In many geographical areas the community of investors is small, and so it is very important to make sure you manage your fundraising process with this in mind.
Investors typically chat with each other about industry trends, deal flow, and possible (new) investment opportunities as well as portfolio companies. Further to this, Investors will often invest in packs and so it is a common practice for them to communicate on an ongoing basis.
As an entrepreneur, there may come a time when you are presented with a Term Sheet that you are not prepared to accept. This could be because you feel the terms offered are unfavorable or perhaps you’re inclined to shop around with another VC.
If it is the latter, be cautious with how you proceed. Closing takes time and the probability of both investors meeting and mentioning your deal is likely to happen. The message of you shopping around the Term Sheet may not be well received by other investors, and could result in burnt bridges with both.
Although a Term Sheet does carry a “no shop” clause, it is very hard to monitor this from a VC perspective. The above is just one situation where shopping around hurts the entrepreneur, more than it hurts a VC. Investing in an entrepreneur that did not stick to confidentiality is unlikely for a VC and most likely this breach of trust will have hindered the deal from getting done.
A term sheet is typically initiated by a lead investor because they understand the stage of the company. In most cases, a term sheet from reputable investors is aligned or “balanced” to the stage and risk of the company.
From an entrepreneurial perspective there are specific sections in a Term Sheet that warrant extra attention. Particularly, the Price Per Share, which outlines the pre-money valuation therefore, creating a base point for how an external party values your company today. This provides a very quick way to assign an expected valuation on the company.
Let me explain:
Let’s say your pre money valuation is at $5m and an Investor gives $3m of Round A investment. The post money valuation is now $8m. This new valuation is an “expectation” in the eyes of the investor and founders for how the company needs to perform. This calculation is critical, as it determines for a VC how the company will develop in terms of revenue and profits in the next 3 or so years. In turn, the VC will have a better understanding on what the value could be in a future financing and/or trade sale. With this one can quickly calculate the multiple.
Ultimately, it is important to pitch the right funding amount and valuation, as it is critical for a VC to understand the expected return, the post-money and the value of the company.
Firstly, it’s best to remember the “bigger picture” when approaching any investment source. This is key as many entrepreneurs fear dilution early on when taking a large amount of capital at a certain valuation. This causes them to “negotiate” taking less funding with the belief that they can “do more with less.”
This is problematic for the most part and typically raises red flags, unless a careful long-term financing strategy in which milestones and increases in valuation has been set in place.
You decide to raise a small seed round of $150K at a $1M pre-money valuation. Normally, $150K not leveraged with government incentives will prevent you from getting close to a Round A investment and/or strategic investor.
At this point, you will realize that you need to raise more as opposed to less. This will cause you to return to your seed round investors and explain to them that you need more dollars, with the hope to raise $500K from them again. Your investors’ confidence in you might be shaken as you have not moved on to Round A with the dollars they have provided you. As a result, they will probably give you the extra dollars but insist that they protect themselves. In many cases, a new class of shares will need to be issued in order to protect the investors. As well, the extra dollars can result in a flat or down round.
To conclude, here a couple of pointers to keep in mind when planning out your fundraising strategy:
- Find a syndicate that has the capacity of facilitating both the seed round and being involved in Round A.
- The fundraising process is lengthy and accordingly, it takes up a lot of time. Planning ahead to raise sufficient dollars will ensure that you avoid any shortcomings and potential setbacks.