that to back into the two other numbers. You can back into that the investment amount must have been $10 million, because that's 20% of 50, and once you know that the investment amount was $10 million, you can figure out that the pe-money must have been $40 million. We will see later that even though you get to choose only two and then the other two numbers are calculated, all of the numbers actually matter, and they will matter to some degree in different scenarios. The dilution matters a lot to you as an owner, the post-money will matter a lot as we see for future financing rounds. So, you might look at this and think well, obviously I should raise at the highest possible valuation so that I have the least dilution. As it turns out, that's not true. There is something called the post-money trap, but to understand what that is, we first need to talk about how much money you should be raising and why. 8. II. Raising a Round : So, how much money should he be raising? The simple answer is, enough money to get to a value inflection point and then some more so you have time for a fundraise. What's a value inflection point? It's a point where you accomplish something that clearly makes the business significantly more valuable. What's an example of that? Well, when you're just getting going, it's actually having a product. When you're just getting going, one of the first value inflection points is going from a prototype or even a napkin to a product that's actually in the market. That's one of the very significant value inflection point. Once you're in a market with an early version of the product, the next point might be a certain number of customers or a certain revenue target or if it's a consumer application, a certain number of end users. When you're further along, the ultimate inflection point will be that the business becomes self-sustaining, that it becomes cashflow positive. So, wherever you are today, you need to figure out what the next big value inflection point for your business is. Then, you should raise enough money so you can get there with some safety margin built in. When I'm talking a safety margin, I'm not saying 2x or 3x the amount. You really want to build a solid budget, you want to have conviction around how much money will take to get there and then you add some amount of safety. Why do you not want to add a massive safety margin? Because that means you get more diluted. If you raise too much money, you get more diluted. There is however also another way to have problems and that's you don't raise enough money. Now, that's especially a problem if you raised your money at a very high valuation. Why? Because now you need to go back and raise more money, but you haven't yet accomplished the thing that you told people you were going to accomplish with the money. The more you pushed up your valuation in this early financing, the harder it will get to raise money to actually reach the value inflection point. You can think about this a little bit like the high jump. You get to set your own bar and now you'll need to be able to jump over. Your post-money valuation is the bar that you need to clear, the amount of money you have is kind of how much speed you get to pick up to go clear that bar. If you put the bar too high and don't raise enough money, you won't have enough speed to clear it. A particularly good place to be if you can, is to raise enough money that you could choose to never raise money again and drive the business to profitability. That may not be possible in the early rounds, but as you get further along, you should always consider that as an option in fundraising. How many months is a value inflection point away? Well, there's no hard and fast rule because it depends on your specific business and the specific value inflection point you're trying to achieve. But as a general rule, when you just get going with seed funding, you should probably raise money for only 6-12 months because generally, if you can't make some amount of decent progress on your product in that time, it's unclear how much more progress you would make if you raise seed funding for three years. Conversely, once you're up and running, often the time frame that people raise for is somewhere around 18 months give or take because that's a good time to take a business that already has some scale, that's already in market and grow it meaningfully to achieve a new value inflection point. Again, though these are just general rules, you need to figure out what's right for your specific business. As you think about value inflection points, one place to go look is to look at the funding history of other companies that look similar to your company. There's a great resource out there in the form of crunch-base where you can for free look up the funding history of almost any company and that will give you some idea how much money that company raised to get to various milestones. You can line that up with what they actually accomplished in those time periods by looking at the history of the company. 9. II. Convertible Note vs. Priced Seed Round : Now, there's one important question on the seed round that I skipped over. Which is, should you raise a convertible note or a priced seed round? For your seed round, you have two options. You can either set a price and raise money and fix a dilution, or you can use what's called a convertible note. In a convertible note, you are telling investors that they will get to convert into the first real venture capital financing, usually at some discount. There are three advantages to using convertible notes. The first one I already mentioned, which is you do not need to come up with a valuation free business. You can defer that until the first venture capital. The second advantage is that it is much easier to do the legal work. The legal work for convertible note is a few patriots compared to stacks of pages for the first equity financing. So, it helps you keep the illegal costs down early on. The third advantage is that you can easily race in small increments. You may recall the concentric circles. Well, it's very easy with a convertible note to get going with friends and family and then expand outwards and just keep adding to the convertible note. That's much harder to do with an equity financing. I should mention, though, that there are a couple of downsides to convertible notes. One of them is that it's easy to actually wind up building up a lot of money that then get converted into financing without thinking about that dilution. This is the mistake we sometimes see people make and then they're very surprised by how much of the business they've actually sold. So, even though you're not putting a price on it necessarily, you want to work out how much of the business you will have sold when those convertible notes actually convert into your first round of venture capital financing. So at this point, you have a business that has raised some seed financing. You're off to the races and you are getting ready to go raise your first venture capital round. In the next section of the class, we'll talk about how you go about approaching firms and how you pitch them. 10. III. Meeting Investors : In this next section, we'll cover how you pitch venture capital firms. The first step to that, is how do you get in touch with them? When I got started with my first company, it was 1996. Most venture capital firms barely had a website, and the only way to really get to meet a VC, was to be introduced to them. Now, it's still true to this day, that the best possible way to meet a VC, is to have an entrepreneur that this VC has successfully backed introduce you. The best way to find one of those, is not to try and email somebody who's currently working hard on their startup, but rather find somebody who's had an exit, who is now angel investing, who is now giving advice, giving back. That's a great way to both get advice and establish a relationship that can then result in an introduction to a VC. Thankfully, there are many other ways to get to know a VC. One great way is to engage them online. Many VCs are active on Twitter or they write blogs. You can comment on a blog post. In fact, a very successful investment for Union Square Ventures, originated was this way. In 2007, I wrote a blog post titled "I Want a new platform." The post was about how I was observing that many of our portfolio companies were struggling with the same problem. They wanted to implement agile development process, but they also wanted to build systems that scaled to hundreds of thousands, or millions of users. They were doing all that using technologies that were 50 plus years old. Once I had written that blog post, I got an email from somebody I knew saying," Hey I saw the post you wrote. That's exactly what we're building. " and that the time the company was called Tenjin, and they were trying to solve this very precisely, this problem I had described in the post,"How can you virtual development but also build a systems of that scale." Eventually, the company was renamed Morgan J.P. and today it's one of the most successful new database companies to have been created in the last 50 years. So, find people in venture capital who are tweeting, writing about the area that you are active in, and then approach them, either directly on Twitter or in a comment on the blog post, or through a cold email. Writing good cold emails is an art. I get a lot of terrible cold e-mails. What makes them terrible, is that they're clearly cut and paste jobs. Somebody is taken no time at all to try and figure out why I specifically should be interested in their company. Do your homework, figure out why I might be interested in your company. Maybe it's another investment I've made in the past, maybe it's something I said at a conference, maybe it's something I said on Twitter. Go refer to that, and explain how your company addresses the thing I talked about. Then make sure to include something else that makes me excited about your company. Like some recent accomplishment, and maybe say a couple of words about yourself. You can do all of that, as it turns out, in one or two paragraphs. If I feel that you've taken the time and effort to research why your business might be a good fit with the type of investing I'm interested in, I will reply to your email. What's great about the Internet is that you don't need to be in the same city. You don't even need to be on the same continent as the investor you're reaching out to, at Union Square Ventures, we've made investments all across North America and in Europe. There are firms that invest even in Asia or South America from here. Conversely, if you're based here, there are investors in Europe and in Asia who are actively investing in the US. So, don't be focused on a particular geography, rather be focused on the kind of investor who would likely be interested in your business. 11. III. Pitching : So, what makes a great pitch? You're now in touch with somebody and they say, "Come in. Meet with me. Tell me about your business." The fundamental thing you have to keep in mind is that raising venture capital is selling. You are literally selling a part of your business to somebody else. Selling is not about constantly talking, selling is about engaging the person you're selling to. It's about getting them to ask you questions. How do you do that? Well, you don't do it by pushing a ton of information at them, you do it by having a compelling story, by making pauses in your story so that they have a chance to ask a question. By then, engaging with the question that they've asked. What are some things you should and shouldn't do? Never send an entire pitch deck ahead of time. It defeats the purpose of having it. It's something you want to be presenting, don't steal your own thunder. If somebody wants information, sent them a couple of slides with key information. Send them a write up in prose, but don't send the deck. Keep the deck for when you're actually pitching. What should be the structure of the deck? There are many people who say, "Well, you have to start with the problem, and then you have to give the solution, then you have to talk about the size of the market. Then you have to talk about the competitive advantage. You have to talk about the [inaudible]." Don't do that. Don't follow a formulaic approach. Tell the story of your business in the way you want to tell that story. You should cover those points. You should cover how you have an unfair advantage, but you could start with that, or you could start with the team. Don't believe that there's some formula, some winning formula for how to put together a pitch deck. But what is important is that you invest a lot of time in the process. Too many people come in with a deck that they've clearly never presented to anybody, that's clearly not well thought out, that leaves major questions open, that starts with a complete snooze fest right at the beginning. And for better or worse, VVCs tend to be on our phones a lot, actually it's for worse obviously, in a meeting. But you want to start whatever you do, whether it's meeting with just one person, but especially if you're meeting with an entire partnership. You want to start with an opening statement that's going to get everybody to put their phones down and focus on you and your story. Keep your main deck short; 12 slides, maybe 15, maybe you can even do it in 10. If you can get the audience excited about what you're doing in 12 slides, you will certainly not get them excited in 37 slides or 78 slides. If you doing your job right, there will be questions, and you should be prepared for those questions. You should have slides ready that answer those questions. If somebody asked about the size of your market, how you came up with that, you should have a slide that speaks to that. Somebody is asking about your sales funnel, you should have a slide to that. Somebody is asking about your marketing budget, about you're technology, be prepared, but don't try to push all that information at the audience. Get the audience to care about your story, and then start pulling information from you. But when they start pulling, it's critical that you are well prepared, because nothing is more off putting for investor perspective than asking a question. That's a fairly obvious question, and having the entrepreneur hoe and ham and not have an answer at all. Now, if there's a really tough questions and they're really unanticipated, it's okay to say, "That's a great question, and I don't know the answer to that, and I will get back to you." If you do say that in a meeting, you better actually get back to people very quickly there after with an answer. If you say that a great many times it's probably a sign that you are ill-prepared. What makes for a great answer? A great answer is both compelling in its words, but to the extent possible it includes a number or two. It doesn't need to be a litany of numbers, but having key numbers at your command will convince investors that you actually know about your business, and you know about its performance, and you know about the market in a way that you can refer to at a moment's notice. So, I always recommend to entrepreneurs, figure out what the most important numbers are for your business and make sure you have those memorized. Always keep in mind that as a VC, we're in the business of saying no. At Union Square Ventures, we make one to two deals per partner per year. We see hundreds, if not thousands of business a year. How do you get better at pitching, you may ask. You get better pitching by pitching. It's one of those things where practice makes perfect. So, if you fiddle with your deck endlessly but you never actually get up in front of the mirror and rehearse it, you're doing it wrong. Get up in front of a mirror, give your presentation, then get up in front of some of your team members, give your presentation. Get up in front of friends, give your presentation. If you can't get a friendly audience excited and starting to ask questions, imagine how hard a time you will have with an audience that's trying to find problems with your business. 12. III. The Fundraising Process : What goes into a fundraising process? At the start of your fundraising process, make a list of the firms that you think are best suited for your business. Not just the firms, but ideally the specific partners at those firms. You should be very careful to exclude firms that have invested in clearly competitive businesses. You don't want to be sending them information about your business that they could then use to help make your competitor better. Your list, shouldn't just include the usual suspects. Everybody wants to pitch Sequoia, Benchmark, Greylock, Union Square Ventures, but there's a long list of venture capital firms out there, not just in the US, but in other countries. If you want your business to get financed, you may need to look beyond the usual suspects. Now, even though you're making a list, don't contact everybody in the world all at once. You have no idea how well your pitch is going to be received. There may be problems with the business that you learn as you pitch. People may point things out to you that are fixable. If you learn that, then you should go fix those things and come back. But if you've already talked to everybody, you have kind of what we call burn the market, and you don't want to do that. Now, what is the sequence of the process? The sequence of the process is that your goal for a first email outreach is to get a meeting. Your goal of the first meeting, if it's with an analyst, is to get a meeting with the partner. Once you have a meeting with the partner, the goal of that meeting is to get a meeting with a couple of more partners. The goal of that meeting is to get a meeting in front of the entire partnership or all the decision makers that need to be in the room. Once you have that, once you've presented to the entire partnership, the goal of that meeting ideally is to get a term sheet. While that is the standard sequence of meetings, each firm operates slightly differently. So, in your first meeting, one of the things you should find out about is what the specific process for the firm that you're talking to is, and you should make a note of this. You should figure out whether they need to have a meeting with multiple partners before going to full partners meeting. You want to learn about what type of due diligence they want to have done before they make an investment decision. Those are good questions to ask if the first meeting is going well, if somebody is clearly interested. You should not try to ask those questions if it's very clear that this deal is not for this firm. There's a crucial question that we'll get asked, and that's the question, how much money are you raising? You always need to be prepared to answer this question. You need to answer with three parts. How much money it is, how you will spend that money, and where that will get you to. Whenever you see here's the size of a race, they always automatically convert that into a valuation for the company. As you may recall from the discussion of delusion, all I need to do is take them onto the financing, and divide by the percentage of delusion. Now, for different stages of financing, it's implied that a certain delusion will likely occur. So, for early financing, that's often 20 percent. So, if you say you're raising $10 million, my mind immediately says you're expecting a $40 million pre-money valuation. Why is that important? It's important because you can't ever go back. You can't do a round of meetings, not getting any term sheets, then call people up and say, "You know what. I've changed my mind. I only need five million dollars." Because, basically, people will conclude that you were not able to raise money. They will assume that even if they liked the business, that other people found things that they really didn't like and that's why it wasn't successful as a fund raise. So, you can't ever smack yourself down. However, if there's a lot of interest, you can always, what's called, upsize the round. Meaning, you can raise a little more money and you can also take up the valuation and keep the same delusion. A crucial ingredient to a successful fund-raise, and maybe the hardest thing to do is to appear confident that this business is going to grow and be successful whether or not this particular firm that you're currently pitching invests. It's when investors feel that they might be missing the train when they're most likely to want to get on the train. Conversely, if your pitch, or your demeanor somehow feels desperate, it is virtually impossible for you to raise money. Ideally, your fundraising process generates interest from more than one firm, and ideally you will have more than one term sheet to look at. Remember though, all it takes is one investor. So, as long as you can produce one term sheet from this process, you'll be in pretty good shape. In the next section of this class. We'll talk about what's in the term sheet, and how you negotiate it. 13. IV. Term Sheet : So, what's in a term sheet? Well, the goal of the term sheet is to summarize all the salient features of the investment. That's important because when you get the long form documents which will be reams and reams of paper, you don't want any surprises that really materially impact what you've just agreed to. So, what are these most important features? Well, first and foremost of course, you start with what is the valuation of the business, and what is the size of the round? The next thing immediately is what's exactly the type of security that the investors have buy? Almost always, in a venture capital financing, the investors will be buying some type of preferred share. It's called the preferred share because it has a preference on the amount of money. What does that mean? Well, let's say investors have invested $10 million. That means they are entitled to $10 million back, even if the business is sold for only five million dollars. In the case of five million dollars, there's no $10 million, so all the five million dollars will go to the investors. If the business is sold for $10 million, all the $10 million would go to the investors. If the business is sold for $30 million, and the investors invested $10 million in preferred, and they bought 20 percent of the business, while 20 percent of 30 million is only 6 million, but because they have preferred they get to get the entire $10 million back. Next is the size of the option pool. That's the equity that's set aside for employees. New investors care about there being enough equity set aside for all the hiring you're planning to do. Why? Well, if that equity isn't set aside right now, then if you start to hire, you need to issue new equity, and that means everybody gets diluted, which is the same thing as saying the price is actually higher. So, investors care a lot to say, ''Well, we have paying this price, and we want you to have this much equity available to issue to employees.'' Then there's the question of the composition of the board of directors. Are the new investors asking for a board seat? Are they asking for two board seats? Do they just want a board observer right? Are they asking for you, as the founder, to have more or fewer board seats than you currently do? Then there are whole sections dealing with the rights for the new investors. These are rights that they have, that are attached to the preferred shares that they buy. I already mentioned one central such right, which is the right of preference that gives the shares their name. Another central right is the so-called pro-rata right. The pro-rata right entitles investors to participate in subsequent rounds of financing, and to invest enough money in those rounds of financing that they, the investors, are not diluted. Pro-rata right is an important right that most investors will ask for. There are lots of other little rights in there, but pro-rata and preference are the two central rights that almost all investors will ask for. Then, there are certain restrictions on what actions the company can take with or without the approval of the investors. For instance, the company may not take on more than a certain amount of debt. It may not sign a lease or other obligation that obligates the company to spend more than a certain amount of money without the specific approval of either the director for these new investors, or the board of directors, or even the investors themselves. Then there's a section on the expenses for doing all the legal work to put all these terms into actual paperwork. Usually, investors will ask to have some of their legal expenses reimbursed. Then there's a section on conditions to closing. This section usually contains a target date by which the investment is supposed to close, meaning by the date by which you are supposed to have the money in the bank, and what needs to happen between there and then. Sometimes this will just say confirmatory legal due diligence, which means the new investors are trying to make sure that all the legal documents are in order, but sometimes this might say ongoing business due diligence. So, they might still be concerned that if they call customers, and the customers say something bad, that they might not want to make the investment. Then there's usually an expiration date. Usually, when investors send a term sheet, they say you, the entrepreneur, need to sign this term sheet by this date and time often in a relatively short timeline, or otherwise, the term sheet will expire. It's important to keep in mind though, that none of these terms are really binding. So, generally speaking, this is just an agreement as to what each side thinks the deal is about. But until the long form agreements are signed, and the money has been wired, the deal isn't actually done. We are all excited because we've gotten a term sheet. What do you do next? The first and absolute essential thing is to have counsel, legal counsel, review the term sheet. They will tell you a couple of things. First of all, they will tell you whether they think it's sufficiently detailed. Second of all, they will tell you about their current perception of what's market. What do I mean by market? Legal firms that do a lot of venture capital financing, see a lot of term sheets roughly at the same time period. So, they have a good sense of whether a specific proposed term is appropriate, or whether the investor is asking for too much. The next step is, you need to negotiate the term sheet. Almost always, there will be one or maybe more points in the term sheet that aren't quite to your liking. Now, ideally, you have run a fantastic process, and you have multiple term sheets which gives you a lot of negotiating leverage, but all you really need is one term sheet, and the willingness to not accept the first offer. Now, what should you be focused on? Too many entrepreneurs focus exclusively on the valuation and the size of the raise. They're very focused on not being diluted, and some of them are even focused on having a large headline number, being able to say I raised at this valuation. Yes, dilution is important, you don't want to be diluted too much. But as important, and in some ways more important, are many of the other terms. In particular, those terms that speak to your control of the business. That is, will you still have control of the board, or at least will have a balance board that doesn't just have investors on it, but also maybe outside board members? Do you need the permission of the new investors for important decisions? For instance, do you need the permission of this group of new investors to do a subsequent round of financing, or to go public, or to sell the company? Those are crucial control decisions, and you want to understand how this control is shifting with this term sheet. One pernicious tactic that you may encounter is the so-called exploding term sheet. Because investors are afraid that you might take their term sheet and use it as leverage to get other terms sheets, and then play them off against other investors, they sometimes say, ''Hey, you've got until the end of today to sign this term sheet, or the offer is no longer good.'' I would strongly encourage you to never sign an exploding term sheet. The behavior of a firm during this phase is a reasonably good predictor of how this firm will behave once they are investors your business. After all, how likely is it that you would want to get married to somebody who says, ''The wedding has to be right now, or it's off.'' As you negotiate the term sheet, even if you have a lot of leverage, for instance, I just worked with an entrepreneur on a financing that had five term sheets. You may not want to take up the post-money valuation to the absolute maximum you could take it to. Yes, that would minimize dilution, but keep in mind you've now set the bar that you need to clear with this financing. If this is definitively the last financing you ever need, you're very clear that you will become cash flow positive, then that's fine. In all other scenarios where you already know that you will need a future financing down the road, don't make the mistake of setting the bar too high for yourself. You will make your company fragile in case there's a downturn in the economy, or in case that you miss the next value inflection point, or you simply take longer or more time and money to get there. 14. IV. Final Steps : Now, we're near the end. You've signed a term sheet, you just need to get to closing. What does it take to get to closing from a signed term sheet? Well, it depends on what was in the conditions to closing. Ideally, you've limited those to just legal and financial due diligence. That means, the new investors want to look at your books and your legal documentation. It's very important that you help drive this process that it did not drag on. It's very important that ideally you have all your financials and all you're legal documents ready. If you are working with a good accounting firm, and with a good law firm that should all be the case. But I have seen financings get derailed because a set of financials was produced and the first set of financials had important inconsistencies that spooked the investors and they decided to walk away from the deal. Anything that's really, really material and important about your business, you should have figured out how to disclose to investors early on, you do not want investors finding some big ugly surprise in this home stretch. Investors do not like to walk away from term sheets, it gives them a bad reputation. But every once in a while, firms do uncover some thing that makes them rethink the deal altogether, and that can put you in a very, very difficult position because now you've said no to everybody else who might have been interested, and it's very hard to come back to people and say, "You know what, these people I signed up with well, that deal didn't close, but now I want your money," because people are always going to assume the worst reason that they can possibly imagine for why that other deal didn't happen and so they will be very unlikely to want to enter into a deal with you now. You should try to keep the timeline to closing as short as possible. Many financings can close within 30 days and sometimes even faster. Keep in mind, the term sheet is not binding, only once the law firm documents are signed, and really only once the money's in the bank do you really have the money. There's a lot of uncertainty in the world, a lot of things could happen. The stock market could crash, there could be an outbreak of a disease, there could be a competitor or a large company that announces a product that's a head-on competitor and spooks the investors. So, stay on top of the process, don't have a long timeline. Ideally, you have all your ducks in a row before this even starts, and get to a closing quickly. 15. Closing : Congratulations, you've closed your financing. What's next? A big party? Well, not quite so fast. There are a couple of forms that need to be filed with the government and for most financings these days, there's a form called Form D that gets filed within some number of days after the financing. Why is that important? It's important because technology reporters will pick up financings from that filing and so they may write a story. So, you should be prepared for that. You should decide how you want to announce your finance. Now, personally, I'm not a big fan of huge announcements, trying to get press. I think a blog post is the best way to do it, to say "We've raised some money, we're excited to be building great things for you, our customers, we're thankful for you having been our customers," and then get on with it. Much as you're excited and you should be excited, always keep in mind, though the financing is just a means to an end. The end is building the business itself. Thank you for joining me for this class on the fundamentals of venture capital fundraising. 16. Ready for More?: