If you have worked in and around growth companies, particularly in Leadership roles or in the Finance department, you are familiar with “the fundraising game.”
Being involved in fundraising is usually a badge of honor – you are “marked” as being in the inner circle and each fundraising can be added as a credential to your resume.
In conversations with friends and those in my business community, we talk often about the fundraising process. We acknowledge how challenging and stressful the process is.
We don’t openly concede how f*&^%d-up the process is.
The Underlying Principle
The principle underlying the game is that the business raising equity must have the potential to become at least a “unicorn” ($1 billion plus valuation), if not a “decacorn” ($10 billion plus valuation), in no more than 5-years.
For early-stage start-ups (my definition being everything prior to a Series C raise), the starting point (where the business is today) is typically somewhere between $1 million and $15 million in annual recurring revenue. Often closer to the bottom end of this range.
The goal is to exceed $100 million in annual recurring revenue in 5-years to achieve unicorn status. This $100mm revenue goal was based upon SaaS revenue multiples of ~10x revenue on average (these multiples have gone up even higher since mid-2020.)
Achieving that revenue level implies between 10x and 50x revenue growth in 5 years.
Doing (Almost) Whatever it Take to “Sell” Your Vision of the Future
Realizing that level of growth requires: (i) an unwavering belief in the future potential of the business, and (ii) selling that belief to investors to access the capital necessary to achieve the growth.
Alex Danco articulated this challenge crisply in his September 2020 post, “Are Founders Allowed to Lie?” In his words, “…founders have to will an unlikely future into existence.”
This is particularly true during the fundraising process. It also matters in recruiting top talent and getting press mentions in relevant publications.
Fundraising (at a high valuation) is about convincing investors that you are going to take something small and turn it into something huge and valuable to lots of people. As James Currier says (around minute 22 of this podcast discussion with Erik Torenberg), fundraising involves convincing investors who are bombarded with opportunities to give your opportunity their time, attention, energy and money.
If the founding team does not project unwavering confidence and believe in the future in an almost cultish manner, investors will wonder why they should. There is a Vince Lombardi quote, “Confidence is contagious. So is lack of confidence.” When you pick the appropriate investors to pitch to, they want to believe in the future (solution and value creation) you are selling.
The Unwritten Rules of the Game
1. Know Investor Expectations. Investors have defined “best” and “great”. They are looking for opportunities that meet those criteria. Some of the more widely known examples (among many) are below.
a. Neeraj Agarwal at Battery Ventures defined the expectations for growth. Great companies should meet the “triple, triple, double, double, double” growth formula.
b. Bessemer Venture Partners, one of the more successful investors in SaaS, publishes its metrics for good, better, and best.
1. Remember that Investors will Haircut Everything. Companies must be extra aggressive and positive about the future potential because the expectation is that investors will haircut all projections. Whatever you put out there is an effort to provide a believable “anchor.”
2. Proactively Share Only the Information you Want in the Public Domain. Give out as little information as you can get away with (and pass the red-faced test). Leave out data points that do not look particularly good for you. Omission is not considered lying.
3. Define and Present your Metrics in the Most Favorable Light. Unlike GAAP standards for audited financial statements, there is no similar standardized and agreed definitions for KPIs and Metrics. Present your own definition of COGS/Gross margin, CAC / CAC Payback and churn. Force investors to ask questions if they want more information.
What is “Lying” In the Private Markets?
If these rules I have laid out above make you uncomfortable, you are not alone. Many with finance backgrounds (including me) find following these rules stresses our personal integrity. After all, a key part of a finance leadership role involves presenting to the Leadership Team and existing investors the most likely version of the future. This increases the likelihood that the business does not run out of cash and creates more awareness of actual performance, allowing for challenges to be addressed more quickly.
However, the private markets are not regulated by a body like the SEC. And they operate on different rules than personal relationships (friendships or romantic), where open disclosure is much more critical.
The argument commonly made is that counterparties in any private investment are “accredited investors”, or “big boys” in the parlance of the investing world. It is their responsibility to do adequate diligence. Since no one can know what the future holds, forecasting a hockey stick is not the same as telling a lie.
Understand How Investors Think
The basics equation for valuation in investing is as follows (discounted for cost of capital).
VALUE OF A BUSINESS TODAY = STEADY STATE VALUE + FUTURE VALUE CREATION
My favorite writer on this topic is Michael Mauboussin. Two pieces I recommend reading for greater detail on his approach to valuation are here (from 2014) and here (from May 2021). In the case of the S&P 500 index, Mauboussin estimates that (since 1960) two thirds of the index value is from the steady state valuation and the remaining one-third from future growth opportunities. For less mature companies (all start-ups), the split in value is much much more heavily skewed towards the present value of future opportunities.
1. What will the Next Buyer Pay? All private market investors are forecasting what the next buyer (or investor in the business) might pay for the company. They are trying to figure out potential outcomes. VCs focus on the next 2 years and PE investors on the next 3 to 5 years.
2. Discounting That Future Value Back to Today. Investors will then take the future expected value and discount it back to the present based on their internal hurdle rate. For examples, VCs often seek to 10x their investment while later stage investors want to 3x their investment.
The Most Challenging Round(s) to Raise: The Series A and Series B
Raising capital for start-ups falls on a continuum as shown below.
Investors deploying capital at the Series A and B stages are unwilling to invest purely on belief. I define belief as being convinced of a large market opportunity (ideally one that is growing too), a strong team, and an innovative product that can solve a real problem.
Yet, there is not enough data (large enough sample size) nor enough proof (relative consistency over a long enough period) to rely primarily on metrics and trends to forecast the future.
Investors at this stage are looking at the relationship between four different “variables”. They integrate the “performance” on these variables with the belief factors (market, team etc.) when making their investment decision.
The four variables are.
1. Scale – How big is the business in terms of revenue?
2. Growth – How fast is it growing? High growth helps reinforce a large market opportunity with a product that fits the customer need.
3. Monthly Burn Rate – How large is the burn? The burn speaks to the quantum of the capital needed to achieve the next critical milestones. More importantly, the amount of monthly burn relative to revenue scale is indicative of capital efficiency to date. Investors will accept a higher burn rate accompanied by larger scale and a higher growth rate.
4. Valuation – The higher the last round valuation or ask, the more critical strong performance becomes on all the other three variables discussed above.
How to Raise When You are Missing Plan?
In the current market, if your business is meeting or exceeding your plan, you are likely to be able to pick your investors, terms, quantum of capital to raise and valuation. This situation is the exception.
Missing plan is common. Almost the norm. The nature of start-up leaders is to be optimistic. The optimism in an uncertain business environment leads to a miss against budget. This miss is almost always around customer and revenue forecasts.
In these circumstances, what should you do?
1. Find Investors with “Extra” Belief – Seek out those that are more aligned with your company’s mission and sector focus.
2. Talk through the logical expansion of your Addressable Market – Talk about how you can grow substantially even though you have a smaller focused target market today. Describe how you will be able to penetrate a lot of adjacent markets over time, and why the total addressable market opportunity is much larger than it might seem at first glance.
3. Stress your “Unfair Advantage” in Go-To-Market – Cost-effective distribution and customer acquisition matters in all businesses. The flavor of the moment is product led growth. Community led growth is emerging as the next hot area. These two unfair advantages help reduce acquisition cost and speed up the sales cycle.
4. Call out the Long Duration of your Competitive Advantage – Examples of this could include talking about the super high stickiness of your product and how hard it would be for legacy incumbents or new competitors to replicate what you have built. The longer length of your competitive advantage will permit you to “over earn” in the future (i.e., increasing your LTV and thus making your LTV:CAC ratio higher than the average successful company in your space.)
Control What You Can
I am not a fan of the “fundraising game.” And I know that I cannot change the process.
As a Finance Leader, I can only do the following.
1. Help my peers (other Finance leaders and emerging leaders) understand the realities and answer their questions.
2. Help my bosses (CEOs / founders) realize that it takes preparation to position themselves well for a fundraising and to start early with a view to the future.
3. Be prepared to answer the hard questions for smart investors truthfully while still showing a believable path to a great return for investors. Really dig into my business and other similar businesses.