Given the vast competition for early stage venture capital and the increased scrutiny being applied by investors to valuations and business plans, it is more important than ever to approach capital raising thoughtfully, whether you are targeting angels, venture capital firms or even strategic investors. Here are some tips for increasing your chance of success from an article I wrote for The Corporate Counselor (an ALM Law Journal Newsletter) in August 2016. Photo:FreeImages.com/LarryCole
1. Setting the Size of the Round
The internal discussion around capital raising usually begins with the age-old question: "How much should we raise?" If you search the Internet for the answer to that question, you'll likely find countless articles and blog posts from people who have been on all sides of the table who simply advise, "As much as you can." That may be good general advice, but it's not all that helpful in actually arriving at a number (and downright wrong in many circumstances). The reality is that answering this question is more of an art than an exact science and, therefore, difficult to boil down to a one-size-fits-all formula. The good news for those not well versed in the art of fundraising is that there are guidelines to follow that will help you arrive at an answer that makes sense for your business and that resonates with prospective investors.
To accomplish both of those goals, your pitch relating to the amount of your raise has to be something better than "$X will buy us Y months of runway at which point we can raise more money if we need it." That approach is not going to sweep any investors off their feet or convince potential strategic investors that they should hitch your proverbial wagons together. It may have done the trick at the height of the late 90s dot-com bubble, but not anymore.
According to Sam Rubenstein, President of Panacea Capital Advisors in Bethesda, MD, "when raising capital, it is critical to be able to effectively demonstrate to prospective investors that your deployment of their investment will result in the company achieving something that will increase the value of that investment."
The best practice is to set the total size of the round at what your company would need (conservatively estimated) to do everything it wants to do between the start of the round and a describable future milestone (e.g., launching the next version of an online platform, commencing product production, or entering new markets). At that point the company would be at materially higher ground in its business plan so that either it won't need additional capital, or it will be poised to raise additional capital on terms that are significantly more favorable to the company than those of the current round.
In other words, you need to demonstrate to prospective investors that the current raise is a means to a specific goal (or set of goals) rather than just the price of another stretch of raw runway. Since unexpected developments frequently occur and the adverse consequences of running out of money can be significant, it's a good idea to make sure there is a little padding in your projections so you have some room to cover a reasonable margin of error. But, the more that maximum dollar amount overshoots what you can demonstrate is needed to achieve the goals that form the core of your pitch, the less confidence you will instill in your prospective investors about your plan and your ability to execute it.
According to Hal Shear, Managing Director of Board Assets, Inc., an investment and advisory firm for early-stage companies, the key to making sure the amount you are seeking correlates well to the progress you are selling is "having an accurate understanding of your current "burn rate" and how that metric will be impacted over time as you deploy capital. If you can articulate that, you will give prospective investors comfort that you understand your business and that your projected expenses are reasonable given your plan."
2. Understanding and Setting the Minimum to Close
Once you establish the overall size of your round (i.e., the maximum you will raise), the next critical step is determining your "minimum to close," which is the aggregate amount of investment that you must secure before you actually close on any funds. In other words, it is your promise to early investors that you will hold all funds in escrow until you reach or exceed the minimum.
The point of this term is to give those early investors comfort that they will get their money back if the company is unable to raise at least an amount that you can convince them would still make their investment worthwhile. This is critical to your ability to get those first investors to commit, which is often the hardest part and what helps you build momentum. Setting the minimum too low can force you to explain it as an amount that simply buys you more time to survive. As discussed above, runway for runway's sake is not an easy sale. Setting it too high will require you to wait longer for an infusion of cash which could impact your ability to stay afloat and/or start executing on your plan.
With that in mind, you should set the minimum to close at an amount you can justify to early investors that is sufficient to allow the company to make significant progress toward that describable future milestone, such that raising more capital at that point is still viable even if the company wasn't able to achieve all of its goals for the round. That significant progress point should be based on something tangible as well, such as completing a major component of a new website (e.g., user interface or back end), completing a prototype, or entering at least one of your planned new markets.
3. Alleviating Concerns About Being Over- or Undersubscribed
I'm sure some of you are now asking, "But what if we're oversubscribed? Shouldn't we go with a higher number to allow for that possibility?" The short answer is no. There are ways to increase the size of your round if truly necessary or desired, depending on how your offering documents are written and other factors beyond the scope of this article. More importantly, though, if you believe you will be able to generate significant additional interest beyond a maximum that makes sense based on the guidelines above, you are better off pushing those investors into the next round, as that same money is likely to be a lot cheaper at that stage. The point is that excess demand is what we call a "high-class problem" and concerns about having that "problem" should not weigh heavily (if at all) upon your analysis.
For those of you that worry about how your investors will react if you are not able to fill your round — don't. You may have to do a little hand-holding, but if you've followed my advice on setting your minimum to close, you should be able to put your investors at ease. More importantly, the fact that you didn't reach your max in this round is not likely to be a relevant factor in your ability to attract and/or negotiate with investors in your next round. Instead, the success of that next round will rest on what you've done with the capital you raised in this round and how well you've executed against your plan.
4. Mitigating Risk by Balancing Optimism and Realism
Finally, no matter how confident, driven and motivated you and your team may be or how good a salesperson you are, it is important not to overreach in deciding which describable future milestone should serve as the basis for the size of your offering. While you don't want to set yourself up for more trips to the capital markets than necessary, in the end, prospective investors have to believe that your goals are achievable and be able to visualize the path you are laying out for them. The higher the mountain you tell them you want to scale with this round, the more they will see unpredictable variables, room for error, and a greater execution challenge. In other words, don't make it any harder than it needs to be.
As put by Craig Adler, Executive Chairman and Chief Executive Officer of Government Revenue Solutions in Herndon, VA, "I can't emphasize enough the need to find the right balance between optimism and realism. You have to be aggressive enough to show prospective investors that you are serious, but at the same time you don't want to set yourself up to underachieve and ultimately lose the confidence of your investors."
Moreover, getting someone's money because they believe in your ability to achieve something totally unrealistic is not success, it's a prelude to a lawsuit.
The bottom line is that your target should be a point that: 1) constitutes meaningful growth; 2) would position you well for the next phase of your financial plan (whether that's raising more capital at a higher valuation or achieving/increasing positive cash flow or profitability); 3) you can sell to investors; and 4) you have a good chance of actually hitting with the money you raise within the time frame you promise.