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May 18, 2011

The right investors for the mission

"How should I finance my start-up?" is a common refrain from first-time founders and serial entrepreneurs alike. There is no manual for how to best do this, and intuition can only get you so far in the absence of experience and mentoring. As with investors evaluating start-ups, it is and always has been people first. Having a deep trust relationship with your investors and confidence in the value they bring is absolutely critical: more important than valuation; more important than pretty much anything. Making the wrong investor decisions might not only hurt a company’s chances to reach full potential, they might impact the company’s ability to survive the inevitable challenges and near-death experiences borne by early-stage companies. This is not an issue to be taken lightly. 

There are a few basic questions that need to be answered, however, before a reasoned approach to syndicate construction can be developed:

Question #1: Does your start-up generate cash flow early in its life?

  • If yes, is the quantity of cash flow such that it could be self-sustaining? If so, keep costs low and bootstrap out-of-the-gate. Keep things simple, enable the founders to retain 100% of the equity and defer raising external capital until you either absolutely need it to build or you’d benefit from acceleration capital to support rapid growth. These are generally nicer financing events for founders than pure seed capital (read: higher valuations) because of the progress that has been demonstrated, the milestones that have been reached and the track record that has been achieved.
  • If not, see below.

Question #2: Does your start-up require significant capital (>$3 million) in order to validate or invalidate its core thesis?

  • Yes, Virginia, not every start-up can be hacked together for $5k in the garage. If yours is one of those deep-tech companies for which prudence indicates a significant initial capital raise, it is likely that even greater amounts of capital will be needed to support the go-to-market and growth phases. In light of this, a larger fund (>$200 million in committed capital) should be sought as an early lead to both provide seed dollars but more importantly to reserve a significant amount of capital for follow-on investment. Opportunities like these don’t subject themselves well to angel financing, as bumps in the road will necessitate negotiating with an unwieldy syndicate and the lack of a single deal lead will make coordination time-consuming and painful. Finally, angels generally lack the big-dollars follow-on capital and culture to support future rounds, in stark contrast to larger venture funds who fully expect that they’ve purchased a “two-ride ticket” and will be able to fund into good and bad in order to give the company a fighting chance at success.
  • If no, hooray, the options open to you are extensive. If your costs of people and infrastructure are low enough to create a functional minimum viable product or “MVP” (say $500-$750k), then a pure angel syndicate or angels plus a smaller, domain-knowledgeable venture fund might be just the thing. However, if the nature of the company is such that the costs of developing the MVP are low but the anticipated dollars required to operate at scale are high, it might make sense to include a larger venture firm in the syndicate that can comfortably bridge to a Series A or even lead an inside round. I am not a huge believer in the adverse signaling of larger funds in seed rounds. In my experience good firms do the right thing, e.g., doing their pro rata unless the company is outright failing or management is poor and/or unethical and untrustworthy, and often times step up to lead the round. I also haven’t seen larger VC seed round participants scare off other VCs wanting to lead a subsequent round, especially if they have written a smallish check, lack a board seat and specific protective provisions, etc. 

Question #3: Is there a “best investor” for your company?

  • Sometimes a company is operating in a specific domain that would benefit from extreme expertise, industry contacts and competitive intelligence. At these times, it is essential to include a “dream firm” in your investor syndicate if you can get them. Leverage the full extent of your networks to get a warm introduction and sell, sell, sell. You simply can’t do enough to get the right investors behind you, especially in a particular area where an super-connected angel or a specific high-value venture investor can be life transforming. 
  • If not, don’t worry about it. But I don’t believe you. There are always “best investors” for your company. The only questions are (a) can you identify them; and (b) once you identify them, can you persuade them to get on board as investors, advisers, etc.? That is your job. Get it done.

In summary, you need to understand your business requirements before figuring out how much to raise and from whom to raise it. Once these requirements are known, it takes laser focus and a ton of work to build the right investor group. But to the extent you are successful, the positive impact on your business cannot be overstated.

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