Startup Fundraising: How to Nail “the Ask”
There’s so much an entrepreneur must think about when going through the funding process. Arguably one of the most critical parts of the pitch process is “the ask,” which can make or break a deal. To alleviate the stress of founders related to “the ask” and reveal what investors look for in the end stages of the pitch process, we spoke with Javier Soto, an experienced Angel Investor and active member of The Alliance of Angels (AoA), the largest angel group in the PNW. Not only does Javier provide great advice for investors related to funding, but there is also much here that can be applied to life and business in general.
*Disclaimer from Javier: Nothing is black and white. The opinions expressed here work on the average, but startups are anything but average; if they were so, we wouldn’t have the startups that we have come to know and invest in, companies that break the norms and far exceed expectations. For every strong assertion I make, there are an abundance of counterexamples. In short, take everything with a grain of salt. There are no hard rules. It all depends on the context.
How should an entrepreneur/startup determine how much money to raise? How long of a runway should entrepreneurs plan for?
A startup is a company with great potential for high growth and scale, going after a big opportunity. Among other things, founders periodically need outside funds to achieve critical mass and a high escape velocity. These funds act as rocket boosters that enable companies to do more, better and faster. It is a race to success. In some circumstances, it is possible to finance through customers, and maybe that’s a better option for some companies, but this route may take more time.
On the path of accelerated growth, entrepreneurs raise funds today to help them get to the next round of funding and continue forward momentum …It’s never about this fundraise, it’s always about the next one.
One way for entrepreneurs to determine how much money to raise is by walking it backward.
Through early conversations with investors, entrepreneurs can identify key milestones they need to hit to ensure a successful raise in the next round of funding (next one, not this one) – Then walk it backward to determine what is needed to reach these milestones, at what cost. The sum will reveal how much you need to raise today to get there. It’s also important for founders to account for the unknowns and uncertainties that may influence their trajectory because, as the saying goes, no plan survives contact with the enemy.
Is there a minimum runway you look for when a company is raising funds? Would you be alarmed if a company had a very short runway?
The runway must be the appropriate length to get a company to the next round of financing and it must make sense given the milestones the company set to get there. These milestones must be meaningful and ambitious compared to where you stand today. They must also track the evolution of the company’s value. For example, if in the next round you plan to double in valuation, you have to be able to justify this change based on what is accomplished during the period leading up to the next raise. It is uncommon to achieve that level of added value in a quarter or two.
A runway that is too short (e.g. “we will raise a series A in five months because our revenues will grow from zero to $1M by then”) may reveal the founder has unrealistic assumptions and expectations, or a lack of experience and self-awareness. Sometimes small runways go hand in hand with small raises, which is a concern to investors because it signals the company in constant need of outside capital and is spending more time fundraising than serving customers. Entrepreneurs are building a complex machine and fundraising is just a part of the machine, not the engine.
At the Alliance of Angels, we typically see funding rounds that provide companies 12 to 24 months of runway, but this can vary depending on each company’s unique situation.
How should entrepreneurs determine what form of fundraising to use – equity, convertible note, SAFE (simple agreement for future equity), etc.?
SAFEs are good for friends and family rounds. Usually, in this round, there’s not much more than a partial team and an idea. There is not enough data to support assumptions, so the proof points gravitate towards the team’s reputation and the quality of the idea itself. Friends and family have a better gauge of the founder’s potential and are better suited to assume that initial risk. Additionally, investors with whom the idea resonates with the most (because of their career or investing experience in the space) can also be a good match for SAFEs in this F&F round.
Another circumstance where a SAFE may be appropriate is when there is high demand to enter the round and the company is clearly going to oversubscribe. This often happens when we see a serial founder who has successfully built and exited startups before. In cases like this, SAFEs act as a prepaid entry ticket to a future round. But beware you may lose some high-quality investors if you go this route.
In my opinion, SAFEs are not the best instrument in all other instances. Specifically, in the PNW angel ecosystem, the use of SAFEs may signify founders have not done their homework on this investor group and it may deter investment from them. This is a pity because, at this early stage, founders should focus more on attracting the best partners than on the financial instrument.
As Angel Investors, we see a lot of deals with convertible notes. The key for founders is to understand where they work best.
For example, if a founder is raising money with a convertible note and in the cap table they have multiple previous rounds of convertible notes pending (I have seen cases going on for years), it creates speculation about the company being in trouble, founders not fulfilling their promise (i.e. a note is meant to convert), and lazy over-reliance. Convertible notes as a bridge make sense, but as a perpetual financing machine, they send the wrong signal.
Notes are better than SAFEs if only because they carry an obligation to investors whereas, SAFEs act as a promise. Convertible notes have a maturity, which means founders must return the debt (with interest) by a certain date or extend the maturity if they have not converted. This forces investors and founders to come to the table and decide what to do next. In most cases, investors will extend the maturity as it is usually in their best interest to do so, but at least they have the opportunity to sit down and re-align with founders (reality and expectations). A SAFE does not provide this security to investors.
Investors should always strive for a price round. In a price round, you have the best alignment between the expectations of the founders and investors. It says, at this moment in time, with the information we all have, we agree this is who we are and how much we’re worth. With a convertible note or SAFE, we agree on an expectation of the future value, and that deferment can create a misalignment between the sides if things go much better or much worse than anticipated.
In a tongue in cheek way, a SAFE is falling in love and promising the moon. A Note is getting engaged. A price round is getting married.
To ensure alignment it’s best to go for a priced round. However, if a company is raising a few hundred thousand dollars, or it needs extra funds in the short term to take advantage of a new opportunity, it may not make sense to do a price round. For this type of fundraising, as a bridge, a convertible note may be better suited.
What should entrepreneurs include in their pitch deck regarding the ask/offering?
In terms of the offering and terms of the deal, I would encourage entrepreneurs to summarize key information in a single slide. As an investor I want to know about the:
- Past (i.e. how much previous raised, when)
- Present opportunity (i.e. how much raising today, instrument, and key terms like valuation/cap)
- Future (milestones for the next round with timeframe)
Additionally, it may be advantageous for founders to include anything that has been made in soft commitments to date.
This is a very formulaic approach, but it’s all you really need.
Should an entrepreneur set the initial terms or wait until a lead investor emerges to set the terms?
As a founder, you are leading the negotiation and should have an idea of what you are looking for (i.e. how much and in what terms). You cannot meet investors and ask them to set the terms, you come to negotiate, not to find out. Find out what terms to set while you are preparing to fundraise.
In the case the founder has no clear idea of what terms will work best, they can still provide a range in terms of valuation and indicate they are looking for a lead with whom to negotiate. Yet, without clear terms, any commitment from investors will be very soft.
Nevertheless, you should guide where you’re going to land because again, it’s about signals. The terms signal how you see the world and your place in it, which in turn will help investors evaluate if they are aligned with your vision or if there is a fundamental disconnect. As a founder, you strive for alignment, you should always be transparent about your expectations and goals, and investors should reciprocate. Alignment, communication, and trust are key to a healthy and successful partnership.
Though not always possible, it’s much better if you can find a good lead at the beginning because there is a correlation between having a strong lead and being able to fundraise successfully. The presence of a strong and reputable lead influences the investor’s perception of risk. A lead with a track record of professional and thoughtful due diligence, of getting involved and being helpful to founders, and with experience in the domain space and skin in the game in terms of reputation, will create a wake that helps to fill the round.
Should the entrepreneur set a minimum first closing amount?
It depends on the circumstances (i.e. market, company, and amount). Sometimes founders may use first closings as a tactic for a successful fundraise.
For example, a company wants to raise $1M but they pitch that they are raising only $500,000, and once they have that amount, they announce they’re going to oversubscribe and raise the other half due to investor interest.
Entrepreneurs may believe this is a way to create “momentum” and “FOMO.” However, it’s likely the first investors will see the company’s fundraising goals and milestones don’t match, and they may not agree with the extensions because what they signed on for is different than reality. Most importantly, a scenario like this may signal the founder is willing to say and do different things. That’s a bad signal. Investors don’t want to waste timing deciphering intent, they want to deal with straight shooters. As a founder, you are looking for long-term partners and trust is paramount.
No matter what, it’s always best to communicate.
Imagine a founder using a convertible note to raise $1M and they set (and pitch) a first close for $500,000 to get the ball rolling (maybe we all know that the market for investor funds is slow this season and you need to hire key people to join your team). The founder should explain what they are going to do with the first close and their plans to raise the rest in the next couple of months. Transparency and clarity are very important, and you want investors to make decisions with the full picture and no surprises. Always explain the reasons behind your actions.
How should entrepreneurs describe their planned use of the funds being raised?
In every founding team, there has to be someone with the experience of or potential to be a strong “operator.” Someone who not only understands the key drivers and priorities of the model but who can lay out a clear path of execution and has an innate ability to get things done. Not micro-managers, but real CEOs/COOs with the key data at their fingerprints.
When describing a company’s planned use of funds, there is a difference between saying “we will allocate 30% of funds to salaries, 30% to marketing, and 40% to product development,” which is good but insufficient, and saying “I need to hire a strong CTO for our ML/AI roadmap. I have already interviewed and selected the right candidate and will cost me X.” Or, “We are allocating $X to run SEO experiments to validate that we can lower our CAC to XYZ in the next three months, after which we will budget ABC for DEF.”
You don’t have to detail the whole plan as you would in your financials. We all know the best-laid plans change and may look very different long term. Founders are expected to be flexible and pivot when necessary. Instead, we are looking for your ability to communicate and execute the two or three key uses of funds that will have the greatest impact.
Provide a strong signal that you know where you are and what’s going to happen in the next few months. Demonstrate to investors that you are running and not walking; that you’re not waiting for the money to come before you consider how to put it best to use.
When should a deal Term Sheet be provided to investors?
The term sheet should be provided or negotiated during due diligence. The general terms of the ask and offer are provided from the start, at the pitch.
For me, there are three stages to the fundraising process from the point of view of investors:
- The Pitch – Is about curiosity. This is where investors decide if they’re curious and excited enough to learn more. The pitch is the bait to entice people to the table for a one-hour interview.
- Founder Meetings – This is where investors engage with founders and start establishing trust. Face to face. One on one. Here they see if the expectations of the pitch match the reality underneath. If the signals are coherent and consistent. This is where we get excited to invest and decide the effort to do serious due diligence is justified.
- Due Diligence – At this point, investors are mainly set to invest but need to dot the I’s and cross the T’s. We will look at every possible angle to find clarifications, omissions, irreconcilable differences, and anything that may deter investment. The investor is spending time and energy that could be allocated to other opportunities and is looking to rationalize and substantiate the investment thesis. Only new information will deter them at this point. This last phase is where the term sheet should be provided.
What’s the difference between a “soft circle” commitment and a “hard commitment”?
A yes is a yes, and everything else is a no. Some investors may string you along. Don’t let them waste your time if they are deferring or being non-committal. Communicate clearly and expect the same in return. Always do due diligence on your investors, ask other founders and investors you trust.
Personally, once I say I’m going to commit (a.k.a. soft circle), only new and negative information will make me break my commitment. For example, an undisclosed fact that materially impacts the viability of the company, with the emphasis on “undisclosed” and “material.”
As an investor, if you say you’re going to do it, you do it. And if you renege on your commitment, then you have to understand your reputation as an investor is going to suffer.
Engaging in Due Diligence is showing an expression of interest, not a commitment. Once you have finished Due Diligence and you say to the founder, “yes I’m in it, I’m going to do it for X amount” – that is a soft circle or soft commitment. That soft commitment is predicated on the ability of the founder to close the round (or first close if appropriately disclosed) and provide a finalized term sheet, and no surprises come up. Later on, the deal will be materialized with paperwork and wiring of money, which will make the soft commitment hard.
I have not seen a lot of people who have bailed out of their soft commitments. I have heard this happened during the initial shock of COVID, but that was exogenous new market information.
What if the round is oversubscribed? Should the entrepreneur take more funding than their target amount?
It depends on the context (e.g. how much, from who, etc.). It is not always bad to be a little cautious and to get a bit more fuel. At the same time, too much will send the wrong signal for many reasons: you are doing something different than what you pitched to your investors, it may create bad incentives (i.e. too much money too early, one could say too easy), or it may set unrealistic expectations down the road (i.e. it is not about this raise, but the next one).
In a situation where the founder is in a position to raise more money, the key is to explain the options and the reason why more funding is the right decision.
Nevertheless, I would strongly urge entrepreneurs to stick to the plan. Consider how much money is needed to get to where you need to be? And then, if need be, instead of raising more, select among the pool of investors. They choose you and you choose them. Who are the best investors for the company? Who can add the most value (now and in the next round)? Be fair, not evil (i.e. if you said yes to an early investor who helped you when no one gave you the time of day, don’t kick them out now because you don’t need them anymore, be classy, be honorable, reputation is everything).
On the other hand, what should an entrepreneur do if they are having trouble closing the round?
It depends. If investors are having trouble closing the round because of an external factor like COVID, investors understand the roadmap will need to be modified, and some may even provide good ideas as to how to do it. In cases like this, it may make sense for founders to raise less in a shorter timeframe. Instead of pursuing the milestones laid out in a year or more from now, change the goalposts to hit relevant milestones nine months down the road that will still allow you to obtain a material amount of funding. Once again, communicate. Be truthful and honest. Investors don’t expect perfection, but potential, trust, and self-awareness.
If you’re having trouble closing the round because reality and expectations are misaligned, you should consider either you are an unappreciated genius or there is something you’re missing. Irrespective of which, when an entrepreneur can’t close a round, it sends a signal of weakness to investors.
I’m a big believer in Colin Powell’s doctrine of fundraising: you only go to war when you are sure you’re going to win it. If you have doubts about being able to fundraise successfully, you should wait. If as a founder you say that you cannot wait, that there is nothing else left to do on your part, not even customer discovery to the point of getting a material amount of interest without funding (e.g. LOI, pilots), then something is not right.
Beware that a founder coming to the well for funding every few months sends the wrong signal and creates “investor burn.” Be strategic and thoughtful about your fundraising path. Talking to founders and trusted advisors, observe what’s happening in the market, learn from the experiences of others, understand incentives and preferences, come to understand the supply and demand of funds for comparable companies, plot a path that starts with a strong lead or low hanging fruit, and only after you’ve done all these things, execute, fast and furious. The way you fundraise reveals how you operate.
What other advice do you have for entrepreneurs in preparing their pitch or on closing their investment round?
First, don’t look at me, look at them. Focus on customers, not investors. If founders are pitching and it’s clear they are focusing on what the investor wants to hear vs. what the customer wants, it signals all the wrong things. I do not care much about what I think, I care (up to a point) about what you think as a founder, but I care a lot about what your customers think. The more empathy, obsession, and passion you have for your customer, the more compelled I will be to invest.
Second, the pitch is a photograph of a moving train. Focus on your customers and make your company a train that is moving. In the early stages, forward momentum doesn’t always have to be about monetizing. There’s a difference between saying “this thing works, I am moving, do you want to be left behind?” vs. “without you (and your money) this train won’t move.” The first scenario creates the right kind of FOMO and indicates funding will help a company do more of what works, faster and better.
Third, focus on what works, and prove it. At this early stage, investors want to see that the idea works (or can work) through data (a.k.a. validation) that support an investment thesis:
- Data or leading indicators that prove your product delivers on its promises.
- Data that confirms you know who your customer is – where to find them, how to convert them, how to monetize and retain them, etc.
- Data that shows, even in low numbers, that some customers engage with your solution in a way that is transactional, meaningful, material, coherent, and consistent over time (i.e. linear growth).
The more supporting evidence, the easier the sale.
Finally, as an Angel, I see founders relying too much on the advice of mentors or investors. We can provide useful input and ideas, but we are not in the trenches talking with the customer; we don’t have the best information, you do (at least you should). Angels are like hammers to whom everything looks like a nail. We are biased by our own experience. As a founder, you should always consider the advice of others, but you bear the responsibility of making the right decisions. Be proactive and hungry for good advice and use the feedback to lead you towards the truth, always consider, never blindly follow.
The Alliance of Angels (AoA) is the largest angel group in the PNW with 145 members who invest over $10M a year in 25+ startups across industries. AoA members provide invaluable business support and connections to help our portfolio companies succeed. To learn more about the Alliance of Angels go to https://www.allianceofangels.com.