Don’t Get Played: The four things every founder needs to do when they seek funding

Some potential investment partners will look to make you a pawn in their larger game. Here’s how to avoid that fate.

I’m not going to mince words: getting funding can be stressful.

I don’t care if you’re working out of a garage and need seed money, or if you’ve got a slick team that hums and you’re seeking scale in a Series C. Finding the right partner is a perilous process, full of potentially choppy water. Within that water? Sharks.

There are four things you need to do to make sure you don’t get bit.

Raise capital specific to the demands of the company, not to the demands of the fund.

If you're going to fundraise, think carefully about what your capital objectives are.

Let’s say you’ve decided you need a million dollar seed. A million dollars is great, but where’s it going to take you? Does it take you to a place where you’re fundable into the next round, and at a premium? Does it meet your operational needs, and set you up for putting the right talent together? Think steps ahead of your current station, beyond your current round. What will your capital requirements be over time?

Companies that raise capital and don’t meet the agreed upon milestones of the financing usually don’t get follow on funding, or they’re forced to take a significant haircut. Seed capital is often hard to gauge, with firms taking too little or too much. You need to know what the fundraising is going to look like over the life of the company, not just the current financing. A million dollars might be great now, but you can’t afford to just think about the present. When capitalizing your company you must play chess, not checkers!

Now, here’s where it’s important not to be a pawn: big funds want to put capital to work. You need to be raising capital specific to the demands of your company — both its current and future demands — and not to the demands of the fund. Remember, the earlier the stage, the more punitive the round from a dilution perspective. So raise what you need plus a buffer as things always take longer than you expect.

Develop a criteria of what you need from your investment partner. (Hint: it shouldn’t just be money).

You need more than capital from an investor.

As you seek funding, make sure that you’re developing your own criteria of what you’re looking for in a partner. One place to start: complementary expertise.

Perhaps you’re an ace coder or someone who’s got a true depth of experience in data science or cyber security. You understand the needs of the market and have the time-tested skills to build a killer product that will be truly disruptive. But there’s a problem: you don’t know the first thing about sales, or marketing said product. You prefer to build, and not to trumpet what you’ve built.

Or perhaps it’s the other way around. You’re sales-first and need a tech-savvy partner.

In each case, your needs are different, but there’s a common thread.

You need more from a partner than just money. You need help in areas that you don’t normally think too much about or focus on.

Run parallel processes and get multiple term sheets so you don’t get played.

If you randomly go to a single VC, he or she is going to take you into deep water. Be careful, because that’s where the sharks are.

Once you’re in deep water, you may find yourself drowning. Perhaps you’re in a place where you absolutely need capital — as in, you need to fund your company now, or you’re not going to eat — and this is it. This is your only offer, your only life preserver.

Well, congratulations. You played yourself.

To avoid this fate, understand the capital structure of your company, then build your criteria for who you want as a partner. Then, in the case that you want traditional venture capital, approach your prospective partners as part of a process. You’re not just going to a random venture guy whose job is to broker people and information and to get in on things.

Those guys aren’t always qualified, so qualify them yourself. Then, identify multiple investment targets prior to engagement, so you control process and structure.

Talk to several different, but qualified prospective investors. With more and better choices comes better terms and a better fit for your criteria, which at this point you’ve sharpened.

Some quick tips for your process:

  • You’re going to want to talk to VCs who invest in your space, and stage. Think about more than just the brand name of the VC firm. Dig deeper, because more important than the brand name is the specific partner you’re working with. These partners are essentially running their own franchise under that brand name.

  • Does the partner and the firm invest in your space? Do they have a good track record? Are they good for the specific stage you’re at? Do they have operating experience?

If you do this right, it will be on your terms. You’ll pick your investment partners, as opposed to you being picked.

Understand your founding team. You want people to bring different things to the table.

In a startup, there are two types of roles: you’re either building or selling.

You’re either getting customers in the door, or you’re making a product that delivers value to the customer. If you don't fill one of those roles, you don’t belong in.

It’s okay to have multiple people wear multiple hats. You can have multiple people who understand product. They can both be voices in the room, but one needs to be the final decision-maker.

It goes without saying, but make sure you have your bases covered. Any area where your founding team falls short — whether it’s functional or domain-specific — needs to be accounted for.

Complement your existing team with the right people, and make sure you find an investment partner who can help you do that.

If you follow these steps, you’re in good shape.

If you meet the capital demands of your company, develop a sharp criteria, run parallel processes, and compliment your team correctly, you’re moving in the right direction.

And you may be ready to create something life-changing.

How venture capitalists make money and why it matters to you

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All venture investors’ actions relate to one prevailing goal: how do you help me raise my next fund?

Successful companies require 3 ingredients: the right idea at the right time with the right team. While the first two ingredients are no doubt important, in order to achieve any level of success, it requires a great team with a common goal.

Most tech startups look to raise investment capital to finance their product development, go-to-market, and to scale growth. As you may have read in many technology-focused publications, building a large, enterprise technology company usually requires in the tens to hundreds of millions to billions of dollars in investment capital. And for every round of investment dollars raised, a company adds another team member. A board member. Their new venture investor. 

Adding the right venture investor to your company’s board can be immensely valuable. The right investor can make all the difference when it comes to: 

  • Recruiting the best team
  • Getting access to customers
  • Honing your go-to-market strategy
  • Helping your company achieve a great outcome

It’s important to remember that venture capital firms are also businesses just like the companies they invest in. While venture capitalists do want to help your company be successful, they’re really in the business of raising more venture funds.

Venture firms are driven to build the most oversubscribed venture fund and make a lot of money doing it. However, a venture fund’s business model is quite different from traditional businesses. If you learn how venture investors make money, you'll understand what motivates the decisions they'll make while working with your company.

How VCs make money: a breakdown

Venture capitalists make money in 2 ways: carried interest on their fund’s return and a fee for managing a fund’s capital. If all goes well, your company is going to experience a liquidity event in the form of an M&A transaction or an IPO. At the point of your company’s liquidity, investors are paid their equity portion of the company’s proceeds (cash, stock, etc.).

Venture capitalists make money in 2 ways: carried interest on their fund’s return and a fee for managing a fund’s capital.

Investors invest in your company believing (hoping) that the liquidity event will be large enough to return a significant portion: all of or in excess of their original investment fund. Once an investor has returned their investor’s capital, they begin to earn carried interest on the returns in excess of their fund size.

Carried Interest

Carried interest is the most lucrative way a venture investor makes money. Traditionally, venture investors earn 20% carried interest on their fund. That means if a fund’s size is $100mm, venture investors earn $0.20 on every dollar earned over $100mm. So if a venture fund can return $300mm on their $100mm fund, they will earn $40mm in carried interest (($300mm return - $100mm original investment) * 20% = $40mm).

Successful companies require 3 ingredients: the right idea at the right time with the right team.

Management Fees

The second way venture investors make money is from a management fee. A venture fund is a pool of capital invested by high net worth individuals, fund of funds, endowments, retirement funds, etc. These investors in a venture fund are known as Limited Partners or LPs. When a venture fund raises capital, it charges its LPs a fee for having venture investors invest and manage investments in startups.

Traditionally venture funds will charge their investors 2% per year of the total value of a fund. Using the previous example of a $100mm fund, the venture firm will earn $2mm per year to pay salaries and other operational expenses of the fund ($100mm * 20% = $2mm per year).

Management fees become more lucrative to venture investors when a venture firm manages multiple funds simultaneously. Typically venture firms try to raise a new fund every 2 to 3 years with the lifespan of a fund being 7 - 10 years. Oftentimes, you’ll see in tech publications that “Great VC” has just closed its new $100mm fund called “Great VC II”.

This means that Great VC has raised its second fund and is likely still managing its first fund: Great VC I and now Great VC II. Let’s assume that Great VC has two active funds at $100mm each. Assuming the same 2% fee, Great VC is making $4mm per year in fees for managing two $100mm funds (2 funds * $100mm * 2% = $4mm).

Picking your investor strategically

All venture investors’ actions relate to one prevailing goal: how do you help me raise my next fund? As demonstrated above, an actively managed fund creates a steady income stream for venture investors. If investors can layer multiple active funds on top of one another, the income stream becomes even more lucrative.

In order to accomplish a successful fundraise, venture investors need to show traction. Traction in the business of venture capital comes in the form of liquid capital returns in excess of the size of their fund, or more likely, the perception of liquid returns that have the potential to return their fund many times over.

As an entrepreneur raising capital, you need to be as strategic as possible when adding an investor to your team. Never forget: size matters. The size of the fund your investment is coming from. The size of the investment you’re asking for. The size of the valuation you’d like to get for that investment. All of these data points will indicate an investor’s actions.

For those raising their first round of capital, taking money from a large fund could pose potential optionality problems if a lucrative sale opportunity arises early in the lifecycle of your company. Typically investors will include a blocking right in your investment agreement that gives them the ability to say yes or no to a sale or even a future fundraise for your company.

Never forget: size matters. The size of the fund your investment is coming from. The size of the investment you’re asking for. The size of the valuation you’d like to get for that investment.

As an example, let’s stick with our Great VC investors and say that they led your seed round for $1mm at a $5mm post-money valuation. Otherwise put, they purchased 20% of your company for $1mm.

In this example, the founders and team own 80% of the company’s equity (which includes any employee stock options and option pool). Over the course of the first 12 - 18 months building your company, a potential acquirer comes along to buy it for $30mm. That would mean, if sold, the investor would earn $6mm (20% * $30mm = $6mm) and the founders and team would earn $24mm (80% * $30mm = $24mm).

That’s a life changing amount of money for the founders and a good return on stock options for employees. However to Great VC, who has to return a $100mm fund, $6mm return from one of their investments only gets them 6% of the way to returning their fund. If you, the founders, decide to take the money off the table and sell your company, the investor has to make a decision on either going along with the sale of the company or convincing you to forego the sale and continue building your company into an asset of greater value.

To sell your company or to continue raising? That is the question

Rather than selling, Great VC would likely prefer your company raises its next round of financing. They may tell you that this offer is an indicator of having the right tech at the right time and we are on our way to a $1B exit. That logic could totally be true. There is no way of knowing unless you try. But my point is to make sure you’re aware of why the venture investor may be telling you to go long with your company.

...the ABC’s of venture capital: Always Be Closing your next fund.

A $6mm return on a $30mm exit only gets their fund 6% of the way to being returned ($6mm / $100mm = 6%). If you instead raised a $6mm Series A at a $30mm post-money valuation, the investor gets to go back to their LPs and show how their investment has created a 5x uptick in value over 12 -18 months (($30mm - $5mm) / $5mm = 5x). That kind of uptick becomes investor deck material for their LPs.

Your company has become an indicator of a positive investment they’ve made tracking to potentially offer a massive return for the fund. Great VC might then suggest to their LPs “How about writing us another check for Great VC Fund III so you can continue getting access to these types of deals?” The suggestion to contribute to another fund is also known as the ABC’s of venture capital: Always Be Closing your next fund.

Understanding how the money is made

The point of this piece isn’t to say venture investors are bad. Rather, a good investor with the right motives and alignment with your company can be extremely helpful. Just make sure you’re cognizant that venture investors are running a business like you.

If you’re raising venture investment, it’s important that you, the entrepreneur, are educated on the business of venture capital. The more you understand about the motives driving your investor, the better prepared you’ll be to handle the inevitable conversations that will arise on your journey of building a successful company.

Cyber Security Practitioner Series: DNS Analytics, What It Is And Why Is It Important?

We are proud to sponsor and support Hack Secure's ongoing mission to cultivate and support the U.S. cyber security community. Part of that sponsorship is working with Hack Secure to connect with cyber security leaders to share their thoughts on different aspects of the security landscape.

For their next installment in the Cyber Security Practitioner Series, they interviewed AlphaSOC co-founder Chris McNab about DNS (Domain Name Server) analytics, it's importance, and what AlphaSOC is doing about it. 

To check out the interview click the link below:

The Secret to Building a Successful Company

As an entrepreneur, my goal is to build successful companies. My assumption is that you’re reading this because you want to build a successful company too. So what’s the secret? Define what success means to you.

For the past 3 years I’ve had the opportunity to work in venture capital. I talk to entrepreneurs every day who are looking to raise early stage investment funding. The question that I lean on to learn how an entrepreneur views success is: Why are you building this company?

I hear all kinds of answers. Some “want to change the world”, some have felt the pain of the problem they’re trying to solve, some are looking to escape their current job, some think they have the next disruptive technology while others want to be the next Snapchat, Facebook, Amazon, etc. None of these answers are right or wrong. Rather, these answers are informative of what’s important to the entrepreneur and the potential choices they’ll make in the future.

In my opinion, all of these answers can be distilled into two categories: ego and money.

We live in a startup culture where we’re enraptured with on-paper success. We love reading about the latest fundraising announcement that floods our daily newsletters, blogs and twitter feeds. We can’t stop talking about “Unicorn” companies who have been valued at over $1B. We idolize the founders and investors who have built these iconic brands and go to conferences to learn more about how they built their “Unicorn”.

Indexing on big valuations as an indicator of success is the ego part of building a company. The larger the valuation and the more capital a company has raised leads to more publicity for the company’s brand, founders and investors. However, viewing fundraising as a measure of success misses the mark on what I would consider the most important metric: maximizing shareholder return. Otherwise known as... Money.

Every time an entrepreneur raises capital, at a higher valuation, the ability to generate liquidity for their shareholders becomes much more difficult. Shareholders (that includes founders, investors, employee option holders) are looking for a return on their investment (time spent working at the company and dollars invested). As a company’s valuation increases, the entrepreneur’s options for creating liquidity for their shareholders decreases as the number of acquirers able to pay for the company decreases.

Raising money and increasing one’s valuation is not necessarily a bad choice so long as the entrepreneur is cognizant of how they’re going to be able to create a considerable amount of additional value that they can ultimately return to their shareholders in the form of liquid capital.

When setting out to start a company, we all strive to build something successful. The real questions is, what do you consider success? My advice to entrepreneurs is, if you want to build a successful company, focus more on figuring out how you’ll ultimately create liquid value for yourself and the rest of your shareholders as opposed to boasting about that flashy fundraising valuation.

Cyber Security Practitioner Series: Information Security as a Revenue Driver for the Enterprise

We are proud to sponsor and support Hack Secure's ongoing mission to cultivate and support the U.S. cyber security community. Part of that sponsorship is working with Hack Secure to connect with cyber security leaders to share their thoughts on different aspects of the security landscape.

The first interview in this series is with Brian Castagna, Director of Information Security at Oracle Bare Metal Cloud. Brian is a big advocate for leveraging a strong information security program as a revenue driver. Check out his interview with Hack Secure to learn more.