Venture Capital: 14 Untold Lessons After Raising $45m (Guide)
In this post, I am going to share with you how I raised $45m in venture capital.
Why is that important?
Because venture capital helps companies accelerate growth.
And because almost every large tech startup in recent years has been funded with venture capital.
But there's a catch:
It's not easy.
Many mistakes can make it hard or even impossible to raise money from a venture capitalist – a VC.
Many pitfalls when dealing with VCs are untold in the startup community.
Because startups don't want to ruin their relationships with investors.
And because of the very common survival bias:
Media tend to pay attention to successful companies only!
And I am going to be as thorough as I can.
My goal is to help you, the entrepreneur, understand how to close the best venture deals.
Many comments have their origin in
mistakes experiences that I made or avoided personally.
And some other learnings are based on the experiences of fellow entrepreneurs I have met about during my career.
One thing I need to clarify first:
I have been picky and lucky with my investors: Most of the less flattering comments here refer to experiences I made with other VCs.
So let’s dive right into it now!
Pro Tip: Click on this icon on the top right corner to navigate through the chapters faster.
1. The "Success-First-Rule"
Some VCs may not admit it, but in almost every case:
It’s only possible to raise venture capital if your company is successful already.
(and I) may ask a good question here:
Why do I need venture capital, if my company is successful already?
And, indeed, some entrepreneurs may skip raising venture capital once their companies are profitable.
So, why should you even consider raising VC money?
To grow faster. Much faster!
But lets first get this straight:
Your revenues, your user acquisition or your broader success indicators have to grow already. And only then you may raise venture capital to accelerate your growth.
There are three exceptions to that rule:
1.) The rare case of a trusted serial entrepreneur, who:
- has already made good money for a venture firm in a previous exit,
- kept a good relationship with that VC firm,
- has not made enough money to finance a new idea alone, and
- asks the same venture firm to re-invest in his new startup.
99.99% of business leaders and entrepreneurs are not in that position.
2.) Non-traditional VCs:
The second exception is when a venture capital firm is not a traditional venture firm, but a group of hands-on entrepreneurs who get involved in the operational execution of your idea.
Usually, those types of firms take a significant share of your company and leave the founder with only a small minority of his shares.
That is a type of partnership you need to think about twice, as you will probably lose control of your company early on:
Normally a horrible idea!
3.) Pitch-Events with competing investors:
The third exception to the "success-first-rule" is the lucky event when you:
- pitch to many investors simultaneously, and:
- these investors then jump into financing with only little interest or understanding but for the only reason of beating one another or not missing out a deal.
Here's a story from my network:
In San Francisco, I once had dinner with a founder of a company developing a new type of databases.
Four years before our dinner he got a rare spot at a Y Combinator Demo Day.
At the time he did not have much to show:
No product, no revenues, no users. Just a dream.
Believe it or not:
He was able to raise $1.2m from 12 top-notch venture firms within only one week!
Each of these investors had thrown in $100K.
Some of them are multi-billion dollar funds...
But, let's do the math here:
How much is $100K of $1bn in percentage?
For most of them, $100k is peanuts!
It is like owning $10,000 and investing $1 into something...
The best part?
After that week that founder almost never heard something back from those venture firms again.
The company itself was not the reason to invest, but yes:
Social pressure among venture capital firms in the audience!
But make no mistakes:
Besides being irrational and potentially harmful in the long run, getting investors who are not primarily interested in your company is rare and nothing you can expect.
If you are pitching one venture capital firm at a time: Forget that scenario!
In almost every case you can only raise venture capital when you are successful already.
So let me finally destroy the first myth here:
The picture of a brave, heroic venture capitalist investing in a brand new idea and young first-time founders is pure fiction.
2. Venture Capitalists (Must) Hate Risks!
Here's another fact some entrepreneurs
including me have a hard time understanding:
Most VCs hate risks despite their sometimes jovial, easy-going appearance.
First of all most VCs are quite the opposite of an entrepreneur.
Most VCs have never led a company with thousands or millions of customers, never had to worry about growth rates, never had to deal with hundreds of employees and customers, and never had to balance the crazy founders' ride with family life.
Yes, there are some venture capital firms led by former entrepreneurs.
But this is only a handful of general partners that you may never meet.
Most of them had their biggest successes already and may not want to take bold risks anymore.
Why should they?
Even more important:
Every venture capitalist has to deal with the tough VC business model.
As outlined below in Chapter 5 for most venture capital firms 9 out of 10 investments are not worth the time and the money spent.
So it is rational for VCs to reduce risks whenever they can.
However, for entrepreneurs perceiving risks as opportunities, this is sometimes difficult to understand.
Look at my story:
I first learned about how much VCs avoid risks with SOFORT, the first company I co-founded.
The product idea was a little crazy but ultimately thrilling, and the team was talented.
And in retrospective, we proved those qualities with a nice $150m exit.
In our first year of 2007, we didn’t do much revenue, of course!
We tried to raise money for more than a year:
14 months to be precise.
That was not cool!
We approached half of the top 50 venture firms frequently mentioned in the press.
All of them turned us down!
No investor wanted to finance a fantastic payment method and an excellent team without revenues yet.
They call it: "Proof of Concept".
No proof of concept, no investment.
It was frustrating and we kept thinking that,
if entrepreneurs would think the same, no company would ever be founded!
So for more than a year, we had to work day and night to make the idea successful:
- with zero salaries,
- zero marketing budget,
- in the private house of one of the founders.
But in 2007, after less than a year, we reached $10m in total monthly transaction volume.
Now, in the payment space, $10m in transaction volume is a rather small number.
But considering that we achieved that within the first 11 months with a completely new payment method, we could clearly prove the disruptive nature of our product.
Even more important:
Our revenues were accelerating 11 months in a row.
We delivered a solid, hockey stick curve in sales growth.
The expectations were high and we celebrated our success openly!
So in early 2008, we finally closed a Series-A financing round with a smart team at a family office.
We then reached the $1bn in annual transaction volume in 2010, only three years later.
And when we then also started to win our legal case against the banks, we started to get bombarded by requests from venture capitalists!
Between 2010 and 2013 we probably met almost every top-tier investor in Europe.
5 out of 10 top-tier VCs from Silicon Valley took the long flight to Munich (that's in Germany and almost 6,000 miles away from San Francisco!) to convince us of an investment.
But by then we didn’t feel any urgency for investors anymore!
So here's the learning:
VCs are not like entrepreneurs. They avoid risks. Don't assume them to think like you about opportunities!
Success comes first. VC money second.
3. Success Boosts Your Negotiation Power!
Besides the fact that it may be difficult to raise money before you show some success, there's also another reason to wait for success:
Your negotiation power.
Let me elaborate this a bit further:
It’s always about a lot of money when raising venture capital.
Most VCs don't invest less than $2-3m for a serious round.
And when negotiating deals, the smart VCs (and you don’t want the others!) always face a tradeoff between:
- securing as many rights as possible at the lowest valuation possible and
- still keeping the founders or management motivated.
In other words:
Smart VCs will always try to find the limits of what they can ask for without damaging the managements‘ motivation or losing the deal.
If you are not careful enough, these limits can result in deal terms that later turn out to be very painful.
It may sound obvious but:
Closing a fantastic venture deal becomes much easier when you, the founders, have the power to set your terms.
However, setting your terms requires your company to be such a hot deal that the VCs can’t ignore you and must accept them.
At this stage “success” or becoming a "hot deal" includes two elements:
- hyper-growth in sales, user acquisition or another key success indicator and
- an auction type of competition among VCs, each of them knowing of others bidding for your company as well.
Get in such a position, and raising venture capital at favorable conditions is only a matter of time!
I understand that it's much easier said than done.
So let's move on now.
4. The Team: The Number #1 Investment Criteria
Most VCs focus on large enough markets to be able to expect large enough exits.
But here's another fact:
No matter how successful a company is now, things can and will change rapidly.
Smart venture capitalists understand that.
They understand that the future of a product is subject to many threats and that markets may change in no time.
And here's the solution to that challenge:
The main factor enabling a company to adapt fast enough is the quality of the team.
Therefore the product idea is just one of the three most significant investment criteria.
The other two success drivers are:
1.) The Team, and
2.) The Team
A smart VC will always consider the strength of the team in the first and in the second place even before the product idea.
What does it mean for you as an entrepreneur seeking venture capital?
It means that you have to be extraordinary yourself.
It means having a hard-working attitude and extraordinary skills at the same time.
You can't leave any doubts that you will work day and night to make your company become a blockbuster type of success.
It's all about attitude and skills!
How do you show or prove your attitude?
By telling your own story that mainly reveals one thing: Your tireless and skilled power in building a fantastic company.
Now, telling a good story doesn’t mean hiding failures or mistakes.
It’s quite the opposite:
Every good storyteller knows that the essence of an excellent story are multiple conflicts a hero (that’s you!) faced, solved or at least used to learn something.
I believe that a great story of entrepreneurship must prove the mindsets as outlined in my other post Entrepreneurship: The 7 Essential Mindsets.
Your mindset should reflect Nelson Mandela's quote:
"I never lose. I either win or learn."
It shows strength and conviction without hiding the mistakes.
It reflects the attitude and spirit needed to build a successful company.
5. Your ROI Expectations Must Be Insanely High!
Venture capitalists are similar to merchants:
They buy a product for the price of X Dollars, with the expectation to sell it later for a multiple of X Dollars.
The product they buy, are shares of your company.
But, of course, that's not the end of the story:
The product is hard to understand.
VCs need to evaluate the team, the company's solutions for customers, the markets, competitors, the risks, the financing requirements, the exit potential and all other criteria relevant to successful investment.
The bad news for VCs:
There are too many moving parts for a VC to rely on simple conclusions.
And, so, the risk of failure is very high.
Here's a quote from TechCrunch on Venture Capital performances from June 2017:
"95% of venture capital isn’t actually returning enough money to justify the risk, fees, and illiquidity their investors (LPs) are taking on by investing in their funds."
A "realistic scenario" according to that study is:
- 5 out of 10 investments are complete losers going bankrupt: They result in a total loss of the money invested.
- 3 out of 10 investments do a small exit with little or no real returns.
- 1 out of 10 investments performs a medium size exit with returns that can't cover the losses of the first 8 investments.
- 1 out of 10 investments (if at all) is the high-flyer and makes most of the VCs ROI.
Put yourself in the shoes of a VC for a minute:
Imagine that you’re buying 10 products to re-sell them later.
You don’t know precisely which products will become a blockbuster, but you expect:
- 8 products to be a partial or complete loss,
- 1 product to be sold for an "OK-price",
- and only 1 out of 10 products to make up your entire ROI.
What would be your expectation for any such product you purchase?
Under these circumstances, you should only purchase a product, if the expected ROI when re-selling it covers all losses from the first eight products...
generates a surplus on top of that to make your business case become attractive compared to other types of investments on the market.
On average the expected venture capital return on investment for your company's shares must be more than 10x of the valuation the VC is currently paying.
And that’s why you must have the ambition and the undeniable arguments that your company will be worth more than 10x times later!
At least that's required in your first financing round when the VC must decide if he wants to invest at all.
I had my own More-Than-10x-Requirement-Experience:
On the notorious Sand Hill Road in Menlo Park, where almost all top-tier VCs of Silicon Valley have their headquarters within walking distance, I once pitched my first company SOFORT to one of the best known and most successful venture firms ever: Sequoia Capital.
Sequoia has backed companies such as Apple, Google, Intel, PayPal, YouTube, WhatsApp and many more in their early days.
So, I presented SOFORT to a General Partner of Sequoia.
I felt like I did a good job presenting the company. The pitch felt inspiring.
But besides the mistake of not checking if they do any early-stage investments outside the Bay Area or China (they don't!), I made another mistake.
Out of the blue, the General Partner asked me:
“Is this company going to be worth over a billion dollars any time soon?”
In those early days, I was not experienced and not prepared enough, so I replied:
“I don’t know. It depends.”
You should never leave any doubts about your ambitions!
The right answer should be:
And I should have said that in the most passionate manner possible, followed by hard-to-argue-against-reasons, why the company is going to be worth even more than a billion dollars!
There's no other way to put it:
The expectations for your company’s growth and exit potential must be insanely high and well argued.
Otherwise, you will never be able to raise money from a top-tier VC.
If you are more up to building a nice, stable company with the purpose of feeding you and your employees, venture capital is not for you.
In the VC world, it’s about all or nothing.
Sequoia declined to invest in SOFORT.
But years later, in 2013, SOFORT was acquired for $150m by another payment company, the Klarna-Group.
Klarna and thus Sequoia made a fantastic deal as growth rates and profitability kept being amazing at SOFORT.
SOFORT by itself can easily become a business worth billions of dollars.
But in those early days, in those hidden, wooden buildings in Menlo Park, California, we would have accepted a much lower share price.
So at least we belong to the so-called “Anti-Portfolio” of Sequoia; the list of companies they somehow missed.
6. Don’t Marry an Idiot!
There is an analogy frequently heard in the startup scene:
Getting a venture capitalist on board is like getting married: You commit to stay and work together for many years in good and in bad times.
Now, that is indeed a good way to look at it.
But what does it mean exactly?
What do you need to consider when taking this advice seriously?
Think of your private life:
It’s hard to know if your marriage is forever, but at least there are a few things you can check to find out if your fiancé is an idiot or not.
You shouldn’t marry an idiot.
How do you find out if a VC is an idiot or not?
Again, think about your private life.
How do you distinguish reasonable people from idiots?
You would ask questions such as:
How does the VC behave with other people?
- How does the VC talk to waiters? Friendly or rather disrespectful? Treating waiters like lower class people is a 100% proof that the VC is an idiot.
- How does the VC treat your employees? Does he salute them? Again: If someone treats others as “lower class people”, there’s no other way to put it: It’s an idiot!
- How does the VC talk about himself? Is he proud but modest at the same time? Or does he always want to prove himself and show how much better he is than anyone else? In the latter case, put him in the idiot basket!
- How does he treat you? Does he let you wait without a good excuse? If yes: Idiot!
- Does he respond to your questions fast and quickly? Good! If not, check if he is an idiot or has good reasons to be slow.
- Does he care about your motivation? – If not, the VC is an idiot. After all, the motivation of the management team is probably the most critical success driver of a company!
- How many details does he know about your business? – If he knows a lot, then presumably he’s interested. If not, you may either need to explain more and check if your company fits in the VCs investment scope. If you already explained a lot and your company fits into the VCs investment scope, but the VC is still not able to have an in-depth conversation about your business, chances are he’s an idiot!
And here’s a tough task for founders:
When you get to know the VC better, and you find out that he’s an idiot: RUN!
DO NOT consider him as an investor.
Here is why:
If your VC is an idiot, it will be even more challenging to deal with difficult decisions and situations later.
Whenever you need to change your strategy or vision or whenever things don’t work out as well as planned, a dull VC will make it even harder to succeed.
Now, that all sounds reasonable and in theory most entrepreneurs would agree to decline idiots.
But in reality, declining idiotic VCs is not easy at all.
Why is that so difficult for entrepreneurs?
Whenever an entrepreneur is still fighting to close a funding round, it's actually not that hard to understand.
- You may get millions of dollars to grow your company.
- You may increase your chances of becoming rich.
- You may bring a lot of excitement to your employees, your family, and friends.
But instead of taking the money right away, you discover that a VC is an idiot.
What would you do?
In fact, most entrepreneurs have a hard time throwing away such an opportunity.
Most entrepreneurs want to close a financing round as fast as possible so they can get back to growing their company.
So, when facing an idiot, entrepreneurs start to doubt their judgment.
Or they tell themselves that they can handle it later.
Or they may even completely ignore the signs of idiocy.
While the desire to close a financing round as fast as possible is entirely understandable, the consequences of accepting an idiot as a business partner may be very expensive or even deadly in the future.
There are thousands of untold stories about startups that failed because the relation between founders and investors went horribly wrong.
Even large, well-known and successful startups are often facing tremendous fights in their boardrooms.
Such useless fights are the result of working with idiots.
So, I would advise anyone raising money, to stay disciplined and resist the temptation.
Let others deal with idiots!
7. The Venture Capital Presentation: Pitching Your Story
All the high expectations mentioned above and your success chances when pitching VCs are founded on the story of your company.
By now it should be clear:
The story of your company must be outstanding. Period.
Now, you may have read or heard about how important storytelling is.
But what’s a story all about?
Most people intuitively like good stories but don’t know, what a good story is made of.
Just listen to company keynotes and presentations at trade shows: Most of them are boring!
So, what makes a good story about your company or your product?
It’s similar to writing a good novel.
So, let me explain the 12 story points when pitching a venture capital firm in more detail:
1 Vision: Destination & Path.
In the first 20 seconds of a pitch, your audience will assign you with a label.
At least until they fully understand what you are trying to achieve.
In other words:
The vision summarizes where your company is heading too and how it will achieve its goals.
A good vision is sticky.
If you're able to formulate a vision that people remember three days after they heard it first: Congrats!
There are many ways and opinions on how to formulate a vision.
And I encourage you to find yours.
But here's a practical way to do it:
First, explain the goal of your company and then use your unique value proposition (UVP) to show how you will achieve this goal.
Let me explain these two elements for a minute.
The goal is what you ultimately want to achieve with and for the company.
There are several dimensions here:
- Product Vision: You want to be the leader in a specific, but large enough market.
- Geographical Vision: You want to be the leader in the U.S. or in the world.
- Shareholder Vision: You want to go for a splendid exit, preferably an IPO or a trade sale to a world-class corporation.
- Technical Vision: You'd like to shape the technology landscape of an industry etc.
No matter which dimension you chose, think big and even more important:
Chose a goal you believe is worth investing the best years of your professional life!
You may also find your company's goal by asking the WHY question famously brought up by Simon Sinek:
The WHY, the goal of the company requires careful thoughts because everything in the story will serve this ultimate objective.
If you state the wrong objective, everything else you do is likely to be wrong.
And here's the second part:
The unique value proposition (UVP).
The unique value proposition summarizes how you help a certain type of customer to achieve a specific must-have value.
The most frequent format of a Unique Value Proposition is:
"We help Customer A achieve B doing C."
The UVP must be formulated very carefully as well, because it will lay the foundation for all of your future steps.
Now, once you clearly stated both elements (your destination and its path) you can formulate your vision.
It may be a simple phrase with only a few words.
But it must imply the following elements:
The company's vision is to end up being X, helping customer A achieve B, doing C.
2 Current Success: Your Traction, Customers & Team
If you have read this post down to this section, you are probably starting to get bored, if I repeat:
Be successful first. Then raise venture capital.
For your venture capital pitch deck the success-first-rule means:
Start talking about your success before anything else!
Success at this early stage of your venture capital presentation has 3 elements:
- Your current traction, e.g. revenue growth, user growth or any other key performance indicator.
- The customers you have already gained (or that are in your immediate pipeline)
- Your team strengths, skills, and passion.
These basic success drivers allow the VC to quickly put you in one of his mental boxes.
That may not sound very appealing to normal founders, always trying to think out of the box.
But it's how VCs screen the world.
And if you want to sell them your company, it's what you need to respect and understand.
Think about this first section like the cover text of a good book:
Readers must decide if they want to spend hours, days or even months reading your book.
If the summary in the cover sounds amazing, it's more likely they'll buy and read your book.
And even more important:
Success makes your business sexy! – And that helps you gain the undivided attention from your audience.
In other words:
Showing some existing success figures at the very beginning of your pitch will make the VC want to read or listen to the next parts of your story.
3 Pain: Frequent & Relevant.
Now it's time to speak about your product and its value to customers.
The value of a product is given by 3 elements:
- The pain customers suffer from alternatives.
- The solution you provide to relieve customers from their pain.
- The advantage of your solution compared to any other alternative.
Let's talk about the pain your customers suffer first.
It's not always clear to entrepreneurs, but:
If there's no pain, there's no business opportunity.
So, the question is:
What is the pain thousands or millions of people have and that your company is addressing?
A customer's pain is usually the result of alternatives being:
- low-quality down to non-existent,
- too expensive,
- socially inferior, e.g. weak status symbols,
- or simply boring (not entertaining enough).
The pain is never a missing feature or a missing technology, but a (big) problem many customers face consciously or even without knowing it.
4 Solution: A 10x Better Product!
Your product or solution is directly related to the customer's pain.
It is the solution to the customer's pain.
It does it 10x better than with any other alternative in the next 5-10 years to come.
I usually create a least two slides here:
One showing the general solution and the other visually showing the product, screenshots or a demo.
(Pro tip: Never rely on a product demo the requires access to the internet. Make sure it works even if you're offline.)
5 Alternatives: All weak.
Who are your competitors?
What are the alternatives?
What about the alternative of leaving the pain as it is?
Be thoughtful, open and transparent about alternatives.
Always assume that investors will do their thorough research once they are willing to consider an investment.
Hiding competitors or alternatives will only lead to less trust and either destroy your relationship or destroy your valuation.
6 Business Model: High Growth Potential & Sustainable Revenues.
Now you are ready to explain your business model.
The business model should answer the question of how you will make money with your products.
There are many types of revenues.
- One-time revenues
- Recurring Revenues
- Transaction Fees
- Up-selling Fees
- Ad Spends
- Affiliate Revenues
Generally, investors value all types of recurring revenues better.
Monthly Recurring Revenues (MRR), Transaction Fees and repeat Ad Revenues can lead to a 2-5x higher valuation of your company than one-time revenues.
That's also why service companies such as law firms or consulting firms are often valued at a fraction of technology companies with recurring revenues.
However, those revenue models also bear significant risks.
The traditional subscription revenue model of MRR in the Software-as-a-Service (SaaS) industry almost always bears a significant risk of delayed cash.
Furthermore, it may slow down growth if your churn rates are too high.
But they are still attractive if churn-rates keep being lower then revenues from new customer acquisitions.
Because then you'll found a business model that implies the most important valuation factor:
Most venture capital investors value those business models best that promise a hyper-growth and are sustainable at the same time.
7 Total Addressable Market: Y Customers will pay X Dollars.
What is the total addressable market for your product or service? –
Be precise and real here.
The best, most honest and most useful method to calculate the market size is a bottom-up approach:
- How many customers are suffering from the pain and will, therefore, pay a specific price X for your product?
- How many of those Y customers do you want to acquire by when?
If your company works in the B2C space, use Facebook Stats (within the Facebook Ads estimates) or Google Keyword search volumes to make your market size assumption more plausible.
If your company offers a B2B product, I would even recommend creating a full or at least representative lead list.
You anyway need a target list of customers sooner or later.
8 Marketing & Sales: A Machine Ready To Scale!
Once you defined your market, you may answer the question how to address that market.
How do you market your product or service to your customers?
Is it pure inbound marketing or hands-on sales or a combination of it?
I can't go into all details of how to sell or market a product here.
The most important point from an investors‘ perspective is the scalability of sales and marketing:
If you are able to show that eventually, 1$ invested in sales & marketing leads to at least 3$ or more in revenues, your so-called "unit economics" work.
You then achieved to build a scalable sales & marketing machine.
And that's when investors get excited:
When it's only about money to make the company even more successful.
9 Research & Development: Industry Shaping!
But your leadership may eventually face pressure from other, better products or alternative.
Therefore, and important question from an investors' point of view is:
How do you make sure, your product stays ten times better than any alternative in the long-term?
In other words:
What are your most exciting projects in R&D?
How is your R&D organized and why will continue shaping entire industries?
These are typical topics addressed in the R&D section of your pitch.
10 Risks: Manageable.
I have not seen many founders and entrepreneurs proactively talking about risks.
But, there is only one choice here:
Either YOU start talking about the risks or the investor does.
If you start with the topic, you may at least lead the discussion to the right direction.
Furthermore, it's your chance to look thoughtful and prove that your optimism includes a realistic view of your company.
Be very open about risks.
What are the internal risks, e.g., lack of skill, staff, financials?
What are the external risks such as shifts in markets, new technologies, regulations, etc.?
Ultimately all risks should look manageable by your team.
11 The Team: Passionate & Skilled.
The main characters of your story are the members of your team.
Remember that a smart investor will always look carefully at the team as the most critical value driver.
So selling your team, its passion and its track record is a good point before the next one: Asking for money.
Mentioning my $150m exit with SOFORT in almost all of my stories helps increase the audience' attention.
Think about why you and your team can scale the company into a big business and global leadership.
What have been your learnings and why is your team exceptional?
12 Financing: Taking The Next Quantum Leap.
By now the investor should be excited about your company:
- You solve a significant customer pain 10 times better than any alternatives.
- Your business model is growth driven.
- You know your market very well and can clearly show, that it's huge.
- Your sales&marketing machine works like a charm, your R&D pipeline is thrilling and you will be able to manage all the risks your company faces.
- Last but not least: Your team is amazing and ready to build a blockbuster success!
So now is the time for the money pitch.
First of all, re-cap what you achieved so far in revenue growth, user acquisition or other key metrics.
What you achieved should clearly show that more money will make a difference.
At this point the investor is interested in 3 questions:
- How much money do you need?
- How will you invest the money to become a $100m+ or $1bn+ company?
- What kind of exit scenarios do you see for the investors?
Pro-Tip: Create an additional slide showing publicly listed companies in your space, their market cap, revenue multiples or other KPIs comparable to yours. Only include companies with good looking multiples.
These are the high-level parts of every great company story.
Every company has some specific parts of that storyline that are particularly interesting from an investor point of view:
Either because they make the case very valuable or because they bear a significant risk.
So you may need to weight certain parts of your story more than others.
Use a great appendix that focuses on these parts.
But there is also another success driver for your pitch:
Understanding your buyer, the VC, better.
So let's now move on and look at the business model of a VC and its implication for you as an entrepreneur.
8. The Venture Capital Business Model
Many entrepreneurs looking for venture capital don’t fully understand the business model of venture capitalists.
And that leads to further mistakes you can avoid.
So let’s quickly outline how venture capital and private equity funds typically make their money and what it means for you as an entrepreneur.
A venture capital fund is usually managed by General Partners.
They are the leaders, CEOs and Managing Director behind a fund and the ultimate decision makers for investments.
The General Partners raise money from other individuals, other investment funds and all sort of investors that prefer investing in a diversified fund rather than individual companies.
Those investors behind a venture capital fund are called “Limited Partners” or simply “LPs.”
The LPs pay money into the venture capital fund so it can:
- invest in private companies, and
- pay in the operations of the VC fund itself.
Venture capital funds usually earn money through the carried interests ("Carry") on the investment returns and the management fees to operate their fund.
The importance of each of these two parts varies a lot with the amount of money that is actually made with them.
To understand that we will need to do some maths here.
Let me explain that in two examples:
Example 1: "Small" Venture Capital Fund
Let's look at a relatively "small" fund first: Small compared to the top-tier funds in the industry:
- Fund Size: $100m
- Management Fees: 2%
- Carry: 20%
- Fund Duration: 8 Years
- Fund Value at Exit: $248m – (that's equal to a 12% compound annual growth rate).
In this example, the Management Fees are 2% of $100m, thus $2m per year and thus $16m for the entire 8 years the fund is active.
The Management Fees are the budget the venture capital firm gets to finance its General Partners salaries, employee salaries, operations, offices, lawyers, travels, participation to investor summits, trade shows, etc.
The Management Fees normally vary between 1.5% to 3%.
On top of that, such a VC firm usually earns a carried interest, or simply: Carry.
The Carry is a percentage of the profits a fund makes when selling all or part of the companies on top of repaying the initial money invested by the Limited Partners.
In simpler words:
It's a percentage of the surplus the fund earns when selling companies.
The Carry is usually 15% to 30% on that surplus.
In our example above the VC get's 20% of what the fund makes after repaying the initial $100m to the limited partners.
20% of $248m minus $100m equals $148m.
The 20% carry for the investor is therefore roughly $30m.
Now here are some facts that are relevant for entrepreneurs:
The smaller the VC fund, the more likely it will focus on the Carry part of the business and, therefore, on helping you become successful.
The smaller the fund, the smaller the management fees.
The smaller the management fees, the more important the upside potential of a company and thus the Carry becomes to the general partners.
Example 2: Large billion dollar private equity funds
That changes substantially when it comes to multi-billion-dollar private equity funds mostly based in the U.S. or Asia.
Almost all best-known funds in the industry have more than $1bn under management.
And here's something to consider:
Large, billion-dollar funds may focus more on the management fee part of their business.
Think about it:
If a venture fund has a size of 2 billion dollars and the annual management fees are 2%, we are talking about $40m in management fees per year!
If a fund duration is, say, eight years, we are looking at a staggering $320m in management fees during the lifetime of that fund!
Sure, some of these funds employ more people, but it almost never goes into the hundreds of employees.
There is no need for huge teams in VC operations.
So, most of these funds don’t hire more than 50 people, and most of these employees are analysts, principals or associates that earn only a fraction of those management fees.
If you'd like to know what the salaries and compensation packages for employees in the Venture Capital industry are, have a look at the recent 2018 Venture Capital Salary Survey by John Gannon.
While renting offices on Sand Hill Road and trips to all sort of conferences are not cheap, they also only cost a fraction of such management fees.
In the case of large billion dollar funds, there is often a lot of money left for the General Partners' salaries or bonuses.
At this point, the management fees become a business model by themselves.
The Carry may be exciting, but ultimately not necessary for the General Partners to accumulate a tremendous amount of wealth.
For massive billion-dollar funds, the ability to raise funds to earn management fees, no matter the outcome, can become extremely relevant.
Management fees become a business worth hundreds of millions of dollars.
What does that all mean for you as an entrepreneur?
It took me many years to understand what that all means for entrepreneurs.
It ultimately follows a straight logic.
Think for a second about the incentives:
What would you do if you could earn hundreds of millions of dollars only by raising more money for your venture capital fund?
Don't think too far ahead:
For large funds, it's about attracting even more LPs.
What does attract LPs most?
The portfolio of a venture firm!
The LPs want to participate in the success stories of a venture firm’s portfolio.
That’s the reason they invest, after all.
If a venture firm can list lots of powerful brands or companies, that made it to an IPO, on their portfolio site, it will attract more LPs.
Yes, LPs are ordinary people like you and me admiring strong brands.
If you’d be a Limited Partner and see that a venture capital fund lists companies like Facebook, UBER, Airbnb, LinkedIn on their portfolio page and pin their logos everywhere in their offices, it would impress you for sure!
Who does not want to work with the investors of a success story like Facebook?
And here’s the catch:
A large number of so-called "top-tier" investors list Facebook & Co. on their portfolio page for the only reason to impress LPs and founders, even if they invested only at a very late stage and did not contribute anything to the success of these companies.
In the Bay Area and San Francisco, there are plenty of VCs following that practice.
And it's pretty smart to do that:
Because success always attracts more success.
But what does that mean for you as an entrepreneur?
If you want to pitch such a large top-tier VC, one you read about in the press, on Forbes, on TechCrunch, etc., then:
Don't be a hidden champion.
You not only need to be successful, but you may also have to be a known brand so the VCs can impress their limited partners.
If you’re a “hidden champion" chances are you’re never going to close a deal with such a VC, despite your success.
And that is especially challenging when your company offers a B2B product that usually is not a brand to millions of consumers.
You can still make it if your growth metrics and your traction are high and a great exit or IPO looks likely in the near future.
But if you're not a well-known brand, it's far more difficult to raise venture capital from top-tier VCs.
Anyway, understanding how venture capital firms work, how they earn their money and how your company can fit into their business model is helpful to avoid false hopes and time-consuming mistakes.
9. Don’t Get Impressed: Understand the Role of a VC
When you enter the office of a top-tier VC or check his portfolio page on the website, you may get impressed.
"Wow, these guys have been investors of Facebook!"
... a thought I had a few times while waiting for meetings at Sand Hill Road.
However, if you’ve read the last chapter carefully, you will notice, that many of the large VCs invest in companies such as Facebook, UBER, AirBnB, Slack, etc. for the sole purpose of listing them on their portfolio pages, attract more LPs and increase their management fees.
In these cases, the contribution of such investors to the success of these companies is close to zero.
So here's a healthy advice:
Don’t get immediately impressed if you see unicorns on a VC's portfolio page!
Instead, try to understand what exactly the contribution of that VC was.
Try researching 3 to 5 levels deeper than most people probably do:
- At what point in time did the VC invest in a blockbuster company?
- What was the share value of that company at the time?
- Is it be possible to talk with the founders of these companies to get feedback?
- What was the VC's most significant contribution to the company’s success besides financing?
Since I started to research such questions, I get much less impressed by most of the VCs I meet.
But exceptional people are always: exceptional.
And: Their success is the result of hundreds if not thousands of mistakes they made and that vanish in the light of their blockbuster investments.
All VCs are ultimately ordinary human beings like you and me: lost in a vast, unknown universe – whether you or they like it or not.
10. Choose Your Venture Firm & General Partner Carefully
Before and while approaching VCs the first step is to clearly understand which firms and which people to approach.
Your list should include the following information:
- Name and website of VC
- Investment Criteria
- The General Partner most likely to help you
- The Fund Size
- Duration of the fund left
- Number of companies the VC can still invest in looking at his fund size and duration
- Average ticket sizes per investment
- Investments into competitors (skip those VCs!!!)
I probably could write a book just about these topics.
I'll try to keep it short:
1 Example of An Investment Criterion: Geography
The investment criteria of a venture firm are fundamental to understand your chances to raise money.
Private Equity investors are usually focusing on specific:
- Sizes and stages of a company
- Majority or minority investments or both
- B2C or B2B or both types of businesses
- Co-Investments with another Lead-Investor
- Buyouts etc.
It may sound obvious that pitching to a VC investing in criteria that are not matching with your company's focus doesn't make much sense.
But sometimes that's not so clear to entrepreneurs.
Let me pick the example of a simple criterion that is often neglected by founders: Geography.
There are plenty of entrepreneurs all over the world traveling for a few weeks (or even years) to Silicon Valley to try raising money for their Startups outside the Bay Area.
I made that
mistake experience too:
While living in Mountain View, I pitched a number of top-tier VCs without seriously researching if they would invest outside the U.S. or even outside the Valley.
And it turned out, that most VCs only invest in companies headquartered within the 60 miles between San Francisco and San Jose.
Things change when the company is close to a brilliant exit or IPO and is likely to impress LPs in the near future.
But there is undeniably a preference for local investments.
The online publisher TechCrunch made this point in a study from November 2017 "Where venture capitalists invest and why" covering 36,700 venture deals.
Here's a chart from the study:
The earlier the stage of your company, the less likely a VC will invest in a company located outside their region.
And even worst:
A superficial look at the TechCrunch study may be misleading because it seems to suggest that you may still get money with a 50:50 chance if your company is headquartered in another state.
That's not correct!
First of all, Corporate VCs backed by their global corporations may have a much broader investment focus in terms of Geography.
Micro VC Firms and Family Offices with limited access to great deals may also need to be more "open" or more flexible to foreign investments.
TechCrunch has researched this aspect too and found out that 58% of the deals made by traditional venture firms are made in the same state.
But here's a weak point:
The study is not focusing on the Bay Area only, but on all of the U.S.
Now, if a VC firm is headquartered in Nebraska or another state with comparably little deal flow, they may need to look for hot deals in other states.
That is very different in cities like San Francisco, New York or Boston, where VCs have access to a large local deal flow.
Furthermore, in the category "Venture Capital Firms" TechCrunch mixes deals of traditional venture firms, that are generally open for investments outside their region with VCs that are focusing on local companies only.
Within the 10 top-tier Venture Firms, Accel Partners is an example of an internationally operating private equity investor.
Accel is probably the most international VC I have met in the group of top-tier VCs.
But if you go back and check the portfolio of most of the other top-tier VCs e.g. in Silicon Valley, you will see that they prefer investing with a radius of 50-100 miles only.
TechCrunch is also not fully getting the reason for this geographical preference.
The reason for most VCs to generally prefer local investments are perfectly rational.
Here is why:
It's not (only) about "easier face-to-face meetings" as stated in that TechCrunch article, but about a much more fundamental topic:
Venture capital firms prefer to invest in companies close to their offices so they can replace the CEO or the management with people from their local network in case the company struggles to meet their objectives.
Imagine a Silicon Valley VC that wants to replace a CEO in another state, in another country or even on another continent.
Almost all skilled people he knows working at Google, Facebook, Apple, UBER etc., waiting for the opportunity to become the CEO of a startup and living within the 60 miles between San Francisco and San Jose may not want to relocate outside the Bay Area.
So that VC would have to build a similar network of talents far away from his home base.
Why should he make the effort, if there are plenty of deals in the Valley?
For most VCs replacing a CEO or management is a nightmare: Even worst if it's far away. Thus, they try focusing on local investments close to their local networks.
I once met one of the Top-20 General Partners of the Forbes Midas List for a coffee in San Francisco.
His feedback was:
"I like your space. You are a smart guy. Your growth rates are impressive. Your track record is great. Your sales pipeline looks amazing. You are 2 years ahead of any competitor I know. Your R&D roadmap is exactly what I would recommend. – But what if that all changes? – I do not have a deep enough network in your space outside the U.S. or even outside the Bay Area. If things go south and I have to replace YOU down the road, I'll be in troubles."
That was an honest and reasonable feedback.
I am still thankful to that VC for not wasting my time further and helping me understand, why some others may have turned us down.
Try to carefully understand the investment portfolio of a VC and his underlying investment criteria even before approaching him.
Combine those criteria.
If you see that the VC has portfolio companies in your region, check at what stage or size they invested in.
Some may only invest ticket sizes of more than $20m per deal.
You're either looking for a larger Series-B, Series-C or Series-D round already or you may have to keep working to bring your company to these stages.
2 The Right General Partner
Make your thorough research on which specific General Partner you’d like to address.
Here is why:
If you approach the wrong General Partner chances are that you lost the opportunity to work with that venture capital firm altogether.
General Partners have an unwritten rule among themselves: Do not interfere with the deal flow of your colleagues.
In other words:
Once you’re in talks with a specific General Partner, the others will not touch you anymore, except if they are invited by the General Partner you are dealing with.
So it's imperative to select the right General Partner, by reading public information in blogs, YouTube, etc. or asking other entrepreneurs.
Before I forget: If you're only talking to associates, principals, and even partners, that are not General Partners or somehow leading Partners, it is most often a complete waste of time.
Those employees of a VC fund are there to analyze markets or help their bosses during a due diligence for a deal.
So, if you’re only talking to an associate or principal chances are that you’re just giving free market insights to someone that will most probably not help you later.
Sometimes VCs use entrepreneurs to evaluate other deals they are considering at this moment.
But even if you talk to General Partners, you may be stuck!
Here's one of my bad experiences:
And, because I was seriously upset by their behavior and have nothing to lose here, let me disclose the firm: Greylock Partners.
Now, there are some great people on the team:
First and foremost Reid Hoffmann, who I don't know personally, but whom I sympathize with for his background (he studied philosophy as I did) and whose achievements as a founder I admire (I love LinkedIn!).
But that day in 2014, another General Partner from Greylock invited me to talk about my second startup Shopgate.
As a good Swiss, I arrived 5 minutes early and starred at the wall full of impressive blockbuster startups.
But then, I had to wait for 25 minutes more after the appointment had been scheduled for 4 pm.
Now that by itself is common practice among VCs and I was getting used to it.
Many VCs let founders wait. (Ask yourself if you'd like to work with such people for the years to come.)
The disturbing part was that I could watch through the glass walls of the meeting room, how the guy I was supposed to meet, played with a french bulldog walking around the office!
I had to wait for a General Partner of a $2bn venture fund to finish his play with a french bulldog!
Now, don't get me wrong:
I love dogs and own a very funny Jack Russell Terrier myself.
But clearly, my time was not respected.
So, I walked to the front desk saying that I had another appointment and that I would leave now.
The partner then quickly entered the small meeting room where I was waiting.
He did not look happy about me interrupting his play.
And after a brief opening chat, he said:
"I'm not sure a platform for Mobile Commerce is exciting for us, but let me think about it."
He then asked me to re-schedule the meeting later and advised his assistant to help us.
Well, his PA was struggling to find a time and I was certainly not pushing her either...
It doesn't matter what they think who they are and which great exits are pinned on the walls: I don't want to work with idiots!
The year after, I learned, that Greylock among others invested in a competitor of ours, called Modest.
We never considered them as a real "threat":
Modest started to create a mobile commerce platform
identical similar to ours, but with a delay of 3 years compared to us.
And Modest ended being a modest success, indeed:
A few months later they got acqui-hired by PayPal.
An "acqui-hire" is a company bought for the main or only reason of getting the management team or staff on board.
I'm pretty sure, that was not a great deal for Greylock. After all, I have never heard of an acqui-hire valuing the company shares well.
Not surprisingly the acquisition price was never disclosed, and the platform was shut down by PayPal.
I learned a valuable lesson:
Be extremely careful about which General Partner you are talking to in the first place.
3 Size and Duration of a Fund
A VC fund typically has a duration of 8 to 10 years.
The Limited Partners (the investors in the VC fund itself) expect to gain their returns after 8 to 10 years.
So, many VC firms face a limited fund duration and, thus, a pressure to grow and sell their companies fast.
Furthermore, there is often an agreed limitation regarding the amount to invest per company.
And here’s what can happen to you as an entrepreneur:
Time and again I talked to VC firms, only to find out later that their fund duration was almost expired or that they did not have any money left to invest in a new company.
No matter how exciting my company was, any kind of investment was not possible for those VCs.
So, why would those people still talk to me?
I’m not sure, but I guess they just wanted to get free market updates from a founder or needed to keep themselves busy while waiting for a fund to expire and raising a new one.
If you’d like to save your time, check early on, what stage a VCs fund has reached.
VCs like to ask direct questions to entrepreneurs. So should you!
One further comment:
Some VC funds are so-called "evergreen funds" which means that they are raising money from LPs continuously and also pay their LPs back whenever an exit occurs or according to other terms.
Such evergreen funds may be attractive, but you should still check their sizes and how they are generally doing.
After all, some evergreen funds may have a lousy track record and are therefore struggling to find new LPs.
11. How to Approach a Venture Capitalist
The best way to approach a venture capital firm is to let them approach you.
You may present your company at a startup pitch event.
Or you may participate at a trade show or when business awards are given to startups.
Just try to find out where investors sit in the audience.
If your story is exciting, you may get approached by VCs looking for great deals.
The second-best way to approach a VC is to get an introduction by a trusted member of his personal network.
It makes a huge difference who exactly does the intro for you.
A fellow entrepreneur that made the VC earn a lot of money in the past and is a trustworthy person with a proven track record is probably the best person for an intro.
If you already have another VC on board, ask if he could do an intro.
Usually, people in venture capital firms are very well connected with each other.
Lawyers often have a good network too.
Although, the lawyers‘ reputation differs a lot and can be anything in between horrible, neutral and fantastic.
You may also check LinkedIn or other social networks to see, who in your network is connected to a VC and could give you an intro.
But don't select a random person:
Research who could be a trustworthy person to the VC instead.
Like in every sales process, it's a lot about trust and differentiating yourself from the thousands of others trying to reach a VC.
Third way: If you‘re good at online marketing, you could also try to target VCs on LinkedIn, Facebook or YouTube using paid ads and smart landing pages.
I personally never tried this strategy, but online-marketing has become a very powerful tool to create awareness.
So why not try that as well?
And, lastly, you may try it with a cold call or cold email.
While many people don’t believe in “cold acquisition” strategies, I was able to get into several talks with VCs using a cold approach.
It all depends on how well written and interesting your email or call is.
If the story you tell is fascinating and you’re able to grab the attention in the first line of your email, you eventually succeed.
The bottom-line is:
Approaching a VC is similar to selling a product to a specific target group with particular requirements.
Think about an optimal sales process.
What would it include?
12. The Venture Capital Process
The process of raising venture capital follows a well-defined path.
If you know that path in advance, you are better prepared and, thus, more likely to close a good deal.
Hence, it's worth understanding each part of it.
With a few exceptions, raising VC money will include the following steps:
1 First Meeting
In the first meeting, it’s about getting to know each other, understanding the fit of the company to the VC's investment criteria and assessing the personal sympathies.
As mentioned before:
Watch out for idiots!
I’d recommend an informal meeting at a coffee shop or a place where you get to know the VC from a personal point of view.
Meet them as you would date someone:
Do you genuinely like these guys?
Ask questions that are polite and deep enough to asses if there’s a match.
If you don’t like the people you meet:
Get out of there or be ready to waste a lot of time!
Some colleagues have asked me if I would ask for a Non-Disclosure Agreement (NDA) in this phase.
In fact, the last time I requested an NDA from a VC was a long time ago.
NDAs are considered to be old fashion, and the reality is that most times they are worth less than the paper they are written on.
The reality is:
I never heard of an entrepreneur suing a VC for a breach of confidentiality.
So what's the point of an NDA?
Furthermore, if you've chosen the VC carefully enough as described before, you should have excluded any VC invested in competitors.
My opinion on NDAs applies to my experience with software companies and companies that may not be able to protect their intellectual property besides simple trademark rights.
But maybe there are cases where an NDA is critical.
For example: I could think of pharmaceutical products in their research phase that may have a strong interest in intellectual property rights.
But the bottom line here is:
If you can skip an NDA, skip it!
One more thing:
After your first meeting, a VC is interested or not.
It's time-saving and important to understand early on, if a VC seriously likes you and your company or not.
You can tell the level of interest by measuring how fast the VC follows up with an email or a call to recap the meeting or thank you for it.
If the VC lets you wait for more than a day, he’s probably not interested.
If the VC wants to meet you again, but only a few weeks down the road, he’s probably not interested.
In these two cases, you should carefully think about if you prefer to skip that VC or try it from another angle.
You may try to get in touch with other general partners but you then need to be careful to not upset the people you met in the first place.
2 First Venture Capital Pitch and First Q&A
If the rather informal first meeting went well and the VC is seriously interest, you may present him more details.
You are going to meet the VC in his office or in yours and present your full story.
For this purpose, you may create a mind-blowing pitch deck following the storyline mentioned before.
And the VC may then dive in into more details.
What's important to know:
Usually, VCs ask questions that they are used to. They do not necessarily ask questions that you believe are important.
Here is why:
All VCs – like all humans – are shaped by their personal experiences.
So, they ask whatever is relevant looking at their experience, not your experience.
So the best thing you can do is:
Listen carefully to his questions.
Furthermore, it’s worth doing a bit of research on the specific experiences the VC made in his past.
Check if there’s a YouTube video, a blog post, another founder or other sources of information to understand what a VC usually is looking for before investing in a company.
As explained before:
Never leave any doubts about your skills, your passion, and your expectation to create a huge company.
Is your company going to be a billion-dollar exit opportunity? – Yes, sir!
Furthermore, consider this:
VCs usually like data. Because data are hard to fake and easy to verify.
So, if your presentation proves that you and your team are extremely data-driven, that's a big step towards gaining the VC's trust.
And, by the way:
Being data-driven always helps to improve your business anyway.
Last, but not least:
Whenever you answer a question think from an investors perspective.
When preparing for the questions that may occur, ask yourself if your answer reduces the future value of your company.
Two small, but typical example:
1. Scalability of your business:
The VC may ask you how much work it is to onboard or service a customer.
Or he may ask how much time is spent per customer generally.
But what they really want to know is:
How scalable is your business?
Limited scalability may imply a limited business opportunity and hence a limited upside potential of your shares.
2. Market entry barriers
Another typical example is the question, how easy it is, to program or build your product.
Some entrepreneurs may think that this is a technical question.
It's about the market entry barriers.
In other words: This question is likely to be about whether it's easy to copy your product for a (well funded) competitor.
Always try to understand the intention or "pain" behind a question from a shareholder value point of view.
Because the VC's job is to asses what the current and future shareholder value of your company is.
3 The 2nd Q&A Round
If the VC has digested the first round of questions and he's still excited about your company, he will probably dig deeper into what the most critical parts of your business are.
He will want to know more details about your technology, your financial assumptions, your competitors etc.
I can only recommend being as proactive as possible and not hide anything.
First of all, the truth is always simple to remember.
And secondly, you will not want them to find out after you spent weeks for the ten steps to come before closing a deal!
And even less you’d like them to find out, once they are on board as investors.
Don’t waste your time!
Be open and share your concerns if you have any.
However, in my experience, you should also make sure the information is relevant to the venture capitalist.
Nothing is more annoying than an entrepreneur talking for hours about technical stuff only he understands.
Such a talk may even end up in serious doubts about the required sales skills of an entrepreneur.
Stay on a strategic level only, if the VC does not explicitly ask for operational details.
4 Prepare a Pitch to The Investment Committee
Usually, a General Partner is not alone.
Almost all VCs have other partners working for the same firm.
And the General Partners are often supported by analysts, associates, investment managers, that are paid to challenge each other on every investment opportunity.
For you as an entrepreneur, that means, that you need to make sure your General Partner can sell your company to his colleagues as good or even better than you can!
Try to find out how decisions are made in a venture capital firm:
Sometimes an individual General Partner is the opinion leader, and everyone else follows him.
And sometimes all General Partners and Partners have more or less equally respected opinions and decide together.
A General Partner may want to reduce the risk a getting blamed for a bad investment decision and may, therefore, want the buy-in from his colleagues as well.
In some other cases, there are internal fights over who gets the best deals. In these cases, you may face resistance from other partners for reasons that have nothing to do with your company.
Either way, prepare a breath-taking pitch.
5 Pitching To The Investment Committee
After preparing the pitch to the investment committee, you may need to present your company to other decision makers of a VC firm.
The most important success factor to present is always: You!
Prepare the meeting well and make a firm impression!
There can’t be any doubts that you will make your company a huge success.
Be obsessed with the details of your business!
If you don’t know the answer to a question, a rational reaction would be to ask them to come back later.
Most probably there will be no “later.”
And therefore, you must instantly understand if a question is critical for the perception of your personality or an investment decision.
If it’s not:
Go for the “I-ll-come-back-later” route.
But if the question is important (and most of them are in the eyes of the VC), then you should try to guess your answer as good as you can. And keep looking firm while doing so!
That may not sound like a serious advice.
But remember that it’s about leaving an impression of strength and excellence.
6 The Internal Decision: Termsheet Yes or No?
After you’ve done your pitch, it’s up to the investment committee of the venture capital firm to decide.
Some VCs have the internal agreement to only go for a term sheet if ALL general partners or even the other people of the firm agreed to move on.
In other firms, general partners may decide more independently from each another.
Furthermore, many venture capital and private equity firms have regular meetings every Monday to review their deal flow.
So you may have to wait until Monday night.
And again, the speed of feedback might be a strong indication of the venture capital firms' investment appetite in your company.
If they let you wait for more than a day after their decision meeting, I’d bet 9:1 that they are not interested.
7 Negotiating The Term Sheet
If the VCs' investment committee decides to move on, they do so by offering you a term sheet.
A term sheet is a letter of intent listing the main terms that will constitute the final, binding investment agreement.
A term sheet may include an exclusivity clause forcing you to stop talking to other VCs.
If that's the case:
Try to reduce the exclusivity period to a minimum!
A term sheet usually does not oblige a VC to invest.
But it sets the framework for the main conditions under which he will invest, given a successful due diligence.
Before sending you a term sheet, the VC may also try talking to you first:
With such calls or meetings, the VC is testing the waters.
And he may negotiate as much as he can before writing down anything.
Here are a few critical lessons learned:
A. Ask for more! Never settle for the first offer.
Now, that may sound like a greedy advice.
And yes, usually, in life, greed is not an attitude or behavior that makes you happy.
But here, we are not talking about small, unnecessary luxury items.
We are talking about millions of dollars, that may make the difference between a wealthy life for you and your family or not.
Modesty is the wrong attitude when negotiating venture deals.
Every percentage, every right and every balance of power in your favor can make a life-changing difference!
If you don't ask for more, you will regret it in a few years time.
I lost millions of dollars for accepting offers too early.
So, don't be shy:
ASK FOR MORE!
You should be very careful with any conditions you accept in your first term sheet.
Here is why:
B. Once you accept a term, you will struggle to re-negotiate it in any future investment agreement.
It’s a fact :
If a term or condition gets into the final investment agreement, such a term is likely to be part of EVERY future financing round.
The argument here goes like this:
You’ve accepted it once, so why shouldn’t you accept it later?
The only way to get rid of the terms you accepted once is to become insanely successful AND irreplaceable for the company.
There is a certain friction between these two conditions and you should never expect this to be the case in the future.
C. Be prepared to the argument that a clause is STANDARD in the VC industry.
Before accepting the "standard-argument", as I would call it, ask yourself:
- Is it really a standard?
- Do you care about the standard?
- What is best for the company and me?
- Can I afford to decline that term?
- How can I argue against it?
You can simply say: "No." to a term.
You don't always need to justify why.
But if you do so, you could say:
"For me, it's not about standards, but about feeling that you guys will help us make this company the huge success it deserves. And that clause makes me feel uncomfortable."
Needless to say:
That counter-argument is as fuzzy and irrational as the phrase "it's a standard", but, heck, did I ever say raising venture capital is a rational process?
And if you're a hot deal, that argument may work once or twice.
An even better approach to get rid of a specific term:
D. Get multiple term sheets.
Try to get as many term sheets from as many different VCs as possible to leverage your negotiation power!
In other words:
To make sure you get the best deal, you need to create a market for the shares in your company.
I know: It's a lot of work.
But we are talking about an essential success driver in the future of your company and about your future happiness as an entrepreneur!
There's a lot lose and a lot to win here.
Thus it's worth the effort!
E. Hire an experienced AND smart lawyer!
The lawyer you are usually working with is unlikely to provide you with good enough advice.
Here is why:
The lawyer you need for a VC deal must have both:
- Legal skills in the specific area of Private Equity deals AND
- Strategic negotiation skills in that space and the ability to sell your interests well.
Important: Do not rely on the lawyers paid by the VC under no circumstance!
They have quite the opposite interests you have!
The next important advice when negotiating a term sheet:
F. Create waterfall exit scenarios!
Waterfall scenarios calculate the precise payouts for each shareholder on sample exit valuations between $1m and $1bn.
Such a spreadsheet will give you more transparency on valuations, liquidation preferences and, generally the kind of deal you are signing.
Let the VC confirm it, once it's done, and attach it to the term sheet if possible.
The term sheet conditions are such an important topic that I’d like to dedicate the entire next chapter on the most critical pitfalls.
For now, let's move on in the VC investment process:
8 Signing The Term Sheet
Once you carefully (!) negotiated all the critical investment terms it's time to sign the term sheet.
Now, signing a term sheet is a real milestone.
But stay careful:
It's still a long way to a final agreement and money paid into the bank!
My personal success rate with term sheets during my career:
- I received a total of 19 term sheets, 8 of which I have signed while declining the others when selecting a VC over another.
- Of these 8 term sheets, 7 have led to a real funding round with money paid into the bank.
- However, one term sheet that I signed did not result in closing the financing with the investor.
Thus, my personal success rate of signed term sheets vs. closed investment rounds is close to 90%.
What happened to the term sheet that did not result in a real financing?
Here's the story:
During the due diligence, the new investor made a reference call to a customer.
He grilled the customer for over an hour until the customer said something the investor didn't like.
He basically drove the customer into claiming that our company was probably replaceable in a few years, but that he had no intention to replace us now.
Clearly, that investor was an idiot.
Give me ONE example of a product that will NOT face disruption in the long term!
The end of that story:
That customer called me right after his weird VC call, complaining about why he had to spent so much time with this jerk, why answering misleading questions, etc.
Luckily my relationship with that customer was good enough to explain him the background.
The outcome was not surprising:
Due to that phone call, the investor terminated the further process and did not follow up on the investment.
The long fought term sheet was a waste of time apart from the lesson learned to work harder in finding out if a VC is an idiot even before signing a term sheet.
In retrospective we were lucky.
We probably prevented a harmful business partner joining the company and probably saved hundreds of hours and the company from a lot of troubles later.
A signed term sheet is a remarkable milestone, but everything can happen before you see the money in your bank account!
So, keep calm and move on.
9 The Due Diligence
During his Due Diligence, the VC will turn every stone in your company.
He will send you a long checklist of data required.
To save time, I would recommend setting up a data room early on.
A due diligence for a NEW investor will usually include the following parts:
- Review of all substantial legal commitments such as leasing contracts, IP rights, licensing agreements, insurances
- Review of company registration documents
- Review of annual and monthly shareholder reports
- Calls with your customers
- Mystery shopping at your company
- Mystery shopping at your competitors' companies
- Personal reference calls
- IQ or personality tests
- A deep check of financial assumptions
- Technical due diligence involving engineers
- Due Diligence on HR
- Specific topics related to your company
I have seen all of it.
But why such an effort?
The VC does that for 3 reasons worth understanding:
a.) The VC wants to avoid investing in a fake or fraudulent company.
That is a legitimate reason.
Every rational person investing millions of dollars in a company should perform a due diligence and make sure a company is not a fake.
But there are also other reasons the VC may want to perform a thorough due diligence.
b.) The VC wants to make sure that, if things go south later on, their limited partners and colleagues can't blame them for negligence.
This reason is understandable but may also give you an indication of the entrepreneurial spirit of a VC.
If a VC asks for hundreds of absurd details and is scared of mistakes, probably he does not share the entrepreneurial spirit you may need later on.
Again, stay brutally honest with yourself:
If a VC turns out to be an idiot, prepare to search for an alternative!
And there's the third, even less acceptable reason for the VC to perform a thorough Due Diligence:
c.) He may want to find weaknesses, that may give him an argument to lower the valuation or worsen the deal terms.
My best advice here:
Clarify early on, that this is not acceptable.
You signed a - hopefully hard fought – term sheet!
And the only real reason to accept a Due Diligence is reason 1:
Helping the VC to avoid investing in a fake company.
If the VC insists in adapting an already negotiated, critical term without a substantial finding in the Due Diligence: It's an idiot, and you should walk away from the deal!
Believe me: It will save you hundreds of sleepless nights later!
10 Negotiating The Final Investment Agreement
While still performing the due diligence the VC and you may start negotiating the final and binding investment agreement.
Here is my advice for the part:
A. Apply the above-mentioned lessons of negotiating the term sheet again.
If you haven't read the above part about Negotiating The Term Sheet, do it now!
To summarize the learnings from negotiating the term sheet again:
- If it's still possible: Ask for more!
- Remember: Once you accept a term, you will struggle to re-negotiate it in any later investment agreement.
- Be prepared to the argument "that a clause is standard in the VC industry."
- Hire an experienced AND smart lawyer!
- Create waterfall exit scenarios and include them in the investment agreement.
Here are a few more topics to consider:
B. An investment agreement will almost certainly include a long list of guarantees and warranties that may significantly hurt you later.
My tips here:
1. Avoid any critical type of guarantee that you may personally be liable for.
2. If you can't avoid personal liability always include the phrase "to the best of the management knowledge,".
Some VCs try to skip that phrase, so that entrepreneurs may become liable even if they didn't know of any issue!
3. Try to include the business risks as something investors must be aware of when investing.
And here's my final negotiating "trick" regarding guarantees:
4. Do proactively offer a huge list of non-critical guarantees.
Why? – Because that will help you argue that you're already giving a lot of guarantees.
And the VC will feel like they took out as many risks as possible.
Here are further comments on the investment agreement step:
C. The investment agreement may include NEW conditions not mentioned in the term sheet.
Try to understand them precisely:
If these new terms are substantial, it would be interesting to know, why they were not part of the term sheet in the first place.
And you then must again decide if you want to accept that or not.
Don't get "tired" of negotiations, because that may be the strategy they are trying to follow to make you accept tough details.
Stay very careful and keep understanding every word of the agreement.
F. Try to get it done in one or two face-to-face meetings.
Sometimes the negotiation ends up in an email back-and-forth.
That can be dangerous and time-consuming as emails may lead to harmful misunderstandings and a waste of time.
At some point, I, therefore, recommend organizing one or two multi-hour face-to-face meetings.
The objective of such meeting shall be:
Get it done!
Try to stay focused even if it takes many hours.
Pro tip: Make sure you eat and drink enough before such a negotiation.
Believe it or not, but one time at my previous company SOFORT we had to negotiate an investment agreement for more than 10 hours.
It started at 4 pm and ended at 2 am the next day!
At 10 pm people started to get tired and hungry.
But everyone wanted to get the thing done!
However, our lawyer, one of the very best I know, forced us to get some food and eating burgers before the meeting...
It was 3 pm and we didn't understand why he was insisting so much on eating this type of food outside the usual lunch or dinner hours.
But it paid off very well:
Starting at 9:30 pm we were in a much better shape than the VC and his lawyers that had little to eat besides some biscuits...
That day, some of the most critical terms were negotiated after 9:30 pm...
11 Signing the investment agreement (Yeah!)
In my career, the signing of the investment agreement has almost always been a fantastic event!
I heard of some entrepreneurs that signed a shareholder agreement and then had to sue the VC for not paying the agreed money.
But I have personally never experienced this:
A signed and binding investment agreement always led to money on the bank account.
So you should celebrate this moment with your employees, your family and the VC himself because you've achieved something that thousands of others did not.
It's better than any business award:
A professional investor gives you credit for your team and your product and proves his appreciation with millions of dollars!
It's something you motivate your team with:
Investing millions of dollars is the best sign you can get, that someone believes in what you are doing!
Enjoy the party, before getting to the real work:
Growing your company to an insane level!
12 Transfer of funds
The moment you see that millions of dollars have been transferred to your bank account is the moment a VC investment is 100% real.
For this step, I've got two tips:
- Inform your bank on time about the new funds transferred to your account. In some cases, they may assign you a more senior banker.
- If the money is transferred in several tranches always try to ask for the next tranche on time. Always reserve enough time for bank transfers!
Some VCs do not have the money on their bank accounts yet, but only the commitment from their limited partners to send their committed money whenever the VC asks for it.
You should never wait to the last minute before running out of cash!
13 Execution: Now, it's 100% up to you!
After receiving the money, the ball is in your court.
Now it's time to 10x the value of your company by growing your sales, your users or whatever makes the value of your company.
In my experience and according to the feedback from almost every founder I have ever spoken to, the VC will not help you at all in executing your idea.
Even those VC firms that appear to be very supportive most likely do not provide any value besides money to grow your company.
Think about it:
A VC firm may be:
- invested in dozens if not hundreds of other companies,
- he must take care of the limited partners, the investors financing their funds,
- he may want to visit conferences and trade shows,
- he may work on new pitches,
- he may be busy with exits of some other portfolio companies,
- he must deal with those portfolio companies, that are in troubles,
- he attends board meetings,
- he is sometimes in the middle of raising his next fund,
- he may party hard and do extensive holidays, and
- some are even trying to become influencers in the startup-scene writing hundreds of tweets or blog posts a month.
Do you seriously think such people have time to get into the operational woods with you?
As soon as you get the money, it's 100% up to YOU to make something out of it and grow your company.
The feedback you may later get in board meetings is equivalent to the feedback you would get from asking an outsider:
It will almost never give you a detailed idea of what to do next.
Maybe it is, if you remember how (almost) all VC sold you their firm in the first place:
An entrepreneur-friendly, experienced group of people with a vast network that will help grow your company besides the money.
Well, that's almost always BS.
VC firms provide one value: Money to help you accelerate your growth. Nothing more and nothing less.
13. Pitfall Venture Deal Terms
Let's now talk about more specific venture capital deal terms.
As you will see, some of these deal terms can turn into crazy pitfalls for entrepreneurs.
In this part of my post I selected those terms that in my experience have the biggest impact on entrepreneurs:
- Pre- or Post-Money Valuation,
- Valuations and startup classes,
- Non-Participating Liquidation Preferences excluding and including interest rates,
- Participating Liquidation Preferences excluding and including multiples,
- Milestone Agreements or Earn-out Clauses.
If you would like to go much deeper into the subject I'd recommend reading or listening to the brilliant book:
Why is it important to perfectly understand and react to VC terms?
In the long-term venture deals are life-changing.
Venture deals are always about gaining or losing millions or even hundreds of millions of dollars for both: The investors and you as an entrepreneur.
Most often they turn out to be either fantastic or horrible.
The difference between a future wealthy life and a future of regrets can be written in the details and nuances of your investment agreements.
So, naturally, everyone should have a close look at the underlying implications of such deals.
Venture deals are not only life-changing but often unfair too:
VCs have a significant advantage against you as an entrepreneur:
They do such deals way more often than you do.
Venture capitalists know the pros and cons of every term and how to argue for it.
In other words:
Negotiating term sheets or investment agreements starts off as an unfair game between two parties playing on different levels of experience.
And that's why you need the experienced lawyer as described earlier in this post.
But don't rely on the lawyer only.
Try to learn and understand what VC terms are all about yourself.
So, let me now highlight a few of the most critical pitfalls and how to react to them:
1 Pre- vs. Post Money Valuation
The first and often most important term of a venture deal is the valuation of your company.
And here's the first common pitfall:
While entrepreneurs think about what their company is worth today, the venture capitalist always thinks about what the company is worth AFTER his investment.
In other words:
The difference between the pre-money valuation and the post-money company valuation may cause the first misunderstanding.
To clarify, let me give you two definitions:
The Pre-Money Valuation is the valuation of your company before a new investment round.
The Post-Money Valuation is the valuation of your company after the new investment round. It includes the money an investor has put into the company.
Let's look at a simple example:
Let's say that the VC wants to invest 3 million dollars in your company.
He may then say:
"I'll invest 3 million dollars. And the company valuation is 5 million dollars."
What you, the entrepreneur may understand is:
"Wow, my startup and thus my shares are already worth $5m and I'm getting another $3m for the business!"
But what the VC really means is:
"The company is worth $2m today. I am going to invest $3m, so the valuation including my investment is going to be $5m."
These are two completely different scenarios:
- The pre-money company valuation today is $5m.
- The VC invests $3m.
- Thus the post-money company valuation will be $8m.
- Thus the VC gets 37.5% of the company shares...
- and the entrepreneur (you) keep 62.5%.
- You keep the majority of the company!
- The pre-money company valuation today is $2m.
- The VC invests $3m.
- Thus the post-money company valuation will be $5m.
- Thus the VC gets 60% of the company shares..
- and, you, the entrepreneur keep 40%.
- You remain with a minority of the company only!
- Scenario 2 values your company less than half the price of scenario 1.
- Compared to scenario 1 in scenario 2 you lose 22.5% of the company shares: In a $100m exit that's 22.5 million dollars less for you.
- And: Losing the majority of the shares and voting rights may also mean losing control of the company.
Here's the lesson to learn:
From a VCs point of view what counts is the Post-Money Valuation.
Think about it:
The VC's main concern is how much of a multiple the company is worth AFTER his investment.
He is not interested in what happens if he doesn't invest.
So, whenever a VC offers you a valuation when talking about a term sheet, ask this question:
"I assume you mean the pre-money valuation, right?"
The VC then must explain, why he is talking about the post-money valuation instead.
Your question may also give him a signal that his offer will be too low.
And his offer will always be to low! –
Ask for more as long as you can!
No matter what, your question will most certainly lead to the first intense discussion about the term sheet and its main terms.
2 Valuation & Startup Classes
So, which valuation should you ask for?
Besides philosophy, I also completed my university studies in corporate finance as a minor.
I've learned several valuation methods such as DCF, Price-Earning Ratios, the Black-Scholls Model, etc.
My experience leaves no doubts:
The mathematically well-described valuation methods you may learn in your finance studies or in an MBA are useless when it comes to startups.
Instead, almost all VCs tend to put startups into six mental boxes once you share your revenue size:
Box 1: Seed Stage
Your company does zero revenue and has no customers yet.
If you're a first-time founder with no track record, I'd say that in 99.9% of the cases you shall just forget the idea of raising venture capital at that stage.
Try to do revenues, gain customers and become successful first.
Please have a look at the first three chapters of this post.
Box 2: Early Stage
Your company does less than $1m in annual revenue run-rate.
A $1m run-rate per year means that your company does roughly $80k per month in revenue. (12 x 80K being approximately $1m)
For many VCs, this stage is still too early to invest, so you have to find that hand full of VCs that really do invest in early-stage companies.
And here's a weird rule about early stage valuations:
For most VCs, a post-money valuation of $10m is the upper-limit they would ever pay for an early stage startup.
It is almost impossible to get a higher valuation at that stage if there are no other success drivers such as user acquisition or other KPIs.
Everything below $10m turns out to be much easier to convince a VC.
I don't know why.
But in my own experience, talking to other founders and even in the book mentioned above, "Venture Deals" the $10m is a mysteriously set upper-limit for VCs to invest in early-stage startups.
The only exceptions to this rule are trusted serial entrepreneurs or companies that are accumulating users very rapidly and may turn them soon into millions of dollars of revenues.
Box 3: Expansion Phase A
Your company does between $1m and $10m dollars in annual revenue run-rate.
Usually, companies doing between $1m and $10m in revenue tend to raise venture capital at post-money valuations of above $20m, but most often below $100m.
A workaround to go higher in valuations is including participating liquidation preferences or milestones in an investment agreement.
But that has its price, as I will explain below.
Box 4: Expansion Phase B
Your company does between $10m and $20m in annual revenue run-rate.
In that stage, a $20m or rather $30m valuation is really the lowest end you should ever accept a deal.
I'd rather recommend starting with the upper end at $100m or above in the negotiation.
Doing more than $10m in annual revenue combined with rapid growth means that you may soon achieve the next, exciting stage:
Box 5: Trade Sale Phase
If you do more than $20m or $30m in annual revenue run-rate and you are not doing much losses, you start to become interesting for larger corporations to acquire your business.
This is usually a phase a lot of venture capital and private equity firms will want to invest in your company.
The trade sale phase is where you really turn things around and may even dictate all the investment conditions you'd like to see.
I have explained the reasons for that shift earlier in this post.
In this phase you may also consider larger investment banks helping you to get ready for the next phase:
Preparing and performing an IPO.
Box 6: IPO Phase
If you do close to or more than $50m in annual revenue, I would definitely start considering an initial public offering (IPO) on a well-known stock exchange.
In such a phase you will start to get bombarded by large multi-billion dollar venture capital firms, that want to see your logo on their portfolio page.
In all stages AFTER the early-stage phase, valuations depend a lot more on revenue size and growth rates.
In these rounds sales growth is by far the most critical metric.
In an IPO you will offer shares of your company to a wider range of institutional investors and small private investors.
And what investors in public companies want, is simple to understand but hard to achieve: A steady flow of good news.
However, in almost all stages of a startup the valuation is made the following way:
First: You or the VC put a valuation on the table.
No matter what, be prepared for a shock:
The VCs valuation is going to be way below your expectations!
And then, in my experience, there's a simple rule:
If expectations are more than 30% apart and you're not desperate as an entrepreneur, the deal will not happen.
If both expectations differ by 30%, chances are you may be able to negotiate a deal that both parties can agree upon.
You may also take valuations of other companies as a reference to yours; the so-called "Peer-Valuation."
Thereby you check the market caps of publicly listed companies in your space and calculate a revenue multiple or any other relevant multiple to argue for your valuation.
Some VCs have argued that a comparison is not easy because public companies are usually much larger, the risk may, therefore, be lower and their stocks can be sold easily.
The liquidity of an investment is by far greater for public stocks.
I do share this opinion, but I also think that from an entrepreneurs' point of view, any argument you can get to increase your valuations can be worth millions of dollars later.
So just try to use the peer valuation method!
3 Simple Non-Participating Liquidation Preference
There's another essential part of the valuation story in venture capital deals:
What's a Liquidation Preference?
A liquidation preference gives investors the right to get paid before anyone else in all or specific cases of an exit event.
It's a fact:
Terms including liquidation preferences have become a standard in every venture capital deal I know of.
And even worst:
The liquidation preferences have become essential parts of the valuation of many well-known deals.
Let me explain:
Liquidation Preferences were originally asked by investors to protect them in a downside scenario.
Let's take the above-mentioned example:
As you can see in the waterfall exit payouts:
- The simple, non-participating liquidation preference means that the VC gets his investment back first.
- Only after the full investment is paid back, you, the entrepreneur may receive a payout.
- In any scenario below the valuation paid by the VC ($8m in this example), the VC gets more than the 37.5% his shares are worth.
Now, in this example, the liquidation preference is simple and non-participating.
- Simple: The VC does not get any interests or multiples back on the liquidation preference and
- Non-Participating: As soon, as the VC percentages of shares are worth the same or more than the liquidation preference, the liquidation preference will be waived.
A simple, non-participating liquidation preference offers a down-side protection against the odds of the company being sold at a lower price than originally paid by the VC.
In other words:
It protects the VC against an underperforming entrepreneur.
For you, the entrepreneur, this logic is hard to argue against:
After all, you raise $3m to become a massive success and presented your company to be worth 10x or more the value of today!
In my experience, such a simple, non-participating liquidation preference is almost standard today.
The only way to get rid of it is to be such a hot deal, that you dictate the terms, not the VC.
And even then some VC may refuse to invest due to their promises to their limited partners.
But it's fact:
For certain exit scenarios even such a simple, non-participating liquidation preference is part of the valuation!
And if you only look at the basic valuations without understanding the liquidation preference, you may give away more of the company than you thought.
4 Non-Participating Liquidation Preferences Including Interest Rates
Here's the catch:
Liquidation preference terms can get much worst!
First of all, the investor could ask for additional annual interest rates on his liquidation preference.
Here's the logic behind that request:
- When raising money from LPs a venture capitalist not only competes against other VCs but also against the stock markets.
- A VC fund has capital costs like every type of investment.
- So, if the VC "only" gets his investment back, he's still loosing against the market.
- And that may also imply that the entrepreneur has failed to deliver on his promises.
The VC may, therefore, ask for as high as 8-12% compound annual interest rates on their liquidation preferences.
It's a stronger form of downside-protection, that can already hurt you, the entrepreneur much more in the long-term.
Lets' look at that example again and assume the lower end interest rates of 8%:
Now the company must already be worth more than $11m before you, the entrepreneur may get your payout according to your shares.
For every exit valuation below $11m, the VC gets more than his share value.
In other words:
For every exit scenario below $11m, the VC gets exit payouts as if he had paid a much lower valuation when investing.
And this is just an example of a minor Series-A round.
Think about the math, when such terms apply to larger rounds of 20, 50 or 100 million dollars!
Hence, it's fair to say that:
Under certain circumstances, even a non-participating liquidation preference becomes a relevant part of your current valuation.
5 Participating Liquidation Preferences
And liquidation preferences can get much worst:
Instead of a non-participating liquidation preference, the VC could also ask for a participating liquidation preference.
What's the difference?
A participating liquidation preference means that in an exit case the liquidation preference is subtracted from the exit proceeds first. The remaining exit proceeds are then distributed according to the share percentage held by all shareholders.
In other words:
The exit proceeds are distributed according to the percentage of ownership after the liq pref has already been paid to the investor.
Let's look again at our example.
Let's assume a simple, but participating liquidation preference:
As you can see:
- The VC gets his first $3m no matter what.
- The remaining payout is then distributed pro rata among the shareholders.
And here's an interesting fact:
A participating liquidation preference for any exit scenario implies that the VC will always get more than his shares are worth in percentage.
Even in an exit of $1bn, the VC gets more than the 37.5% his shares would pay him out without the participating liquidation preference.
In other words:
A participating liq pref without restrictions is a relevant component of the valuation in every possible outcome.
As I will explain below, in my opinion, you should rather lower the valuation than accepting a participating liquidation preference.
6 The Unicorn Lie: Participating Liquidation Preferences Including Multiples
By now, you should know, that things with liquidation preferences can always get worst...
Not surprisingly VCs may even suggest a participating liquidation preference including interests rates or – even more common – including multiples.
In other words:
A VC may ask to receive a multiple of his investment first in any exit scenario, no matter what!
Now, instead of continuing the above example, I'd like to show this crazy term with a personal experience of mine.
I once received a term-sheet from a billion dollar VC fund located in San Francisco.
The term sheet included:
- a $20m dollars investment by the VC, and
- valued my company doing roughly $5m in annual revenues with a $150m post-money valuation.
At first glance my reaction was:
"Wow, a 26x multiple on revenues pre-money valuation and $20m in cash to boost my company! How exciting!"
Well, but then I discovered a participating liquidation preference including a multiple of 3.
In an exit case, the VC would get 3 times his investment back, before distributing the remaining payouts pro rata among shareholders.
Let's do the math again:
That proposal was nuts:
- Up to an exit of $60m the current shareholders including me would get exactly 0$.
- The exit price minus the $60m would then be distributed according to the share percentages (86.7% for us, 13.3% for the VC).
The Liquidation Preference was heavy:
- Even in an exit at the current valuation of $150m (not a bad exit for a $5m revenue startup), the VC would earn almost half (48%) of the payouts.
In other words:
- The actual valuation of $150m with this type of liquidation preference would have been equal to a post-money valuation of $42m (48% of the company being valued at $20m) with such a liquidation preference.
Needless to say:
The deal was crap.
It sounded fantastic at first glance, but when understanding the extent of the liquidation preference the $150m became a joke!
The VCs reaction?
He was surprised and told me that these types of deals are common in the Bay Area whenever new companies get high valuations.
He then tried to blame me for not being ambitious enough...
But there's a difference between being ambitious and being dumb.
So, why would entrepreneurs ever accept such a participating liquidation preference?
I can think of a reason:
Crazy liquidation preferences allow entrepreneurs to ask for absurd valuations, achieve a unicorn status and get all the marketing and press coverage unicorns enjoy.
Think about it:
Let's assume the above offer was not a $150m valuation, but a $1bn post-money valuation instead.
Gosh! I'd the become the legendary founder of a unicorn!
The VC would still earn at least 3x on the investment if the company gets successful.
If the company would be sold for $1bn or more, that would turn out to be a great deal for me.
But here's the catch:
For any exit below $60m, I'd still remain with 0$.
And even in an exit below $200m or $300m, I'd give away substantial parts of the company!
By now you should get the point:
Liquidation preferences can be much more than a simple down-side protection.
Depending on their exact wording, liquidation preferences may become an insane part of the valuation!
If you ever admire unicorn companies, think about it twice:
It may turn out to be a donkey with a fake horn.
And here's the best advice I'd like to repeat:
Always – and I mean always! – create a spreadsheet with exit waterfall scenarios to get 100% transparency on the suggested deal.
Calculate the distribution of payout in all exit scenarios between 1, 2, 10, 50, 100, 200, 500, etc. million dollars.
Then let the VC confirm it and attached it to the term sheet and the investment agreement.
And if it looks like a hoax:
The VC is probably an idiot, and, well... by now you should know, what to do with idiots.
7 Liquidation Preferences: Summary & Tactics
I'd like to summarize the four types of liquidation preferences and how I recommend you to react:
The best way to get rid of any bad VC term is to be successful and have multiple venture firms offering you term-sheets.
Competition among VCs puts you in the driver seat.
However, sometimes you can't avoid accepting terms like these.
So here are my tips regarding liquidation preferences:
a.) Simple, non-participating liquidation preference without any interest rates:
It's hard to argue against it, as such a liquidation preference does indeed serve as downside-protection only.
Such a liquidation preference may therefore be acceptable.
b.) Non-participating liquidation preference including interest rates:
Interest rates on liquidation preference are already very questionable.
In any case: Do the math and create waterfall payout scenarios.
If the VC asks for higher-end compound annual interest rates of 12%, he is going to receive 2x of his investment in an exit 6 years later!
You need to at least double his investment to get any payout yourself.
The VC will argue that his fund must be competitive against the market.
He may also argue that because of his management fees, a simple liquidation preference without interests rates, may still mean a loss for his LPs.
Well, that might all be true.
But the alternative is a slightly lower valuation without such a liquidation preference.
In most cases, if you can get rid of interest rates for a slightly lower valuation, I would advise doing that.
Because such interest rates will only get worse when it comes to further rounds later.
c.) Participating Liquidation Preferences (both types)
My clear advice:
Always accept a lower valuation instead of a participating liq pref.
Here is why:
A participating liq pref including or excluding multiples will follow you forever as a fixed part of the valuation.
You may only get rid of it under extreme circumstances, like threatening the VC with leaving the company or so.
And there's another, even more, important reason:
As an entrepreneur, you will always have such a liquidation preference in mind when exploring exit opportunities or even when thinking about your own private exit potential.
In other words:
You may start to take unnecessary risks.
Because whenever you'll receive a reasonable offer for your company to get acquired, you have to compensate for such a liquidation preference.
It's very dangerous:
You may actually turn down reasonable offers, only because you have to think about serving the VCs first.
Even if you're a risk taker by nature – like ALL entrepreneurs are – you should never forget your long-term happiness.
Don't follow those fake unicorn stories:
Their life is way more stressful than you want yours to be.
You already have enough of a stress building up a big, successful company.
Declining tough liquidation preferences in exchange for a slightly lower valuation will make you happier in the long-term.
8 Vesting: Earning Your Shares
Many times the VC will also ask for a vesting clause.
Vesting means that you as an entrepreneur or management will only get or keep all of your shares if you stay X years with the company.
Most often the vesting is linear.
You may get 1 of 48 parts of your shares every month for the next four years.
I can't go into too much detail about all the aspects of vesting here, but here's a short list of what you may encounter in vesting clauses:
- The vesting period, usually is 3 to 4 years: Try to lower the years.
- Cliff-vesting: A clause whereby all shares are vested if an exit occurs before the four years are over: You should ask for it!
- Good and bad-leaver clauses are defining what happens if you get fired (good leaver) or if you terminate your service agreement yourself (bad leaver). Make sure you get all your shares vested in a good leaver scenario.
- Probation periods whereby you lose everything if you leave the company within the first 6 or 12 months: For founders, that's usually easy to accept. And I recommend considering this for any new employee getting shares or option plans.
Vesting clauses are also hard to argue against.
Here is why:
As outlined above, smart VCs invest in smart people.
So they have to make sure, those smart people stay.
And, when looking for a VC deal, you, the entrepreneur, are an essential success factor.
But you need to carefully think about it:
Is building this company really what you want to do day and night for the coming 4 years?
Accept the vesting period.
But here‘s a clever way to react to such a term:
Never just say "yes", no matter how easy it is to accept.
Try to be smart:
Fight against it. But then concede that term, by trading it against others that you believe are much worse.
Fight hard against vesting periods, even if you don't see much issues there.
But then, slowly concede vesting terms if the VC is willing to give up a part or all of his liquidation preference terms.
One tip that I can give you looking at my own experience:
Install vesting conditions for your co-founders or key people as well. It's highly frustrating to see a co-founder leaving you with the hard work while waiting for his share returns.
6 Milestones & Earn-Out Clauses: Nice Idea But Useless in Practice
Sometimes investors come up with the idea of setting up milestones or earn-out clauses allowing them to get more or fewer shares according to certain results in the future.
It sounds fair when a VC says:
"You told me the company would become a huge success. So if you really get successful, you'll get rewarded with better terms. If not, you underdelivered and I get better terms ex-post."
But it's not so easy:
Milestones are a nice idea in theory but useless in practice.
Here is why:
It's easy to say "let's define milestones," but it's much harder to find the right ones.
Think about it:
Which milestones make sense for a startup?
Intuitively sales growth or user acquisition are the primary value drivers.
But if the VC defines milestones according to these KPIs, you, the entrepreneur may have a strong incentive to achieve them at all costs:
- You may then "buy" growth with unsustainable products.
- You may spend a fortune on marketing without caring about the losses or unit economics as long as you hit your growth objectives.
So what about combining growth milestones with cost, EBITDA or net income objectives?
Well, good luck with finding a long-term sustainable agreement there!
And here's another, dangerous dilemma of milestone agreements:
All companies may need to reinvent themselves from time to time.
So whenever it makes sense to focus more on R&D than in growing your business, any financial milestone may fail miserably!
Milestones are hard to define and may limit the entrepreneurial freedom needed to achieve a long-term sustainable success.
Try to explain that to your VC.
Avoid milestones as much as you can.
I you made it until here: Congrats, we are almost done!
But there is now a final question to answer: Should you raise VC money?
Let's now explore this final question with all the knowledge given now.
14. Should You Raise VC Money?
Here's a way to look at it:
First of all, as explained before your company needs to show some sort of success.
Success can mean:
- Fast growing revenues,
- fast growing user acquisition,
- achieving an important milestone that may increase significantly your chances of success,
- other venture firms that are bidding for an investment in your company
no matter what the heck you are doing.
If you're not successful already: Get back to growing your company first!
Some business models or teams have a hard time arguing, that their company may once deliver a MEGA-Exit worth $100m, $1bn or more.
That's because they may be in the wrong industry or following the wrong business model to justify such expectations.
Industries that are generally considered unlikely to produce blockbuster startups are:
- Services & consulting
- Retailers (currently facing very tough times)
- Hardware companies
- Generally: hard to scale businesses
That does not mean, these businesses are bad!
Not at all!
I bet that founders, CEO's and other leaders of such "un-fundable" businesses can get both: rich and happy as much as their venture-backed peers.
But the bottom-line is:
If your business model does not allow and long-term sustainable double- or triple-digit growth per year, it's unlikely that venture capital is for you.
You may then either change your business model or skip venture financing when growing your company.
No matter what, one question always prevails:
Will Venture Capital make you happy?
Don't rush into an answer!
Think about the implications of raising venture money:
- You are expected to build a company worth hundreds if not billions of dollars.
- That means: You need to work day & night for 6 to 10 years.
Forget the myths of over-night successes: These are just myths!
And that means: Your company must come first.
Think about it carefully!
If your family or your health require you to take some time off, it's only possible if the company doesn't need you. And that's almost never the case.
In my experience the only time when you really have enough time for your family are the days of Thanks Giving, Christmas and New Year:
When your team, your customers, and your investors are busy with their own families themselves.
And even then you may have to deal with company related matters from time to time.
Think about it carefully!
Will it make you happy to put your company in the first place for the next 10 years?
Your answer must be a clear "Yes".
You are not allowed to doubt here.
Otherwise venture capital is probably not for you.
I mentioned that already several times, but you need an experienced lawyer on your side.
Great lawyers have both:
- knowledge of how private equity deals work legally and
- strategic qualities such as negotiation and sales skills to help you secure your long-term interests.
Without such a lawyer I guarantee you an unhappy ending of your venture deals.
Find and engage such a lawyer or forget dealing with the much more experienced VCs.
And there's one more thing required to raise venture capital:
You need to be a fantastic salesman.
It's not only about telling an amazing story, but also about the persistence to continue even if you hear dozens or even hundreds of "No's".
Your attitude must be:
Every "no" brings me one step closer to the life-changing "yes".
If that all applies to you, I guess you should really try to raise venture capital for your company!
And to repeat that as well:
- Always do the math and understand every word you sign!
- Always try to create competition among VCs.
What if you answer one or more of the above questions with "no"?
What if Venture Capital is not for you?
It's not the end of the world.
You can become a successful and respected entrepreneur without venture capital.
There are many other financing options.
- Revenue and sales growth: I love that financing type more than any other!
- Friends & family,
- Bank loans (for more traditional and tangible businesses),
- Crowd Funding,
- ICOs (Initial Coin Offerings),
- Grants from your government,
- Mezzanine Capital,
Here's another tip:
No matter what, there is always one thing that is interesting about trying to raise venture capital:
VCs can provide valuable feedback on your company's success drivers.
Today, many general partners send their associates, principals, and what-have-you-managers, to call entrepreneurs "for a chat" or "for an update."
That's really great for them:
A free market update from entrepreneurs that most often are the best experts in their industries.
For entrepreneurs, that is often a waste of time and "beginners" may have the false hope to get an investment someday because of such talks.
But what about turning the whole thing around?
What if you, the entrepreneur gets in touch with VCs not primarily to get an investment, but to get free feedback on what makes your company successful?
Creating a compelling company story is not just useful for VCs, but for you as an entrepreneur as well.
Because you, the founder or entrepreneur, are always the most important investor in your company:
You invest more than money. You invest your life!
So, whenever you verified that a VC is not a shareholder of a competitor (skip those!):
- Create the very best story for your company,
- pitch VCs,
- and learn how to improve your company!
Raising VC money belongs to the deepest, most disciplined exercises to understand the big picture behind what you are trying to achieve.
Take advantage of that free consulting as much as they take yours.
Thank you for reading or listing to this blog post!
All the best, Andrea
I am curious:
What is your experience with venture capital?
What are the learnings you'd like to share with other entrepreneurs?
Please let me know by commenting below.
building $100m+ companies!