Six Questions To Ask Before Raising Capital
Taking investment introduces a new set of decisions, trade-offs and expectations for the future of a company. I’m going to talk about the six answers that I think every entrepreneur should seek before making the call to raise capital.
Before we dive in, I want you to know that not every company should (or can) raise capital. Just because your venture is a startup does not make raising money a priority. An entrepreneur’s priority is to create super fans of their product. And those fans should be convinced to pay something for the value they enjoy.
That might counter the popular startup narrative, but as entrepreneurs, we’re here to build successful companies. Not win a capital raising competition.
In 2019 I spoke to several friends and mentees about their capital raising strategies. The conversations usually covered how much capital is needed, target investor profile and timeline to close the round.
When entrepreneurs focus on these topics, it’s usually because the decision to raise capital is a foregone conclusion in their mind. As part of that decision, they have also made the psychological switch to be in continuous pitch mode.
While that’s OK and these topics are a good start, this mindset tends to reduce their focus on the implications of taking investment. The issues that could come back to bite the company in the future.
The Six Questions
In 2019 I found there were six questions that entrepreneurs (and some investors) didn’t seem to ask. So I asked them. Once they understood the implication of each question, as best as I could explain it, their approach to financing changed. And in most cases, it streamlined their fundraising strategy.
As an aside, if you are thinking about raising your first round of capital, take a read of 11 Things You Don’t Know About Fundraising The First Time Around.
The six questions I ask fall into two camps. The first is the ‘investor capital’ camp. The second is the ‘alternative funding’ camp.
Can you value the business?
This question is crucial because it guides the type of investor you should target and the financial instrument that enables investment capital to enter the company. Experienced early-stage investors use their experience, market signals and the stages method to value an early-stage company. The stages method considers product maturity, traction and the makeup of the team in the context of the size of the market opportunity. The more mature the product, traction and team, the higher the valuation.
Entrepreneurs should form their point of view about the valuation range as they engage in early conversations with potential investors. An external perspective from mentors and other early-stage CEOs can also help level out the sometimes wildly different valuations that investors can offer.
At this point, I will also note that I favour ‘priced rounds’ overusing instruments like convertible or SAFE (simple agreement for future equity) notes. A ‘priced round’ is a financing event where the valuation and the investment are known. At the conclusion, all parties have a precise understanding of their ownership and obligations.
A convertible or SAFE note have roles to play if the valuation cannot be determined. I’m of the view that the valuation of 95% of early-stage ventures can be determined. I also think it’s the entrepreneur’s ego that often stands in the way of locking down a valuation. Understandably, entrepreneurs want the first valuation of their company to be as high as possible. In the short-term that affords higher retained ownership. Unfortunately, by holding firm on a high valuation (in a priced round context), they trade-off time. In other words, investors might think a valuation is unreasonably high and won’t engage. Meanwhile, the entrepreneur will keep shopping the high valuation to other investors in the hope one will engage and lead the investment round.
The irony about convertible or SAFE notes is that entrepreneurs and less experienced early-stage investors don’t often understand how the mechanics of the instrument work. When an investor enters into a convertible note, the entrepreneur and her company acknowledge that the:
- Capital coming into the company is a loan
- Loan will convert to equity at a point in time called the Conversion Event, either the next investment round or on a specified date
- Conversion to equity will attract a discount on the valuation of the future investment round
If it’s not already obvious, there are three inherent risks with convertible notes. And I’ve lived through all three.
First, a loan is a liability on the balance sheet. That means if the conditions of a Conversion Event are not met, the lender can call on the company to pay back the loan with interest. As most startups are cash poor, that can be a terminal situation. Entrepreneurs can negotiate their way through this situation, but it often ends in investors receiving additional benefits or a souring of the relationship, or both.
Second, the risk an investor took entering into a convertible note isn’t always commensurate with the equity they receive. The math on this is simple: An friend or family member invests $20,000 via a convertible note. The Conversion Event is a priced round where the (pre-money) valuation is $1,000,000, and $500,000 is the investment. As part of the deal, convertible noteholders receive a 20% discount on the round. This means that the calculation for their equity is based on a valuation of $800,000 instead of $1,000,000.
There are very few people willing to take the risk on the venture in the early days, and $20,000 is a lot of money to the friend or family member. When the Conversion Event takes place, they receive less than 2% ownership of the company. That might be OK if this expectation has been set by sharing calculated scenarios before investment. But this doesn’t often happen. I think scenario-based explanations should be a standard step in engaging with friends and family who are likely to be less sophisticated early-stage investors.
Third, subsequent convertible notes might be in the companies future. This can get problematic very quickly. As the layers of convertible notes stack up, the earliest investors usually end up at a disadvantage. And this assumes that convertible notes carry the same conditions from one investment round to the next, which is often not the case. To convince new investors to come into an already opaque valuation environment, the scope of benefits can expand to include increased discounts at the Conversion Event to liquidity preferences and share class variations.
What will you do if traction stalls?
When I see a proposed product launch or growth initiative timeline, I double it. That’s because despite the best-laid plans, developing and maintaining momentum typically takes longer than expected. So if an entrepreneur raises just enough capital to survive for say 12 months, what happens when unexpected expenses or a game-changing opportunity appear?
Some entrepreneurs will drink too much of their own Kool-Aid and stand resolute behind their plan. Others will have survival plans A-H well documented.
Be the latter.
Use lived experience from mentors and other entrepreneur friends to detail scenarios that will help you develop a capital survival plan. Investors look for this behaviour in entrepreneurs. Because they are also trying to weigh up whether they will want to commit follow-on investment, most investors say they will. Until they don’t, and that can harm momentum.
Are you OK to change the relationship?
This question relates to taking money from friends and family. Despite what you might think, taking money from your family will change your relationship with them forever. Because you’re likely to lose their money, that’s the reality, especially when you look at the survival rate of most new companies.
Family and friends have your best interests at heart. They want you to succeed. But unlike early-stage venture capital investors who deploy capital from limited partners on a portfolio basis, friends and family are investing post-tax money.
I have accepted capital from my family in the past. The company failed, and difficult conversations were needed.
I’m not saying avoid friends and family as investors, but I do advocate a ‘no surprises’ policy. If family and friends offer to invest, dial up the candour on risks and tell them point-blank, that while you hope it won’t play out this way, expect never to see their money again.
The next three questions relate to the alternative funding camp.
Is your product pricing right?
A mentee recently discovered that she was significantly under-pricing her product. The software as a service (SAAS) product dedicated to serving business customers was priced like a consumer SAAS product. The signals she was receiving from potential customers were that the product seemed too cheap, given their typical investment in B2B technologies. A shift in pricing helps and by extension, signing deals that pre-pay a portion of the price is even more helpful.
There is a growing acceptance that products with a free or low-price tier will deliver limited benefit. My message in asking, ‘Is your pricing right?’, is to encourage entrepreneurs to reasonably price their product and fight to demonstrate its pain-killing impact to potential and existing customers.
Using pricing as a lever to develop momentum may delay the need for fundraising or tip the valuation dynamic in the entrepreneur’s favour.
Can partnerships fund growth?
I’m a big fan of partnerships to fuel growth. That is a focus on mine at Drop Bio, and I encourage entrepreneurs to do the same.
Here’s how I think about it.
There are companies in every industry who have an established customer base. They serve those customers with a defined set of products. If your product can plug into and add value to those existing customers, your acquisition cost decreases, and you start developing a white-labelling capability enables your product to get into the hands of more customers.
The alternative is that your company fights to
I wrote about this strategy in my post called ‘Intel Inside’ And A Growth Path For Startups.
By the way, I also use a particular mindset when approaching partnerships. I call it the 49:51 rule.
My mission, when engaging in a new partnership, is always to strive to deliver 51% of the value. In essence, this means going above and beyond to ensure the partnership runs well. This might mean doing unscalable things, like long-haul travel to meet and support customers.
The other aspect of the 49:51 rule relates to negotiating the pricing of a partnership. There is rarely a case when partnership pricing ends up being a ‘win:win’. If I forecast that a pricing deadlock is looming in a partnership negotiation, I will move quickly to ensure my partner philosophically takes 51%. This might not literally mean taking 51% of a revenue split. Instead, they might want to be the primary brand on a marketing campaign or be the one to maintain the ‘ownership’ of the customer. My point is that providing my company does not suffer financial or reputation damage; I will trade aspects of the partnership that the partner considers important with time so both companies can start generating value.
The bottom line is that if an entrepreneur hasn’t considered partnering or white labelling their product through an established brand(s), they are leaving significant value on the table.
What are the alternative survival plans?
This sixth question is the easiest to ask and the most difficult to answer. By asking it, it suggests that the entrepreneur may need to find alternative ways to keep the company and themselves alive. That might mean taking a job that is adjacent or completely separate from their companies mission.
The next thought that enters the entrepreneur’s mind is, ‘How will I explain that to investors? I need to be all in!’
There are two realities here. First, investors will want to see you all in at some point. Second, if you can’t afford to work in the business, either for free or where you and your team are receiving a small salary, then your company is not likely to be investment-ready.
Use mentors and other entrepreneur friends to suggest alternative survival plans, like the entrepreneurs taking part-time or freelance gigs to pay rent. And if it comes to that, I can guarantee you that the entrepreneur will be thinking more about this than anyone else. The job of the entrepreneur is to survive long enough in the market to achieve product/market fit.
If you haven’t heard the story of how Airbnb CEO Brian Cheskey and his team avoided bankruptcy, take a listen to this.
In other words, you’ve got to do what you’ve got to do.
One last thing…
I have raised investment across Asia and experienced the highs and lows of equity and debt financing. These six questions come from hard-won lessons and experience tells me that any entrepreneur considering raising capital should have reliable answers to each one.
I hope that’s been helpful. If I’ve missed something or you have any questions, send them here.