How to think about different types of funding for your early stage startup

One of the things that I’m noticing is that the early stage financing scene is changing quite rapidly. It may not feel like it — it’s still hard to raise money of any form, but there are a lot more options now than say even 5 years ago.

Traditionally, you have a lot of tech startups flocking to venture capital firms to raise money, because VCs have done a great job, as an industry, in marketing themselves. But the vast majority of startups who seek VC funding are not the right profile for that type of funding. As an entrepreneur, this is something I didn’t understand — what types of funders are out there and who is a good fit for what?

For example, angels and VCs are often lumped together in the same category. Afterall, they both invest in early stage startups on an equity-basis (this includes investing in convertible notes and convertible securities as well)  But they could not be more different. (See my post on closing angel investors)

In this post, I want to talk about different categories of funding beyond equity-based financing. These are categories I’d not even thought about as a founder. Here are the rough categories of financing options for early stage founders:

1) Equity financing (priced / notes / convertible securities)
2) Revenue based financing
3) Debt financing

…and some permutation of the above!

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Image credit: Giphy

1) Equity financing

This is the one that everyone knows about or at least has heard about. In its simplest form, with equity financing, you as the founder sell shares in your company for cash.

Variations on this include using convertible notes and convertible securities (SAFEs / KISS doc). (see here for details on the differences)

What most people don’t realize is that this is the most expensive form of financing if you are successful. Why? Because your payback amount is delayed significantly and the amount you end up paying back is a LOT if you are successful.

Let’s say you sell 5% of your company for $100k. You think “whee! I have $100k to work with.” In 10 years, if you do incredibly well, and now your company is worth $100m and you sell your startup for an all-cash deal, you pay your investor $5m (assuming no dilution in this example). That is a 50x return for your investor.

Now let’s suppose you had a crystal ball and you knew this outcome would definitely happen.  Knowing that, would you take this deal? Of course not. $5m is a ridiculous amount to give up for a $100k investment. If you knew for certain that this outcome would happen, you would likely try to fund your business with other money so that you could retain the extra $5m for yourself. Right?

Now of course, the reason entrepreneurs take this deal is that you don’t know ahead of time if you will be successful in 10 years! And most founders don’t get to this outcome. A common phenomenon that I see successful founders face is that they are at first incredibly excited to raise their first couple of rounds of equity but then later, they become a bit frustrated that they have taken too much dilution.

Guess what — equity investors need to take a lot of your company in order to justify the risk they take so early on in your business. The heavy amount of equity you sell in your business needs to offset all the losers in a given investor’s portfolio (plus more).

People don’t realize that equity financing is one of the most expensive forms of financing — because you don’t feel it until years later.

The flip side is if you raise equity financing and your company does go belly up, you don’t owe anyone anything. The investor is taking all the risk here as well.

2) Revenue based financing

Revenue based financing is a bit akin of income-shared agreements (ISAs) for individuals. With revenue based financing models, an investor invests money not for shares in your company but for a repayment percentage until you hit a certain cap.

In this model, say we invest $100k and the deal is to pay 10% of your revenue every week until you hit 1.2x or $120k in total repayments. Let’s say that next week, you generate $10k in revenue, so in this model, you pay back $1000 that week. And the week after that, let’s say it’s a great week, and you generate $20k in revenue, so you pay back $2000 that week. Now let’s say that the following week, you have a bad week, and you make $0. You pay back $0. In this model, the investor is with you through the highs and the lows — always taking 10% no matter what. If it takes you 6 months to hit $120k in repayments, that’s a great fast return for the investor, and if it takes you 3 years to repay back $120k, that’s probably a lot slower than the investor would have liked with a much lower IRR. He/she is with you through the ups and the downs — that is the risk that he/she takes.

Investors in this model make money by essentially picking companies that are generating fairly consistent revenue that have low default risk, and they are trying to target quick payback periods so that their IRR is high.

Now, let’s compare this form of investing vs equity investing. Suppose again we are pretty certain we can sell our company for $100m in 10 years, I would rather take $100k in revenue-based financing. Afterall, I would only have to pay back $120k instead of $5m.

But, let’s say we are at the very very beginning of our startup, and we don’t have many customers and not a lot of revenue. Equity financing allows us to keep all of the cash we make to pour back into the business. We don’t have to pay anyone out each week, and that extra cash can help us get to the $100m outcome faster on an equity investing model. Moreover, we probably wouldn’t qualify for revenue-based financing at that stage.

3) Debt financing

The last form of common early stage financing is debt financing. Unlike revenue-based financing, this is time based. This is also the cheapest form of capital but also the riskiest to the entrepreneur. In debt financing, if an investor puts $100k into your company, he/she is looking to be repaid back with interest by a certain date. So, say we do a debt investment of $100k into a company, we might ask for $120k back after 1 year (the principle plus 20% annual interest).

In addition, often, you have to personally guarantee a loan if your company cannot pay it back. Sometimes, debt financing come with warrants as well — if an entrepreneur cannot pay back the debt within a certain time period, the entrepreneur must give up other things including equity in the business.

So even though this is the cheapest form of financing, it’s also the highest risk for the entrepreneur.

Tying this all together…

Let’s analyze all of these forms of financing. First off, usually debt is the cheapest form of capital and equity is the most expensive. Now you might think, “Wait, a minute! 20% annual interest in this last example feels really expensive!” But when you compare the interest to the revenue based financing model and the equity model, it’s not.

To compare all 3 of these financing options, we need to look at the returns on the same time scale.

  • An equity investment of $100k that turns into $5m 10 years later has an average annual IRR of 48% per year.

 

  • A revenue-based financing investment of $100k that turns into $120k in 6 months has an average annual IRR of 44% per year.

 

  • And of course, a debt investment of $100k with 20% interest after 1 year has an average annual IRR of 20% per year.

Of course, if the time scale for the revenue based financing model changes, that will impact the IRR. And if the company that raised money on an equity basis exits earlier or later, that will also change the IRR for the equity-based investment.

Now of course, we are just looking strictly at what capital each scenario can provide. However, it’s possible that with a value-add investor, he/she can change the trajectory of your company. In the equity example, what if it were your $100k investor who introduced you to your would-be acquirer? Then the $5m repayment seems totally worth it. Or what if he/she introduced you to your key hire that led to the acquisition? Totally worth it.

Wrapping this up…

Even though it’s a much cheaper form of financing, founders are typically averse to debt. It’s a natural reaction, because in our personal lives, we go around saying, “Oooooh, debt is bad.” In our personal lives, debt is often bad, because your own cashflows are generally not growing faster than your interest rate. You typically are not getting 20%+ year over year raises each year.

In a startup, if your revenues are growing 20% MoM and your interest rate is only 20% year over year, you are growing your business significantly faster than your debt. And so not only will you have the cash flows to cover this 1.2x multiple of investment, but cash that you can put to use today will make your company worth (1.2^12) 9x more valuable a year from now, while you are only required to pay back 1.2x of the cash you took in.

In the early days when you have no revenue (and maybe you cannot get other forms of financing), equity financing is the least risky for you as the entrepreneur, because not only are you NOT on the hook for losses, but you can pour all revenue back into your business. But once you start to get some certainty around your revenues and some predictability around your cash flows, it may make sense to look at a blend of different forms of financing.

For example, let’s say we’ve started a business, and we are doing $12k per month in revenue and growing on average 20% MoM. What if we did $90k in equity financing and 10% in revenue based financing? If our revenue and cash flows are growing at more than 20% year over year, then this could makes total sense.

On the surface, it may seem insignificant to only raise $10k in revenue based financing, but when you think about what that could potentially become in 10 years,  using the example above, it would be $500k in liquidity in 10 years on a $100m company exit, which is pretty significant.

I think that once you have some level of understanding of your cash flows, it makes sense to look at your composition of financing and try to figure out what proportions of various forms of financing make sense based on your risk tolerance and predictability of your cash flows. I don’t think we do this enough as business owners.

How to close angel investors

Last week I spoke at the LAUNCH Festival Sydney in Australia. Huge thanks to the entire LAUNCH team for bringing me down and for their fantastic event / hospitality; it was an awesome experience and I had a great time!

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Photo courtesy of someone on Twitter – apologies, I didn’t write down who took this — thank you! (Email me and will credit you)

Most of my posts are about raising money from Silicon Valley VCs. But, the world is filled with all kinds of investors. And most businesses are not backable by most Silicon Valley VCs because:

  • They are not software-enabled ideas
  • They are not deemed to be in a large enough market for a VC to invest
  • The founders don’t want to build a “Go big or go home” business
  • Etc…

But these are not bad things. There are going to be plenty of big winners in say e-commerce / direct-to-consumer products that VCs will not back. Or in real estate. Or all kinds of other things. And it isn’t a bad thing if a founder wants to build a business that gets to say $10m per year and sells for $40m. That’s a fantastic outcome for founders. But, most VCs will not back any of these things.

So who do you pitch for money?

The good news is that the world is filled with money. It may not seem like it, but it really is. Your job as an entrepreneur is to find it and unlock it. So, I wanted to share some new material I created for the LAUNCH event on how to find angel and close investors. Here are my slides:

The overall takeaway from these slides is:

  • There are lots of rich people worldwide — they don’t even have to be super rich. There are lots of angels who can write you a $1k-$10k check.
  • Angels may not know they are angels. It’s your job to plant the seed in their heads that you are open to an investment from them!
  • Angels are motivated by many different things; figure out how to tie your story to something that they want; getting an investment – much like sales – is about solving for their needs not yours
  • It’s a numbers game — pitch many many people and don’t give up

Go out and pitch your eye doctor!

Thoughts on our 10 year wedding anniversary

Today is my 10 year wedding anniversary! Happy anniversary to my better half who goes by online alias John Jacob Jingleheimer Schmidt (JJJS)!

wedding

Photo credit: Earl Solis 

Something I’m thinking about today is that I feel so lucky. Namely, I’m glad that someone is willing to deal with me! Being together with an entrepreneur is really really difficult as many of you know. We started dating when I was 23 years old, and like for so many people, at 23, you just don’t quite know where you’re going in life. Years later, my career has taken both of us on a path of so many meanderings, ups and downs, and geographical relocations, and I’m so grateful that JJJS has been through it all with me. A few thoughts and anecdotes to share about all this:

10 years ago

When we got married 10 years ago, I had left my cushy job at Google just months before to become an entrepreneur. I had no idea what I was doing. And, I didn’t know how to make money. At that time, he was starting his post-doc.

On just a post-doc salary, we scrimped and saved like crazy. To make extra money, I did really bizarre side gigs. For example, one of those side gigs was a research study, where some lady from Xerox Parc followed me around for several days. She followed me to the grocery store — and even around in our apartment — literally everywhere and listened in on all conversations and took lots of notes! Other side gigs that I undertook included critiquing resumes for aspiring MBA students in Taiwan and categorizing whiskeys. Looking back, financially speaking, it was an incredibly stressful start, because I was making no money from my startup and the supplemental gigs came in weird ways. (This was before the rise of the gig economy.)

Career sacrifices

Lesser talked about amongst dual income households, in general, are all the sacrifices that are made in order for both people to work — specifically when you have children. When I was 23 with big aspirations, I didn’t think about rearing my future children. Questions like “Who is going to take care of them when I’m traveling?” Or “Who is going to do drop off and pick up?” never crossed my mind. A few years ago, when we had our first child, all of those questions suddenly came up. By complete luck, I picked the right partner, and all of those logistics have worked themselves out, because JJJS has made so many sacrifices to make our household functional. But this is not something that I had thought about at all when we first met.

When I was going through the acquisition process with my startup a few years ago, my baby was just a few months old. As so many of you know, being a parent to a very young child is incredibly draining — babies don’t sleep through the night and they constantly need to feed. So while I was traveling all around the country for meetings about my company, JJJS was holding down the fort at home, slogging through traffic to do all the drop offs and pickups at daycare, not sleeping and being the 24-7 solo parent. At that time, so many people commended me — “Wow, that is badass — YOU are running around doing all these business meetings and pumping in between meetings?  That’s amazing!” But, it’s often the spouse who has to hold down the fort outside of the company who is the unsung hero — for anyone who has ever had young children, wrangling your child is often even more challenging than running a company! (no joke…)

The article that I often refer to and think of that really hits close to home is this one by Andrew Moravcsik where he talks about the necessity of becoming a primary parent once his wife Anne Marie Slaughter’s career became really demanding.

JJJS has made a ton of sacrifices in his own career for mine even though he has big aspirations himself. For example, he left a unicorn synthetic biology startup with great culture and where he was employee #2 to trek across the country so that I could advance my own startup. He is the rock in our family who has taken on much more stable jobs throughout the years to pay the bills, while I’ve largely gone about taking on a lot of risk in building my startup(s) and now nascent VC practice. I know that so much of my own career is only possible because of all his support and sacrifices.

So here we are — 10 years in. Although I could not have predicted what life would look like when we got married, I’m incredibly grateful to JJJS for this journey we’ve been on. I love you, JJJS!

How do VCs make money?

I’ve written a little bit before about how venture capitalists (VCs) make money (see this post).

But I’ve never quite spelled it out, and in this post I’ll do just that. I think it’s useful to understand this — certainly for anyone who is an aspiring future VC — but even for entrepreneurs, because it helps to understand the mindset of people you’re pitching.  

What is a Venture Capitalist (VC)?

At a high level, the concept of a VC is relatively straightforward — a VC is basically a middle (wo)man.  On one side, a VC will raise money from rich people called Limited Partners (LPs). These can be individuals, families, corporations, and other funds who invest in funds, etc. VCs then take that money and on the other side, invest in startups. The hope is that some subset of those startups will grow tremendously, and then through some sort of liquidity event — it could be an acquisition or an IPO or even a way to sell shares to someone else in a secondary sale, the VC will receive back a lot more cash than initially invested.  That cash then gets returned back to the initial investors and the VC makes some money in between. 

Typical VC structure

A very common lifespan of a VC fund in the US is 10 years.  In other countries, this varies quite a bit — in China, for example, VC funds have been set up to be closer to a 5 year time horizon.  

The term is largely based on how long it will take to get liquidity on deals. Investors who invest in such a fund are committed to locking up their capital for 10 years. Now throughout the 10 years, it’s possible that investors may receive capital back from exits that happened before 10 years, but the bulk of the great exits will happen closer to the 10 year mark. For reference, Dropbox went IPO after 15 years, and so if you were an early stage investor, you would’ve made a lot of money, but that may not have happened for many years.

Side note: it is possible with the new Long Term Stock Exchange (LTSE) coming to fruition, we may see early stage VCs shorten their time horizons to getting liquidity.  The bar to have a successful IPO on the NYSE and the NASDAQ has been raised considerably since the 90s, so companies have been staying private for much longer. If you look back at Amazon’s IPO in the 1990s, their valuation was pegged just over $400m. These days, Uber went public at over $80B valuation!  If we enable more liquidity events at earlier stages, it’s possible we may see changes in fund lifespans.

In the US, a typical VC firm economics structure follows a 2% / 20% rule.  The 2% rate represents management fees. And the 20% represents something called carry.

What are management fees?

Management fees are basically the operating budget for a VC firm on an annual basis.  So in a 2% model, if you have a $10M fund, you have a $200,000 budget every year for the course of your fund.

If you have a $100m fund, with a 2% structure, you’d have an annual operating budget of $2 million each year. So as you can see, there is a stark difference in budget between a microfund and a large Sand Hill VC. And when people talk about VCs having nice salaries, they are referring to partners and employees who work at the latter type of firm — firms with a lot of money under management. Microfunds are very much like bootstrapped startups.

Let’s dive into the economics of a $10m fund. The $200,000 budget needs to cover just about everything.  Certainly, it includes salaries, but it also needs to include other things like marketing expenses, health insurance and travel. If you have an office, that must fit under this budget too. And so if your typical microfund has two partners, they are definitely earning well under $100,000 per year, and more likely closer to $50,000 given that all expenses must fit under this $200,000 number.  For us at Hustle Fund, in our 3 person partnership, we have publicly stated that we currently each make close to $50k per year and feel lucky to be able to bootstrap for a while.

What is carry?

The 20% represents the profit sharing of a VC fund. The way profits are distributed look something like this:

Say a $10m fund returns $20m. The initial $10m is first returned to the Limited Partners (LPs).  Then the $10m profit is returned such that the fund managers receive 20% of this profit, or $2M (the yellow shape) in this example.  That $2m is then distributed to the employees / partners of the fund based on however they’ve all mutually agreed to do so. (At Hustle Fund, all 3 partners have equal carry).   And, the LPs receive the rest – $8M in this example, and so the LPs receive a total of $18m in this example (the blue shape).

Even though the fund returned 2x at a gross level, after all is distributed, LPs see a net multiple of 1.8x, because of the carry.  

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The power law of startups

Ok, now let’s look at the investing side. The interesting thing about the investing side is that startup outcomes are distributed very much in line with the power law. Namely, most startups will fail and will go to zero — i.e. you will lose your money entirely.  Some will maybe return 2x or more. And if you have an excellent portfolio, you will capture a 100x-1000x returning company once in a while.

In order to succeed at investing in startups, you absolutely need at least one of these outliers in order to be successful. I hear all these non-investors or new investors talk about trying to find 3x multiples in startups. If you are investing at the early stages, you need to be aiming for much higher than that…  

I put together this spreadsheet of startup outcomes that everyone can copy, so you can all play with the numbers.

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Let’s look at the tab labeled “1 – 100x return”. If we assume the trite saying that 9/10 startups fail, and let’s say we have one big winner that delivers 100x returns, you can see that we can return an overall nice fund — 8x gross multiple, 6.6x net multiple to LPs.  From this, you can see that it doesn’t matter that we have really low survivability in the portfolio. All that matters is that your one big winner was quite big.

Dilution impacts your returns as an early stage investor

Now, let’s add the impact of dilution back into this equation.  Typically, a cap table will get diluted down by 10-30% each round, with an average being around 20%.  Assuming that we are the earliest stage investors, this means that if a founder does 3 rounds of funding after ours, we will be diluted down by about 50%!  So I modeled out the 100x winner as 50x in the next tab. You can see we are still returning good returns but if you aren’t aiming for 100x gross difference between your entry point and exit point in your investments, things start to get a bit dicey.  

Can you improve survivability?

There’s a lot of debate amongst VCs about whether the 9/10 survivability that everyone touts is actually accurate. Can you help your companies survive longer so that you have more winners?  

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I personally think the answer is yes, but I think you still need at least one big winner to make the portfolio work out well. If we look at the tab labeled “5 – 3x returns”.  You can see that even if we do phenomenally well with picking startups who have high survivability, if they are not returning much, our multiple on our fund is just barely over 1x and the net to LPs is basically that they get their money back.  Wait, what is going on? There are a lot of 3x returners!

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The primary reason for this is the management fees.  Even though this VC fund isn’t making money off management fees — heck their budget is only $200k per year, on a $10m fund, $2m in total is used for management fees. In other words, this money isn’t being invested.  So only $8m is invested, and so you have to overcome this initial hurdle to get to 1x. A lesser reason is once you cross the 1x hurdle, carry digs into some of the profits. (Side note: most VCs recycle small exits in order to invest more than 80% of their fund, but getting money back to recycle is not guaranteed and for the purpose of simplification, I removed that scenario.)

To be clear, this isn’t a situation that the managers of the fund want either.  They are taking a puny salary of like $50k per year. And their profits are only $400k after 10 years of work that gets divided across the partnership — this is really dinky.

So you can play with the numbers on this spreadsheet, but you’ll find that even if you can increase survivability, you still need to be aiming for big winners.  

How do you get a big winner?

Now, what does it mean to get a 100x returner? This means that if we invest at say $3m post money valuation, and the company sells for $300m, the difference in entry point and exit point is 100x. (Accounting for 3 rounds of dilution, this will be closer to a 50x returner).  

Think about it — $300m is a big exit. It’s more than life-changing for most entrepreneurs. And many entrepreneurs might be tempted to sell even sooner.  Heck $30m for most people is life changing. Remember, as a VC, we are the middle (wo)man, so we need that exit to be large for us to make a lot of money. But the entrepreneur doesn’t need a large exit to make good money. So there’s a bit of a disconnect there.  

Large multiples occur when there’s a large spread between entry point valuation and exit valuation. VCs all have different strategies to achieve this. Some like to go in at low valuations and then sell for sub billion dollar exits.  And this works, because there are many more exits that are sub $1B. And then there are VCs who have the exact opposite strategy. Entry point doesn’t matter, but they are gunning for an exit at a multi-billion dollar valuation. For example, Uber’s IPO was approximately at $80B valuation. If you got in at $5m valuation, then that’s on the order of a 10,000x multiple after accounting for dilution. So with that kind of exit, who cares if you got in at the $5m valuation or the $10m valuation or even higher — it’s all a wash at that scale.

But regardless of the strategy, all VCs aim to have large multiples.

You can also see that VCs can do VERY well if they end up getting a few 100x winners.  Play with the spreadsheet — even with just one more 100x winner on the first spreadsheet, you can see that the net fund outcome to LPs goes up to 13x. So, a $100k investment into a fund turns into a million dollar outcome.  On the flip side, more 3x outcomes on the last spreadsheet with near perfect survivability in a portfolio isn’t that awesome.

Takeaways

Based on all of this, this explains why VCs:

  • May be valuation sensitive (depending on the strategy)
  • Are only looking for super large outcomes and don’t care about good businesses
  • Often pattern match — if they believe that “certain types of founders” can get funding easily, then they may have an easier time growing super large companies (I don’t believe in this personally, but this explains this behavior)
  • Are looking for fast growth — winners must get to a billion dollar level within just a few years since a VC fund term is 10 years
  • Fight over pro-rata — dilution can be rough so maintaining ownership in companies that are clearly strong winners is helpful to returns
  • Don’t care about massive failures and would much prefer even just 1 “go big or go home” outcome to one that will be successful at a $50m outcome level.

I think following the money is always a good way to understand why people behave the way that they do. Hopefully these spreadsheets help to understand how VCs make their money. 

To SAFE or Not to SAFE?

VCs debate quite a bit about whether they like The YC SAFE or not. (Spoiler: Most do not…) We’ve done a lot of investments on SAFEs as well as on notes and in equity rounds, so I thought I’d outline pretty openly the pros and the cons of raising money on a SAFE.

First off, what is a SAFE?  

A SAFE is a convertible security that was developed and evangelized by YCombinator.  (500 Startups also has a convertible security called the KISS).  The convertible security concept, in itself, is an interesting innovation.  In essence, the convertible security is a placeholder for equity without the cost of both time and money doing an equity deal.  For a more detailed primer on convertible securities and the differences between those and convertible notes and equity, read my post here. (A lot of people, especially investors, confuse convertible notes and convertible securities but they are actually quite different! One is debt and the other is a placeholder for equity)

PROs for using a SAFE:

  • Your legal costs will be zero or low because it’s a template
  • There is no minimum threshold to raise before a deal goes through; investors simply sign and wire
  • Investors receive equity when an equity round happens; if a company goes through a liquidity event before an equity conversion happens, you’ll convert to equity and receive your proportional share
  • The new SAFE is a post-money SAFE, which is a BIG deal

The last bullet deserves a conversation in itself.

The post-money SAFE is easier math to calculate than the old pre-money SAFE

Previously, there was a lot of confusion before about how much equity an investor really owned.  The old SAFE was a pre-money SAFE — meaning your equity ownership was affected by how much money was raised on other SAFEs.  When companies raised lots of money at different caps on the pre-money SAFE, the math got to be pretty confusing for many people — both founders and investors.  No one really understood how much equity they owned. I also saw a lot of math mistakes in various deals that we were in that converted these SAFEs to equity. Investors were upset because they thought they owned a certain percentage of a company but then actually didn’t.  Founders didn’t understand how much of their company they had company they had sold.  This is why there are so many articles about how SAFEs are not SAFE.  The biggest pushback against the SAFE is in response to the old pre-money SAFE not the new post-money SAFE — namely, that no one knows how much equity they own.

With the new post-money SAFE, it’s quite easy for everyone to figure out how much equity has been sold.

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Photo credit: Giphy

How to compute your ownership with the new post-money SAFE

Let’s say that we invest $30k on a post-money SAFE with a $3m.  We own $30k (how much we invested) / $3m (the post-money valuation) = 1% of the company.  That’s it.  When we convert this SAFE in the first equity round, we will own 1% of the company.  It doesn’t matter who else is investing and at what price or anything.

This is a lot easier for people — both investors and founders — to understand.

Now let’s say the company raises another tranche of money on a post-money SAFE with $5m cap.  Let’s say we put in $50k now.  We own with this tranche: $50k / $5m = 1% of the company.

Now when both of these SAFEs convert, they will convert at the same time.  So we now own 1% + 1% = 2% of the company upon conversion.

One update and caveat (6/7/2019): Thank you to Seth Bannon of Fifty.vc — “The new post-money SAFEs get diluted by any options pool created for the equity round (the old SAFEs did not) so an investor’s actual ownership will likely be ~10% less than this example.”

Continuing on with the other PROs…

SAFEs enable small investments

For smaller investors (such as ourselves), there’s a cost to doing a deal (mostly legal).  So, with a SAFE, this makes our costs virtually nothing.  This means that with a SAFE, as a founder, you can bring in small investment checks here and there a lot more easily, and you don’t even need a lead.

The reality is that most companies will not be able to raise a seed round with an institutional lead, but there are many more startups that will go on to do incredibly well and should be able to be backed.  I like that SAFEs democratize the startup ecosystem and make funding more accessible beyond the 100 or so seed funds that write large checks. 

What are the CONs?

These are the biggest CONs that I hear about the SAFE:

  • People don’t know how much of a company they own (addressed above)
  • Investors modify the SAFE
  • QSBS tax exemption doesn’t apply to SAFEs
  • SAFE holders don’t receive dividends

Another pushback that I often hear about the SAFE is that a lot of investors try to modify it to create weird new SAFEs.  I encourage investors to please please please not do that.  Templatizing docs, in general, is a good thing — it reduces time and legal fees to do a deal, and if you want modifications, please use a side letter.  The SAFE is meant to remain a lawyer-free template.  Templates keep the expenses down for smaller investors who cannot afford high legal fees.  Reviewing a side letter is a lot easier / faster / cheaper than reviewing a modified SAFE.

From our experience, the biggest downside as a very early investor is that QSBS tax exemption doesn’t apply to SAFEs. This is a much longer blog post, but the QSBS tax exemption was enacted in the US to encourage early stage investment.  If you hold private company stock for more than 5 years and there are other criteria met by that startup, any gains from a sale of that stock after the 5 years is tax exempt. This is amazing!  However, if you are a SAFE holder for 2 years and then you convert to equity and then the company sells 4 years later, you do not reap those benefits even though you made the investment 6 years ago.

One last corner case of being a SAFE holder is that even though you will convert to equity, if a company doesn’t raise more money nor has a liquidity event and then starts printing money and issuing dividends to shareholders, you as a SAFE holder do not get those dividends. This is a possible situation (though rare) – have never come across it myself personally.

SAFEs avoid dilution

There’s one last interesting tidbit about SAFEs – I couldn’t decide whether this is a pro or a con. I’m seeing money raised on SAFEs at the pre-seed, seed, and post-seed levels.  Let’s go back to that prior example where we invested in a company twice at two different caps on a SAFE.

Now let’s say that we invested those same amounts on two separate equity rounds at the exact same prices.  The interesting thing is that when we invest in two separate equity rounds, our first check got diluted down…  But when we invested both checks on SAFEs, we did not get diluted down, because both SAFEs converted simultaneously into the first equity round.

As we see multiple tranches of seed happen more and more, investors who write checks on a SAFE will avoid some dilution than if they were to invest in the equivalent equity rounds.

And for founders, this characteristic of the post-money SAFE is a double-edged sword.  On one hand, the post-money SAFE is great because it’s easier to figure out how much of the company a founder has sold.  On the other hand, ultimately, its founders who take more dilution on this new SAFE than on the equivalent equity rounds.  However, I think if everyone is aware of how this conversion happens, then this characteristic should just get priced into the initial cap of the SAFE.

Final thoughts

All-in-all, on the net, we, as a small fund, like the SAFE, because being able to do small deals as a small fund or an angel enables more startups to get funded. I can understand why larger funds would prefer to do large equity rounds – the reality is that often it’s the smaller investors who bubble up those deals before the large funds end up funding some of them.  And empowering smaller investors is a good thing for the ecosystem, because more startups can then have a shot at the big stage.

Featured photo courtesy of Pexels

 

The #1 thing most people do wrong when they fundraise

“So why do you like fundraising so much now?” 

It was a dreary day, and I was catching up over coffee with a friend of mine whom I hadn’t seen in a couple of years. And we were talking about startups and fundraising.  This friend has known me since when I had my company LaunchBit, and she knew just how much I hated fundraising back in the day.  In fact, when I was running LaunchBit, the fundraising process was super tough for me.   In fact, it took a huge toll on my health.

Back in 2011…

“We can’t find anything wrong.” said the physician.

There I was at Massachusetts General Hospital. I had been referred to a specialist to check out a problem I was having.  My problem was tough to explain – I kept feeling like someone was constantly poking me all the time with a pin. Just everywhere all over my body.  The prickly feeling didn’t stop anytime during the day – even when I was trying to sleep. It had started a few weeks before and it just would not go away.

After seeing a number of physicians who could not figure out what was wrong, Massachusetts General Hospital was the final stop.  MGH was a world premier hospital with a billion and one specialists and researchers including in fields such as the nervous system.  All these doctors appointments were a bit of a distraction for me, because I was in the middle of raising a seed round for LaunchBit. But this issue was becoming so bad that I couldn’t even sleep.  

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Fundraising had been a stressful process, and I had felt so much pressure to raise a $1m round.  And, after raising almost $400,000, I decided to just stop. I wasn’t getting any more momentum on the round, and my health problems were really starting to bother me. Immediately after halting my fundraising activities, surprise surprise, all of my ailments stopped and magically disappeared. There was never any scientific explanation or diagnosis for what had happened.  The only explanation that I have for myself is that I was just so stressed that weird things were happening to me because fundraising was taking a toll on my health. Fundraising was definitely not fun to me back then.

Back to the meeting with my friend. “So why do you like fundraising so much now?” she asked.  

“Hmm…that’s a good question. Because I now understand how to do it.  And, because I’m good at it – hah!” I responded half laughing.

It was even hard for me to believe that I could get good at fundraising.

In the past 7 years, I’ve learned so much about fundraising – partly from my own fundraising experiences LaunchBit, but much more so through helping hundreds of founders I’ve backed over the years with their raises and in raising Fund 1 for Hustle Fund.

7 years ago, I didn’t understand how to fundraise. I think when we hear the word “pitch”, it almost seems to imply that we are talking at someone. But fundraising could not be further from that.

My biggest learning around fundraising is that fundraising is actually a series of dialogues – not pitches – and success is contingent upon need finding and finding the right investor match.  

The reason I think fundraising is so fun now is that I’ve learned that fundraising is more of a customer development exercise out of the Lean Startup playbook than anything else.  And that’s fun.

A noob fundraiser will go into a first meeting, open up his/her deck, and start going through the slides.  In doing so, you don’t really know how your story is landing.  You’re not having a conversation.  But, an experienced fundraiser knows that the goal in going into your first fundraising meeting is to ask lots of questions and walk away understanding what next steps make sense. You should understand your potential investor’s pain points. Is there something you can solve for a potential investor by having him/her invest in your company? Do you have a solution for those pain points?

There are many reasons to invest

For example, let’s say we’re selling pet food – hippo pet food – and let’s say that I were raising money for this company.

There are a number of reasons why someone might like to invest in this company. It could be that an investor wants:

 

  1. To make a lot of money and believes that hippo pet food is an amazing market
  2. To invest in a basket of e-commerce companies
  3. To invest, because he/she believes in me personally
  4. To invest in more female entrepreneurs
  5. To invest, because he/she has a pet hippo and really loves the product
  6. To invest, because he/she believes that I have a strong network and wants to get tapped into it
  7. To invest in a bucket of Xooglers’ (ex-Googlers) companies

The list goes on and on. As you can, there are many reasons why an investor might like to invest in this business.  And my job is to ask lots of questions in a first meeting to learn what an investors’ interests and challenges are.  And can I figure out which of these reasons, perhaps, might be one that resonates with a potential investor.

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I think we fixate too much on what VCs are looking for, but it’s important to note that the world is filled with many would be investors, including individuals, corporates, and family offices.

In general, most VCs are trying to maximize their dollar return in the shortest amount of time possible.  (This is reason #1) But, for an angel investor, there are many other reasons to invest, and some of those reasons may be #2 or #3 or #5 etc…

Fundraising is about doing customer development

It is your job as an entrepreneur to figure out what a potential investor is interested in in a first meeting. Can you help that person or that company achieve its goal. If the investor is trying to invest in more e-commerce companies, you’ll want to tailor your story to that thesis, and if the investor is trying to invest in more women, you may want to play up that angle.

Your job in the first meeting with a potential investor is to ask a lot of questions – ala customer development style – to understand how you might be able to tie your story to their problems and interests.  And so your pitch should not be stagnant, and although you may have created a deck before the meeting, it’s important to tie your talking points together as a solution to the problems you learn about in that meeting.

The first meeting with an investor is really about truly understanding their needs and triaging whether you think your company might be a good fit for that investor.  Your job is not to try to convince a potential investor to invest. Your job is just to triage. It is much easier for you to close an investor who is already bought into your story than it is to try to sell an investor who is not bought in. And it’s ok if someone is not a good fit.  In fact, I would just address that head on — “It sounds like this might not be a good match — you’re generally a series A investor and you’re looking for a lot more traction.  Why don’t I put you on my newsletter, and perhaps there may be a fit down the road?” Addressing things clearly and directly is the best way to communicate with investors, and it’s ok if there’s no match.

There are billions of investors

I’ve observed over the years that when founders create their list of investors they want to pitch to, they often draw from common directories.  Such as Crunchbase.  Or AngelList.  Or various Excel spreadsheets that are passed around.  It’s often the same set of hundreds of funds and about 100 angels.  These lists are a great place to start for sure.  But what I’ve found is that these lists also narrow people’s thinking.  Why do founders just pitch these people?  Why not the billions of other people in the world?  There are so many rich people or even people who are not rich but may have conviction to write a small check.  By limiting ourselves to these lists, we create unnecessary pressure on ourselves.  You end up in a weird mindset — if I cannot convince these people to invest, I’m hosed.  Right?  A bit of an exaggeration, but has anyone else had that mindset before?  I certainly have.

But this is the wrong way to think about things.  The right way to think about fundraising is with a growth mindset.  There are billions of people in the world – many of whom are rich – any of these people could potentially invest. This takes the pressure off right away.  The game changes from “How can I convince this small group of people to invest in my company” to “How do I triage people quickly and get to meet with a lot of people quickly?”

Once you have that mindset, then it’s just a matter of finding potential investors to have a conversation with, figuring out quickly whether they are a good fit, and if they’re not,  move on quickly. Instead of wasting time trying to convince someone to invest, you want to actually spend as little time with people who are not a good match to focus your energy on getting new meetings. Your job is not to try to pitch at people or convince. Your job is just to have a conversation and do need finding, triage accordingly, and then rinse and repeat.  (See my post on finding potential investors.) That is what fundraising is all about when done right.

For people who are not a good fit, you definitely want to cultivate those relationships.  Put all of these people on a monthly newsletter with your clear progress.  Much like in B2B sales, if a lead is not a warm lead, you should use automation to keep those people engaged but don’t spend a lot of time with them until they are actually interested.

When I was fundraising for my startup many years ago, I took the totally wrong approach. And you can see that by limiting yourself to some silly list that you have and putting pressure on yourself, fundraising can be a bear.  But if you can change your mindset and approach, it’s actually pretty fun.

Feature Image credit: Pexels