Money Mirage

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The second part of our agenda is relationships and money. This can get simplified, but it requires a bit of art rather than science. Let’s start with the science.

Signal versus noise

VCs receive thousands of plans. You’d think that’s great news, but the bad news is most end up in the trash, and there’s one main reason: they’re non-targeted. Time is a real challenge too, and so is chemistry, and yes, if a VC firm isn’t generating great returns it won’t have money to invest (so check their track record). But the real challenge is all this noise coming at us. How do we find the signal? What really helps is knowing where the signal is coming from, so we can determine whether it’s a credible source, because otherwise it’s too hard to filter that fast.

Do your research

Most people do the basics: grab the website, find out about the partnership. In the valley people don’t even bother; they just say, “It’s Brand X, they’ve been around, they’ve made money, I’ve got to go there.” That’s fine, but consider a few more steps:

• What’s the fit? Do they invest in this geography? Do they know the sector? Have they done this before?
• Am I at the right stage for them, early or late?
• Do they have a portfolio complementary to mine? Do they know this space from other entrepreneurs?
• Never mind the partnership; who’s the individual partner with the right expertise, experience, or even interest in what I’m doing?
• What’s the track record?
• And, least thought about: have they actually done their capital planning, so they’ve got free reserves to invest in you as you build? One of the tragedies of 2008 is that even some very big brand firms in the valley didn’t have the capital to follow on when things got tough, and even though they had great investments, they were forcing those companies out to find capital at the worst possible time.

One of Rich’s great skills is tremendous capital planning. In our case we can invest across funds because we have similar investors, so even while investing out of a five-hundred-million-dollar fund, we’re still investing out of the previous five-hundred-million-dollar fund as necessary and still holding reserves. We’re always thinking about how to make sure our companies have the full reserve to take them from what we’d call a “twosie,” the first stage of their lifecycle, all the way through to standalone or acquired.

Build the relationship

The biggest thing: even if you’ve done all the research and targeted us perfectly, if we haven’t got a clue who you are, you’re part of the noise. I’m trying to change that, and a lot of VCs are, by being out in the community and making the process transparent, so I get to meet you and you can call me by first name. That’s the goal of things like the iLab. So triangulate ways to connect with VCs, whether by blogging on their site, meeting them at occasions like this, or getting to the same conferences.

There is no one process. Every VC has a different one. One of my public companies, Demandware, took eight days for us to decide to do, because we already knew e-commerce and knew the founder. That’s the good news. The bad news: the company I mentioned that started in our office took six months just to write the seed check, because we were trying to figure out whether they really had it there and whether we’d picked the right founding team.

Run your own process. It’s your process to run. You should be figuring out whether you’re checking off the right things in your own criteria: is this the right VC, the right fit, somebody you want to work with?

Some VCs have no thesis and just wait for great people. Others have a thesis they’ll write. I was lucky to see great things from my partners Jamie and Rich in the mobile space, so we sat down and made a thesis about enterprise mobility, and out of that came an investment in one of Maya’s companies, Apperian. It was very easy for us to engage quickly. But lots of VCs don’t do that, in which case you’ll have to teach them and help them qualify the opportunity.

The dating game: who, what, why

A big part of this happens around socializing, which people think of as optional. But if you’re going to date somebody and ultimately marry them for at least several years, you’ll take some time to get to know them. So don’t ask us to rush this through in seven days; do you really want to get married after seven days?

The first connection is critical, and it’s often where things go wrong. It’s basically the who, what, and why: can you very quickly tell us your story? (There’s a whole workshop on the perfect pitch on the site.) Don’t spew your entire business plan on the phone and try to get us to buy the whole thing in one mouthful; that very rarely works, and we’re seeing hundreds of these. But if Joe gets on the phone and says, “I’ve figured out how to build a stent that’s stronger than steel and more flexible than rubber, and I think I can do it in a way that’s bio-reabsorbable, and we’ve got the best team out of George Whitesides’s lab behind it,” I’m paying attention, and I don’t need any more than that. I’m going to want to go see Carmichael Roberts, trust me. You just want the hook, just enough. That’s the who, what, why.

Build momentum

Think about the process like any sales process, except it’s a very special relationship. Figure out your own way to build momentum, so at every step you and the VC feel like you want to take it to the next step. I see most VCs and entrepreneurs get stuck at the point where they’ve met and pitched each other but don’t know what’s next: that awkward third date where you’re on first base and it gets tricky. The most important thing is to constantly develop, in your mind, the progress points to share with the VC, and go validate them. I have an entrepreneur, I won’t name Matt, who’s done a magnificent job of constantly telling me, “Here’s what I’m going to do, and I’ll share how it turned out.” Sometimes a couple of weeks, sometimes a couple of months, but he keeps coming back and sharing his progress. We’re building the relationship, he’s building credibility, and every time, I get to know a little more about the business. There’s natural momentum, as opposed to coming in, pitching it all up front, and making promises you can’t fulfill.

The biggest challenge I see: entrepreneurs expect themselves to have all the answers. They’ll say, “I’m not sure I can pitch you because I don’t have a complete financial plan.” I didn’t even know what a financial plan was for the first six months of my first business. We don’t expect entrepreneurs to have complete business plans. Most entrepreneurs, when we see them, are incomplete in at least one of these six categories: team, product, value proposition, go-to-market, business model, and financial plan, if not all of them. So make sure that instead of worrying about that, you have at least one area where you really stand out, preferably a perfect ten in terms of your background and experience to solve the particular problem. When Carmichael’s team came out of the Whitesides lab, uniquely qualified to solve that problem, and the materials part of the team came from Bob Langer’s lab, that’s Bob Langer and George Whitesides on the same board doing something truly unique. That stands out. I don’t give a damn whether they’ve figured out their business model or how the product’s going to come together at that point. We pay real attention to real standouts, even if they’re incomplete, rather than a generic broad-brush set of things that covers all the bases but isn’t exciting.

Dating and validating: diligence

Diligence is typically thought of as something the VCs do, but it’s important to you. The VCs will be doing blind references. It doesn’t matter what references you give us; we’re going to find out who you haven’t told us about, your peers and people you’ve worked for. We’re trying to understand the business, even the parts that are incomplete, even if it’s just to say to ourselves, “We know we need to find somebody to help with the business model.” We check under the hood, and usually we’re not smart enough to know all the areas, so we’ll bring in experts from the field and other investments to work with you. That’s a great learning experience: don’t view it as “Oh my god, I’ve got to do the diligence.” View it as, “This is great, how else would I get access to this person?” As they validate assumptions, you’ll learn what you’ve missed. This should be a collaborative process, not “the VCs have got the microscope.” It’s an opportunity to figure out where the gaps are, what you could fill in, who you could reference, and indeed to see whether the VCs have the network that can actually help you get there.

Term sheets

When you get the term sheet varies a lot from firm to firm. I’ll simplify to two cases. Some firms will give you a term sheet really early, up front, which can be great if it’s a really solid term sheet. Other firms give you a term sheet after they’ve done the diligence, when the only thing left is the legal paperwork. Which would you rather have? The second, because it has more certainty. At the time you’re looking for capital, your investment needs are clear, so if they’ve done the diligence, the probability of you closing is much higher.

What if a firm gives you a term sheet early and you like them, but there’s another firm you also like a lot that hasn’t given you a term sheet yet because they typically do it later? Go back to the VC and say, “I’ve been shopping this around; this firm has presented me with this. What can you do to help us achieve this dream together?” And if you’d like to work with the second firm, carry on being transparent: “I like your terms, where are you on the diligence? Are my terms acceptable to you?”

Jeffrey Beer’s take: “I wouldn’t sign the first term sheet. If there are any loopholes, I’d hang on to it, keep working the second partner, and be transparent about that.” And startup secret: venture guys are competitive. They don’t like losing deals to other venture guys. To the extent you can turn the tables and make venture guys pursue you because they don’t want to be excluded, that’s a tactic that typically accelerates a deal closing.

Three things to remember. First, if you have a term sheet before somebody’s done the diligence, you’re really not sure they’ll get past diligence and actually do the deal; they’ve only just met you. Very few people will go from term sheet to close without doing diligence, and I’d be very suspicious of a firm that does. So an early term sheet is interesting, but a post-diligence term sheet is a much better place to be, because it means they’re actually going to close. Even then, later-stage firms may add expectations like an all-hands partner meeting as the final step, and I’ve seen deals blow up even there: a thirty-million-dollar financing blew up last year at the final partner meeting after everything was done, and that company gave up a bunch of term sheets they’d had earlier and endured six painful months. That’s why Jeffrey’s point is so relevant: keep them working until you’ve got a place where you can compare offers that are like-for-like. Multiple like-for-like term sheets is a great thing; until then, you really don’t have a deal.

On exclusivity: if they insist on some limited exclusivity, for an early-stage company it’s all about the relationship. Rich’s view, and mine: not only should you say no, but if they’re trying to force something on you, it’s not really the kind of relationship you want. You want a natural fit that feels mutual. You don’t want to get too pregnant in your deal anywhere in this process; you want to be clearly able to make your choice at the end, together.

Train your VC: how much do you need?

Rich epitomized a phrase: the process of doing the diligence became the deal. At every stage of working together we figured out what the deal would look like and how much capital we needed. If you have to find a VC who’s not trained that way, train them yourself. Here are the questions.

How much do you need? Run the numbers. We’re not looking for tenth-decimal-point accuracy; we’re looking for an understanding of what it will cost to get from your current stage to the next, with enough validation and proof to say you’ve built value and reduced risk. Build the assumptions, assess the dependencies, figure out what it takes to get from A to B, and know it for yourself long before you ask us for money.

We typically recommend at least eighteen months of runway. Why eighteen? Because it typically takes three months, even with an efficient process, to raise a round, so you really have fifteen months, and you don’t want to be right out of capital before you start, so you’d start raising a bit earlier. A year won’t give you enough time to get the proof you need. Every business is different: you might need only six months if it’s crystal clear what you have to prove, or far more if you have something like an FDA approval process. More important than the spreadsheet are the assumptions, and I always recommend at least a cash-flow projection.

In the end I look for realistic optimists. Most of you walk in with a plan that says you’ll go from zero to fifty million in three years by getting two or five percent of a billion-dollar market. Great idea, but precisely less than 0.0001 percent of companies do that; a few, like Compaq or more recently Salesforce, broke that. Come in with a plan that says it’ll take ten years to get from zero to fifty million, and VCs are greedy enough to find that unbelievably boring. You want a plan that’s more realistic but still has real upside. None of us know what’s going to happen; that’s why the plan matters less than the assumptions and how realistic you are about them. And the funny part: all of it is wrong. What usually happens is it takes way longer than any of us thought, but if it’s really successful, it’s also way bigger.

How much do you want, and what should you raise?

How much do you want is subtly different: think through all the milestones, allow for eighteen months, and allow for an acceptable fudge factor, because there are lots of things outside your control, number one being the market and how quickly it adopts your solution.

What should you raise is not just the first two questions. One strategy is very dilution-sensitive: if you’re risk tolerant and confident you’ll nail your milestones, raise just what you need and not a penny more. I know entrepreneurs who are just-in-time, raising just before they need it and nailing it. (When you do raise, raise it at a point in time where you can actually close it; I’ve seen investors make that mistake.) The other strategy: some entrepreneurs feel they need to raise more than they need. Money is cheap, they want the extra cushion and room to get things wrong or experiment, so they raise more than they need and well before they need it. There’s nothing wrong with either strategy; you just have to identify which is right for you, or something in between. This is subtle but fundamental, including getting comfortable with your investor being in the same place as you, because some investors love the top strategy and some love the bottom. There’s no right or wrong, but you must be in sync with your investor.

Either way, timing is everything, and you should assume the unexpected. The worst mistake VCs and entrepreneurs both make is overestimating the pace of adoption or growth and underestimating the amount of capital, so we find ourselves not raising money from strength, which is never where you want to be. Some businesses are very predictable (an e-commerce business driven by daily transactions lets you see future cash needs clearly). A business inventing something and going through government approvals is unpredictable and needs lots of leeway. And sometimes you’re in a market with winner-take-all dynamics, or the classic Geoffrey Moore example where the gorilla takes sixty percent, the chimp takes thirty, and the rest fight for the last ten. There, your balance sheet probably matters, because customers look at who has the credibility, and that may be more valuable than cash.

Valuation: the mirage

Last but not least is valuation, the sixty-four-million-dollar question where most entrepreneurs get stuck. In my opinion this is the least important question. I’ve modeled it hundreds of ways, and every time you go back and look at how much you haggled up front on valuation and compare it to the end outcome, the question is really the same: was the business successful or not? If it wasn’t, it doesn’t matter that you owned a hundred percent of Joe Blow. If it was successful and you managed to own one percent of Google, I’ll take that all day long over Joe Blow. So it’s really about setting your capital up to be part of your success and not a problem for you.

What I recommend: project out the valuation not for the round you’re taking, but where it takes you in the next round. Simple model: raise on a five-and-five Series A, so your pre-money was five and post-money ten million. Next time you want to raise another ten million with a nice step-up, doubling the business, so that’s a twenty-million pre-money plus ten, thirty million post for the next round. That’s the ramp. Using a simple revenue multiple of five, that implies about a six-million-dollar revenue run rate. Do you really think you’ll have a six-million run rate at the end of your Series A? Maybe, and if so, great. But if you’re actually on a three-million run rate and you try to raise at a double, everybody’s expectations are out of sync, and this goes on all the time. What’s much more important is to have the conversation early with your investors: never mind the A we’re raising now, what’s going to happen in the B, how are we thinking about the C? Just one round ahead; it’s too hard to think beyond that. Always put the vector out there and get in sync on the expectations, so when you raise the next round you’ve met all the milestones, including the financial one that adds up to the right valuation.

Startup secret: don’t just value things, evaluate them. Always be one round ahead in your thinking, put it in all your metrics, and account for the unknowns, including the time to fundraise. The goal is to make sure you have the capital to capitalize on your opportunity, and no more.

Entrepreneurs also play the valuation game the other way: “Salesforce went public at X billion, Genentech was worth several billion, I applied their multiples to mine, and we’re going to get there.” You can play that all day long, but neither of us knows, the market will have changed by then, the multiples and competition will look different; it’s meaningless. Do it for fun, put it in your bottom drawer, and forget about it.

One important tip: fundraising should be a continuous process. Between each round, to use the famous Glengarry Glen Ross quote, always be closing, always be developing the relationships with the venture investors who are coming next, so they’re ready when you are.

The most important capital: human capital

Just like the earlier slide, I left off one critical piece. Someone in the audience got it: the most important capital you raise is human capital. It’s building the team. So another factor in what and how much you raise, at least as important as anything, is your option pool, because it enables you to hire the people you want. If you want the best, you’ll have to pay for them, they’ll expect equity, and you’ll need that equity in your option pool, and you do not want to have to renegotiate it with your investors. Agree it up front. If you really value building a great team, get a big option pool and be ready to hire the best team you can.

To summarize: what really matters is investor fit, picking the right amount of capital raised (including the human capital), and then timing it, plus clearing the bar on things like terms. And to bring it back to basics: it can be fun when you finally raise it. It needn’t be complicated. Pick your own path, and find yourself in that embrace with your investor, hopefully not literally.