What you need to know about VC world as a founder
Running notes on VC world on the book Secrets of Sandhill Road by Scott Kupor
There are two types forms of money from market:
Debt
Useful when you have near term cash flow.
Complete control of business- no equity dilution
Equity Dilution
Convertible Notes:
Looks like debt
Principal to be returned by a certain date with certain % interest.
Conversion to equity feature.
Turns non permanent capital to permanent capital
How do early stage VCs decide to invest ?
People:
Ideas are not proprietary
For VC opportunity cost is infinity.
VCs have a positive signalling effect -for hiring/other VC etc.
Founding team evaluation:
What is the unique experience that led this founding team to pursue this idea?
Product first company: Founder experienced some problem that led her to work on the problem. This sort of company is attractive to VCs. It’s an organic poll on the customer.
Company first company: The founder first decides to build the company and then decides on the problem.
Founder market fit - Unique characteristics of founding team. Sometimes distance from the problem leads to a solution. This is less common though.
Founder’s leadership ability: Will this founder be able to create a compelling story for engineers/sales executives/marketing/customers etc.
Founder should have the ability to plough through dark phases. Have to be partly delusional to work on non-obvious ideas. VCs have to spot non obvious ideas that look like bad ideas. The hidden gems.
The fundamental idea are not proprietary. Execution is important.
Product:.
Solve a real need in the market.
Product generally changes based on customer feedback.
VC evaluate on:
How did she got to this idea
Incorporating which insights
VC wants the founder’s attitude to be “strong opinions, weakly held”.
New idea should be X amount better or X amount cheaper. (he says 10 x as example) for people to adopt the product
Products should be like aspirins and not Vitamins (dispensable).
Market:
Ultimate market size should be good.
It’s not easy for the VC to get this right.
What are LPs? Type of LPs:
University Endowments
Foundations - Ford Foundation
Corporate and state pension funds
Family offices
Sovereign wealth funds
Insurance companies
Fund of funds.
LP invest a part of their portfolio in VC firms
Raising money from VC:
Right time to raise capital is when capital is available.
VCs see a big market: market opportunity should be several hundred millions $ of revenue over the next several years and several billion $ of capitalization.
Sometimes there are a certain segment of VCs that invest so that they can exit at higher evaluation and can get interested in small market sizes too.
How much money should you raise?
Raise as much money as you can that enables you to safely achieve the milestones you need for the next round of fund raising.
You need to demonstrate progress and de-risk the business for raising money for the next round of evaluation.
Normally, you raise money for 12-24 months: raising money timelines
When you are at round A u need to have to hit enough milestones to get round B.
For series B:
Initial commercial version is built
Demonstrate proof in terms of customer engagement and contracts that company is willing to pay money
U might be able to raise 3-5 million $ in series B.(old value)
Raising large money isn't good for founder:
He suffers higher dilution.
He doesn’t remain frugal. A founder should be evaluating objective/investment with opportunity cost.
Valuation indicates actual progress. Current round of financing is influenced by progress and de-risking of business.
Valuation metrics depend on:
Market environment
In terms of results, VC expected more.
Raise sufficient amount of money so that you can reach higher VC expectations. Say your expectation is valuation should double, but VC feels that revenue should have tripled for the same evaluation.
Don’t raise too small an amount at higher valuation since it leaves you with little cash required to reach the milestone for next round of evaluation.
Competition between VCs raises valuation offered.
Note that employee expectations must be met on valuation. Employee seizes on valuation, Sees it as measure of quantum of progress.
Say theoretically, you are overvalued in one round and undervalued in another round. Such that you reach the same equity dilution at the end. Then remember that employees judge momentum by valuations. Employee will compare valuation with that of other companies.
VC can be reached out in the following ways:
U cold email them through the emails given on the website. This is not ideal thing to do.
Angel/Seed investor: Introduces you to VC. VC are happy they get curated opportunities to invest and Angel are happy that their investments are growing
Lawyers: Lawyers u engage to incorporate your company refer sometimes.
You need a warm email from someone to the VC:
Shows a creative way to get the VC.
Indicator of grit: that you can get a warm introduction
It could be anything- networking/hustle/salesmanship/dumb luck/story telling.
What goes in the pitch deck:
LPs invest in VC for 10 years -> u need to convince VC you will be the good outlier for them.
Term sheets
Economics:
Founder’s have limited term sheet negotiation experience.
Instruments:
Series A preferred stock
Series B preferred stock
Common shareholders - founder/employee
“Post closing fully diluted capitalization of company” -> 20% ownership of the company.
Note/debt/safe securities is superior to series A preferred equity. VC want that in case of liquidation, nothing should be above them.
Convertible debt types:
Uncapped Note: value at which note converts is not decided and will depend on series A round. Debt converts to equity at the same price as the series A purchase equity.
Capped Notes: Ceiling price is set at which(or lower) debt will convert to equity.
Convertible Note: Say 10% discount to series A valuation
Capped + convertible note
Why will entrepreneurs will raise money using convertible notes instead of equity financing?
Debt documentation is simple
Both the founder as well are the investors are punting when using convertible notes.Parties differ on valuation and dont need to agree on it.
With capped notes, you are agreeing to a valuation.
Mistakes founders make:
Multiple rolling closing for convertible debt.Founder raise a round with convertible debt, then another investor comes asking for similar terms. This ends with (say) founder raising 3 million on the same terms as he/she raised the first million. Founder loses a lot of equity. Take on too much convertible debt, leading to high dilution.
Series A financing: Equity financing its clear how much equity you will lose. That is not the case with convertible notes financing.
Example: Founder owns 70 out of 100 shares. Now when debt converts to equity, assume you have to issue 20 shares to the debt holder. So now total shares are 120. So ownership of the founder is 70/120=58%. If series A investor that founder equity is too low and wants to increase founder equity. The series A investor forces the company to issue x number of shares so that founder equity goes up to 65%. Note, the equity % of other owners (including employees) drops in the company in this case.
Resolution of this situation is:
Let things remain as is
Series A investor handles it head on,
As an entrepreneur, be mindful of how much equity you are diluting.
Price per share:
Valuation 50 million post money: means valuation of the firm after VC invested his $.
Pre money: Valuation of startup before VC invested his $.
Pre money + VC investment = post money.
So 40 million pre money + 10 million VC investment = 50 million of post money
Investor gets 20 % of equity as for a valuation of 50 million, he invests 10 million(means 20% equity).
“Any shares that convert as a result of prior convertible debt called notes, have to be included in this valuation”
Mistake founders make is aggregation of debt, which is taken into account as a part of valuation, VC is willing to pay. In series A, the founders get shocked at the amount of equity loss suffered by them.
How VC do valuation:
Comparable company Valuation Using comparable companies as a benchmark to derive valuation. Example, yahoo is an internet company and its valuation is 5 times the revenue. So an internet startup we are evaluating will be valued 5 times its revenue. Of course we are technically ignoring that potential markets could be of different size, growth rate could be different or others.
Discounted Cash Flow analysis:
Definition: Valuation of company is present value of future cash flows.
Discount rate: Opportunity cost for company’s investment. So, if company could 10% on alternate investment, the discount rate is 10%.
For this you need to build a financial forecast of your company, Cash flow the company will generate in future years.
This technique is useful for mature company, where forecast are rooted in past performance.
This technique takes into account working capital (employees salary etc).
Companies raise multiple rounds of financing. When VC invests in series A, it reserves some amount to invest in future rounds to preserve ownership. If VC is in early in lifecycle of fund, it will set aside funds to invest in next rounds. If company raises another round of company, VC
Note when series B happens, series B investor wants to see that series A investor invests more into the company. Series B investors look for this as a sign of trust a series A investor has on founders/company.
What do I need to believe analysis done by VCs:
What company needs to look after 5 years, so if a VC invests 10 million, we would be expecting 10X returns, which means $100 million in return. Since the VC has invested 20% stake, he will need company valuation to be $500million so that we can get 20% of it, which will be 100 million.
Now if comparable companies trade a revenue multiple of 5, so to achieve a valuation of $500 million, $100 million revenue is needed in 5 years time.
What would be needed to go right for that (Market size should be big enough) and what would be the causes of failure. This is the valuation maze VC goes through.