When it comes to fundraising, entrepreneurs are like knights on a quest to find the Holy Grail. Out here on the internet you can find many opinions, representing completely different – sometimes contradicting – approaches and philosophies. At the end of the day, how could it be possible to sum up the tears, the effort, and the hopes into numbers and discuss them with people that have not been involved so far? Well, it is. This guide wants to cast light on this often obscure topic, defying some myths and saying things as they are, to provide entrepreneurs with the weapons to rule the fundraising process.
KNOW WHAT YOU WANT
Only when victory is well defined in your mind you will be able to win.
In terms of fundraising, this means knowing how much you need and when you need it.
First of all, draft your cash flow projections without considering the fundraising, assuming you can have unlimited overdraft. If you are able to create an excel model to project it, that is a solid advantage, otherwise – for now – pen and paper would be sufficient.
Be careful! Or, better, be sensible: growth – of customers, revenues, and hires – does not happen instantaneously! Try to reason by milestones and then consider the resources and timing you will need to achieve them.
Likely, you will see that for a certain period (months or years) you will burn cash, rather than generating it. This happens because you have to pay salaries, purchase machinery, pay for advertising, etc. while revenues are just getting started.
There is a common misconception about the fact that the larger the round, the better. This is rarely the case. As an entrepreneur, you should consider the returns you will get from the business. Having large rounds when you have not reached many milestones is not only harder, but also reduces your leverage during negotiations, lowering the valuation or increasing investors’ share in the company. Considering the fact that you’ll probably need to raise multiple rounds, it’s better to be careful with the equity you give away.
A good way to get to the cash amount you need to raise in this round is to identify the relevant achievement in the next 12 to 18 months.
Aim at raising the sum of your projected negative cash flow for that period, i.e. the amount that enables you to avoid cash overdraft, plus a buffer – a famous rule of thumb suggests +18%.
You can iterate on this process for the following rounds. Always be consistent with your purpose: do not allow others to impose amounts, whether lower or higher, without solid argumentation on your projected needs. In one case you will need to go back to fundraise too soon. You will risk giving away cheaper equity that may be better used in the future at a higher valuation. Speaking of which…
KNOW WHAT YOU HAVE
Now that you know how much money you need to raise in this round, you should consider what you have in your hands: your company and its monetary value – its valuation. This number defines the percentage of shares future investors will acquire (% = investment / (investment + pre-money valuation)) and so deserves special attention.
One thing is the intrinsic value of the company, one is the result of the negotiation with the investors.
The former is defined as fair value (valuation) since it ignores the specifics of the deal and assumes a perfect market situation, i.e. lots of people willing to invest (liquid market) and no cheating between the parties (perfect knowledge).
The latter is named market value, as it takes into account all the elements of the negotiation, and is the unique result of the bargaining between the company and the investors. It follows that you will always close a deal at the market valuation, which can be at a discount (if lower) or at a premium (if higher) in respect to the fair valuation.
There are three main approaches to determine the fair valuation of a startup:
Asset based approach: the value of the firm depends on the balance sheet assets.
Pros: really hard to question, as it uses the conservative accounting value of the assets.
Cons: ignores the future potential of the venture and misses intangibles such as software, resulting in lower valuations
Comparative approach: look for recent transactions of similar companies in the market and relate their valuations with key metrics, which can represent accounting (EBITDA, EBIT, etc.), business (number of active users, database population, etc.), or qualitative aspects converted into scores(experience of the team, status of IP protection, etc.). The value of the company will be the average of these ratios times the same internal metric.
Pros: valuation is easy to compute and based on data accessible or verifiable by everyone; possibility to take into account qualitative factors.
Cons: no company is perfectly equal to another, so the choice of the peer-set will always be questioned, and even the existence of suitable benchmark companies could be troublesome to demonstrate.
Discounted cash flow approach: the valuation is the net present value of the future cash flow (over the next 3 to 5 years), which is estimated thanks to the same model used for computing the investment need.
Pros: provides the most tailored picture of the company, takes into account all its specific factors, allows business decision making and scenario analysis.
Cons: complicated to implement, effort to defend the assumptions both at a business level (future clients, future costs, etc.) and at a technical level (discount rate to compute the present value, long term growth rate)
There is no absolute best approach. Comparative methods are easy, but leave behind much company-specific information, while discounted cash flow ones enable you to adopt good monitoring practice, but are more difficult to defend. However, we could set aside the asset based methods, which are usually unsuitable for startups. They are designed for companies whose future is linked mostly to their current assets, whether because they are being liquidated or for their specific business (e.g.: real estate agencies).
The solution we adopted is a weighted average of comparative and discounted cash flow valuations (you can check our full methodology here). This approach highlights both market and business specific aspects, showing the most complete picture of the company in its environment.
KNOW WHAT TO SAY
Now that we’ve prepared the ingredients, let’s proceed with the recipe: you need to present your project to investors, showing them that you are able to fulfil your promises and bring you company to success.
First thing you must keep in mind: investors are human beings, they are people like you and me. They deserve to be treated with respect, but you are not begging for their money. You are offering them the opportunity to invest in you and your project, but as they choose among different startups, so you can choose among different investors.
Stress the fact that the possibility to invest will not be open forever, follow-up after each step of the screening process, never accept just a no, but ask for feedback if they communicate they are not going to fund you.
On your side, transparency should be a value. You should provide investors with a clear picture of you company, stressing past results and how these ensure you will be able to fulfil the promises for future achievements.
Overselling is dangerous, you will be perceived as detached from reality, and, even if the investment goes through, you will lose credibility if you do not live up to your statements.
Underselling, on the other hand, decreases the probability of closing, as you are expected to be ambitious with regard to your business, being the first person to believe in it. Just be honest and, at the same time, confident of your potential and your strengths.
Both in presenting your idea and in negotiating the deal, storytelling and valuation must go together and be consistent, as numbers are just numbers without a story behind them. Enthrall investors with a compelling story, supported by your pitch-deck, and impress them showing that there is sensible reasoning behind what you are saying. You will have to defend these hypotheses, both for your credibility and for negotiating your valuation.
In these regards, let’s bust a myth:
There is no way to sensibly boost your fair valuation.
Comparative approaches may allow you to tweak it by playing with the peer selection, and you could intervene on the business assumptions of the discounted cash flow model to increase the projected cash. In any case, you should be able to defend any choice you will take in these terms, so the more daring they are, the harder it will be to justify them.
Closing the deal and defining the final market valuation will consist in demonstrating your assumptions are reasonable or intervening on them along with the investors to reach an agreement. In fact, you may also extend the discussions to the clauses of the term sheet, the working document which describes the financial and legal agreement between the investors and the company. Granting extra-rights to investors in terms of voting or future cash (coming from dividends or exit) will enable you to negotiate a higher market valuation, at a premium on the fair one, but should be carefully calibrated, as their presence might just be postponing the same effects of the lower valuation.
Fundraising, if done with the right instruments and with clear ideas in mind, is an exciting moment in startup life. You are reaching out and getting challenged about every single aspect of your business, which gives you the opportunity to reflect about all of its elements. Tell your story, refine it pitch by pitch, and have it consistent with your valuation assumptions: this will lead to successfully raise what you need at the fairest price in terms of equity. Then, with those resources, you can finally go and crunch it!
BY LUCA TREVISAN