If you’re having trouble raising money, give good terms to your early investors.
The number one complaint I hear from entrepreneurs is that raising money at an early stage is the single biggest challenge. This complaint could not be more valid or true.
You are not alone and you can over come this obstacle. There is a plethora of early stage capital; you just need to learn how to attract it.
A Frequent Scenario
You’re an entrepreneur and you’ve put $25k of your life savings into your company. Your family, friends and rich uncle have donated another $50k for you to create a working prototype and beta website. You have grand plans of disrupting a huge market with a product that scales but all you need is $500k to hit the milestones that institutional investors will pay attention to.
Thousands of entrepreneurs are in this exact situation. Tens of thousands of investors are being approached by companies at this stage and few investments are taking place. With general solicitation now in effect, there will be many more early staged investment conversations, without an increase in investment, but an increase in time spent and energy lost.
Why Raising is Difficult
Early stage investors can sit on their hands without needing to pull the trigger. They are seeing companies further developed, with more traction at the same valuations. Startups with a publically launched website, user traction and modest revenues are raising capital at pre-money valuations of $2-7M.
The convertible note you’re offering at similar terms is not compelling when there are lots of opportunities from companies that have de-risked their technology and have a promising growth path.
Realistically, your company is not worth the median $2.5M pre-money valuation as reported in the Halo Report until you have a completed product, users and sales.
Example of Poor Fundraising
A founder sent an email to a broad network of friends and family. The founder won a business plan competition at a top 3 Business School. The website is complete but has limited content and 50 signups; they’re joining a brand name incubator for 6 months.
Offer – Convertible Note, 10% discount with $6M valuation cap
As an investor, I immediately think the company has unrealistic expectations about their fundraising in the present and future. A simple search on Tech Crunch, Crunchbase and Angel List will yield plenty of ‘comparables’. A company in the same exact space with 1M+ users, high engagement and beginning to monetize is raising money at a bigger discount and same valuation cap. The founder is signaling to prospective investors that they don’t have a pulse on their sector or competitors.
Offer favorable terms for the first $250-500K of investment. A lot of challenges, time and luck stand between your company and a successful exit. The dilution you take early on will not cause a material difference when you exit; you’ll be rewarded either way. Seed capital is the most important funds you’ll ever raise, as it’ll enable you to focus on building a company. If you don’t do this, you’ll spend 12 months struggling to raise capital at less favorable terms while your competitors leap ahead of you. You have a window of opportunity before someone else comes up with the same idea and executes better.
How to do it
Call the investors that expressed interest or soft-circled an amount and offer them common shares at a $1-1.5M valuation. You’ll end up selling 25-33% of your company but they’re taking the most risk, enabling you to build a company.
Spend 6-9 months building your company into something that is presentable institutional investors. If you’re able to raise capital at $3M+ pre-money valuation, your early stage investors will be happy with a 2x return. Founders will still own 66-75% of the company and haven’t had to spend months struggling to raise capital. Moreover, a vanilla common equity investment will only cost $5-15K in legal fees.
If your investors want to own preferred stock, offer them attractive convertible note terms. A 35% discount and $3M valuation cap is appropriate for early stage company. Investors more frequently convert at the discount than the cap. The 35% discount will attract lots of interest and rarely comes out of the pre-money valuation applied to your company in a preferred equity round.
You should not worry about the dilution you take today, when thinking about how much you will earn on an exit.
In a true success, founders will be recapitalized in subsequent investment rounds. VCs will carve out shares for entrepreneurs from the ESOP to make sure they own a significant portion of the company.
Raising the first $250-500K of capital is the biggest obstacle you’ll face in your first year. Offer favorable terms to investors who are taking the biggest risk in you, not just your company. Without capital, you’ll own 100% equity of a worthless company. With capital, you have the opportunity to be rewarded professionally and economically while making your early stage investors happy.