Venture Deals - Spring 2023 Course - 2. Preparing to Fundraise

This post features my notes from Lesson Two of the Venture Deals Spring 2023 course. This is part of a post series. Go to Part 1.

Preparing to Fundraise, How a VC Works, Valuation, and Cap Tables - 7 takeaway points

Think seriously before raising venture capital.

7/10 venture-backed companies fail. The odds are not in your favour! Discuss with your cofounders to decide if venture capital is the correct financing for your company. Raising venture capital can distract you from building a profitable company and introduces new external pressures on your team.

If you decide to fundraise, understand what venture capitalists will consider about your company. VC funds typically want to return 3-5x on the money they borrow from their investors. If 7/10 of their investments never return capital, then the math is such that a minority of companies within the fund need to produce exceedingly large multiples. Ask yourself:

• Could we generate a 10x+ return for investors?
• What's our exit strategy?
• How long will we be in this company?

VCs must see tremendous growth potential, an exit strategy, and a realistic liquidity timeline.

Think like an investor

When an investor reviews your company, they are looking at several things:

• What are the risks and opportunities associated with your company?
• Investors "invest in lines, not dots."
• Does this investment opportunity suit me/my fund right now? Experienced fundraisers will speak with venture capitalists about their fund's lifecycle. It's okay to be direct about this. For example, a typical VC fund lifecycle is ten years. There will be a specific investment period, usually five years and then a support period in which they help the portfolio companies to flourish. I've left out some of the nuances here for brevity. The key takeaway point is to ask the fund about its lifecycle.
• Will this team be good stewards of the capital we provide?

Understand how a VC firm makes money

Typically a VC firm makes money in two main ways:

1. Management fee - The annual fee charged by the VC. Usually, it's around 2% of the capital committed within the fund.
2. Carried interest (carry) - The percentage of profits the VC keeps, usually 20%.

Carry is the main thing a VC is interested in.

10-20% of investments will generate 80-90% of the fund's returns.

Understand the typical VC fund lifecycle

Some key definitions:

• Fund life - The duration of the fund. Typically ten years with a two-year extension (at the discretion of the VC).
• Investment period - when the funds get deployed. Typically 2-5 years.
• Therefore, if a fund is in year five or later, it might not have funds to invest in new companies.
• Vintage year - The year the fund first deployed capital.
• Dry powder - The remaining money in a fund.

Experienced entrepreneurs will ask a VC about the vintage year and how much dry powder remains. This information helps the entrepreneur to understand if this fund could commit additional capital when the company needs to raise next.

On the topic of valuation...

Many early-stage companies delay the valuation conversation by issuing convertible notes, often with a cap. You can learn more about this over at YCombinator's Documents page.

Before going out to market, look at similar companies for indications of their valuations. Your valuation will likely be a product of how much you want to raise, how much dilution you will tolerate, and how much your investor needs to own.

Brad Feld says that a Series A investor typically looks for 15-20% of the company. He recommends having valuation conversations early on with your handful of suitable investors. Explain to them that you want to raise X for Y% of the business and ask if that fits with them. Brad also recommends asking whether a valuation you're receiving is pre or post-money. Not asking the investor and misunderstanding this concept can trip up founders.

Don't lie to VCs about offers you've received because it's an interconnected industry, and information flows between different venture capital firms when they want to test your claims.

If you are lucky to obtain multiple term sheets, sit down with your other founders and consider the pros and cons of each investor. Measure their values and decide what fits best with your company.

Know thy cap table

A cap table lists which entities own what of the company. You could make it in Excel or use software tools provided by companies like SeedLegals.

Investors want to see your cap table to ascertain how much of the company you own and whether you have an employee options pool to incentivise and attract staff.

Founders commonly make mistakes about whether a valuation is pre or post-money. Consider the following example:

• $10m valuation
• $5m investment
• If this is a post-money valuation, the $5m bought the investor 50% of the company.
• If this is a pre-money valuation, the $10 + $5m = $15m and the $5m bought the investor 33% of the company.
• Always ask if a valuation is pre or post-money!

Modelling your future cap table can also help to avoid simple misunderstandings.

Keep your cap table clean

When you're fundraising, investors will want to see your cap table because it gives them an idea of your company ownership. The investors will look for many key things; having a clean cap table is ideal.

A clean cap table refers to the following:

• The number of investors. Sometimes, a startup could have many angel or crowdfunding investors. Lots of investors can create a headache and a time overhead.
• No bad debts.
• No toxic convertible notes, defined as one in which an early-stage investor ends up with a disproportionately large amount of your company.
• No investors holding shares with much better rights than others (e.g. liquidation preferences)
• Preferably no ex-founders that left and still own a sizeable amount of the company

Up Next

Part 3 - Term Sheets and Negotiations.