The venture capital ecosystem is a hall of secrets. The rise of the venture capital blogger, notably Union Square Venture’s Fred Wilson, entrepreneur-turned-VC Mark Suster and Foundry Group’s Brad Feld, is a welcome first step in providing budding entrepreneurs a view into the venture world.
But they are the exception to the rule. For the most part, VCs prefer to keep their entrepreneurs in the dark about how the process really works for one simple reason: it benefits them greatly.
My company, Buddy Media, raised $28 million last month. I’ve now closed about 10 rounds of financing for three different companies. With the most recent process still fresh in my mind, I have decided to use the experience to provide transparency into the major leagues of VC fundraising. Pulling back the curtain on the fundraising process will help entrepreneurs create more investment-worthy companies that can become large enterprises. That’s good for founders. It’s also good for the nation’s economy, contributing to rapid job creation and continued innovation.
What follows is an anatomy of a fundraiser. I’ve come up with eight lessons, all of which should help entrepreneurs — and some of which should benefit VCs, too. If you just want the top lines, they are:
- Be deliberate about who you raise money from
- Remember that VCs are pack animals
- Bond with the associates
- Avoid the shotgun marriage
- Be sceptical and don’t always trust VCs
- For the VCs: Be good and you’ll do well
- realise that valuation isn’t the only thing
- Think carefully about raising money from partners
But I’d recommend reading on for this entrepreneur’s guide to the VC galaxy.
If Buddy Media were the first company we had started, we may have looked to sell. But we feel strongly that this is just the beginning.
SINCE I FOUNDED BUDDY MEDIA three years ago, I have received an email or phone call from a new fund looking to invest nearly every week. The activity heated up this past July when I received strong interest from three leading late-stage venture capital funds -- as well as two hedge funds -- in the space of two weeks. These investors weren't just on fact-finding missions. They all had done their research and were actively looking to invest in my space.
At the July 29 Buddy Media board meeting I proposed we raise additional capital for several reasons. Specifically, the industry we are attacking -- tools and platforms that help businesses market on the large social media sites like Facebook and Twitter -- was heating up. We've seen very little competition to date but large companies surely will enter the space in the near future.
Meanwhile, our revenue and cash flow were all increasing dramatically, as was our headcount. Despite being cash flow positive, we had reached a place as a company where we had to decided if we wanted to sell the business, grow incrementally, or raise a war chest to attack our market.
If Buddy Media were the first company I had started with my wife, Kass, we may have looked to sell. But we feel strongly that this is just the beginning. We wanted to go for it. The board agreed with us and approved a $10 million to $20 million fundraise with the following stipulations, which I agreed to. No. 1: We keep the list of potential investors small (3-5 firms); No. 2: Each firm signed an NDA (something I normally do not advise); and No. 3: We all agreed which companies were let into the process.
Raising money is not an end in and of itself. It's the means to an end, the end being to create a monster business that we take public or sell for loads of cash or liquid stock. I've been starting and running tech companies since I was at sophomore at Northwestern and have observed a cycle that plays out in every emerging sector of tech -- from AOL's dial-up business to Google's context-driven advertising model.
The cycle is this: A sole company is funded. VCs learn the business and the approach of the founders, and get excited about the new market, and invest in a slew of competitors. Then the funded companies attack each other and the whole sector becomes a race to the bottom. One company remains the dominant player (AOL (AOL), Yahoo (YHOO), Google (GOOG), Omniture, etc.) and the others either shrivel and die, or are sold at a valuation at or below their last round of financing. I'm not interested in being No. 2 in a race where there's only a nominal prize for second place.
By signing NDAs with all prospective investors and only speaking to firms I already knew, I was making sure that I didn't educate the market about why we were crushing it, thereby creating newly educated investors who could take our game plan and go fund our competition. This will probably happen anyway but I'm more confident in Buddy Media at this time for many reasons, some of which we've talked about, and many others I'm not going to write about here for competitive reasons. (Sorry, but that's another lesson: Only the paranoid survive!)
I was confident that each of the investors I spoke to either would do our deal, or do no deal in my direct space as they didn't want to fund a business to compete with Kass, my wife and business partner, who is the best operator of rapidly expanding companies I have ever met.
Despite what many founders may think, today's venture market is a 'sellers' market. The demand to invest -- the amount of money looking for deals -- far outstrips the supply of quality deals. This doesn't mean that your ideas will attract funding, or that you will continue to be funded after your company hits the next stage. The two best times to raise money -- at least in the current fundraising environment -- are for seed capital (sell the dream!) and growth equity (fund the growth!).
We are in a bubble for early-stage deals that have a ton of promise. The traditional seed investors (friends and family members who want exposure to the space) have been joined by an army of seed funds, micro VCs and successful entrepreneurs plowing capital back into the ecosystem. In short, it's a great time to be an entrepreneur -- whether your company exists on the back of a napkin or is nearly pre-IPO.
For the former, accelerator programs like 500 Startups, Techstars, and Y Combinator, are providing both seed money and direction -- think business-building boot camp to early stage startups. Crazy man Dave McClure's 500 Startups will fund 60-plus companies this year alone.
I'm also seeing the same activity for late-stage deals that need capital to grow. Those founders therefore control much of the leverage when you are selling the promise of what you will do, or raising money to fund the execution of an idea that has significant marketplace traction.
VCs need to invest the money committed to them by limited partners to make real money. But most great VCs are extremely disciplined and only invest in businesses that can rapidly scale and grow revenues, and eventually profits, for the next three to five years at a minimum. If your growth flat-lines, you're dead to VCs. Don't even try to raise money. Save your time and either run it as a profitable business or figure out a new plan to sell the future or the business outright.
Fortunately, fundraising has not been an issue for Buddy Media. When we first started, we sold the promise of Facebook. We felt strongly that Facebook would be an enormous business. And companies would need to figure out a way to tap into it to grow their businesses. This helped us raise an initial super seed round in October 2007 of $1.7 million from an amazing group of seed investors: Facebook board member Peter Thiel, Zynga CEO Mark Pincus, Stocktwits' Howard Lindzon, Bay Partners, Brian Bedol, Roger Ehrenberg, several of investors from an earlier venture and others. A few months later, in April 2008, still selling the promise, we closed a $6 million Series B with Softbank Capital, Greycroft Partners, Ron Conway and European Founders Fund.
We found our business model in March 2009 with the launch of Facebook Pages and our own Facebook Page Management System. We added headcount, signed up clients and started to gain some market traction -- what many call the 'product/market fit.' Earlier this year, we were confident that we had a business with a scalable, repeatable business model. However, it was still a bit unproven. So we decided to do a small inside round of $2 million to fund further growth while letting us execute the model and let our story play out.
And execute we did. We went from 30 people to 100 people in less than a year. We signed up 8 of the top 10 global advertisers to use the Buddy Media Platform to manage their Facebook marketing efforts across their organisation, as well as over 500 other clients and agencies. And we saw our revenues soar, growing 15 per cent a month on average. We knew we had something that was valuable and hard to replicate in the most vibrant part of the $50 billion-plus digital marketing ecosystem.
As we started to talk to our short list of investors about our Series C round, we were blown away by the amount of capital looking for a home. And that money wanted to be in companies just like ours: ones with a large market, room to grow, repeatable and proven business model, 90%-plus recurring revenue, run by experienced entrepreneurs with significant support from existing shareholders, partners and clients.
For me, this stage of entrepreneurship is the most exciting yet. You have a business model, so you are no longer a startup burning money. You are paying yourself a real salary so you can feed yourself and your family, even if you're still taking a hit compared to your worth on the open market. And, for the first time, you can start to feel the financial value you have created for your family. I got the same feelings I first felt when my first company, U-Wire, started to take off nationwide, and later at Golf.com when companies started to approach us with acquisition interest.
At this time, I put together a short slide deck that complemented my management dashboard and financial projections and started to talk to several firms. The names aren't important, but the dynamics are hugely important.
Buddy Media investor and board member Roger Ehrenberg and I put together a short list of five firms we wanted to talk to. Take note: All of these firms had taken the time to reach out and get to know us before we needed their money. Here are the big lessons I have learned over the years, many of which were confirmed in this most recent fundraising process:
The most well-known venture investors aren't necessarily the best for your business. Don't waste your time trying to get in front of investors who aren't interested in your space or can't help grow your business. Plus, most investors only talk to companies that come in through a trusted source. Don't have a connection? Move on.
No matter how hot you are as a company, raising money takes time. And that distraction can often cause founders to lose focus to the detriment of other employees and the company. Assume you will need to do four meetings with each firm you speak to get to the almighty term sheet, or the official document that outlines the terms of a business agreement.
The first meeting is with a partner or associate. This is the screening meeting where within the first five minutes the lead person on the deal will make a decision whether they want to spend time pushing it forward or not. Be animated. Be excited. Show some passion. And know your numbers cold. You'll know if they're interested right away. Signs that they are interested: they ask questions and ask to see the product, they start making introductions to their network or they call in a colleague to meet you. Signs that you're screwed: they are on their Blackberry, they say that they love the idea but need to think about whether it fits their investment goals or if they fall asleep (Yes, that's happened to me and yes, they rejected me).
Once you have a deal champion, you will need to do another meeting with the lead on the deal to answer any questions that may come up and to further vet the idea. If the lead still wants to do the deal after that meeting, you move to the third meeting, which I call the 'Am I crazy to want to do this deal?' meeting. The lead wants to make sure that he or she can get someone else to support the deal. Will someone else go to bat for the deal and support it?
That 'someone else' could be one other person or a larger group of three to four partners, depending on the firm. After the third meeting, you will be asked to come back to present to the entire partnership. This meeting sounds like the scariest but is actually the easiest. If you get to this meeting, they're looking to do the deal. You have them at the one-yard line. Short of throwing up on the conference table or offending one of the partners, you will get a term sheet after this meeting. Going into this meeting, you have a deal champion at the firm who has sat through hundreds of full-partnership meetings, now knows your business and will prep you for potential questions, tell you who you need to win over, let you know about the partner dynamics and who you need to ignore. (There's always at least one at every firm who none of the other partners really respect. If you are a VC reading this and don't know who that person is in your firm, well…). Lastly, by the time you give this meeting, you have done your dog and pony show so many times that you can pretty much do it in your sleep.
I started to speak to five firms and added three others as the process went on and word got out. How did word get out if we were under NDA? Simple. VCs like social validation to get a deal done and the only way to get that is to talk to others outside their firm. This always seemed silly to me -- why tell your competition about what you're working on? Increased competition creates more demand and higher valuations. It makes no sense, but many VCs seem to be willing to trade off some profit for the validation of their peers.
Yet the best firms make their own decisions. They get to know the companies before they invest. This was the case with Institutional Venture Partners (IVP), our new investor that lead our most recent Series C financing.
Jules Maltz started a company at Stanford in the social advertising space. We met at the time and I was impressed with him. Jules then joined IVP as an associate and attended a party we gave in New York in the summer of 2009. From then on, he continued to reach out to touch base and make introductions.
Jules wasn't trying to sell IVP. He was trying to build a relationship more than a year before we were in the market for money. This is the single most important thing you should look for in a VC as an entrepreneur. You will get a ton of calls from investors, but there are just three main reasons they will call:
- They are looking to invest in a competitor and want to dig up information on what you are doing.
- They are researching the space and doing background work to put together an investment thesis.
- They are genuinely interested in your company.
The first two points are most common. Rarely are VCs really concerned with your business. Remember, they're pack animals; only interested if others say they should be interested. Make sure you ask their intentions upfront and don't assume they're attracted just because you get a call. Ask them the following question, 'Are you actively talking to any of my competitors about funding their business?' If they hesitate, the answer is yes, they are. If they say no immediately, they're usually telling the truth -- more on that later.
Many firms actually employee associates whose primary job is to cold call every company, set up meetings and use your valuable time to get educated on the market. They can take 50 meetings to learn the landscape for just one deal. You can't. You have a business to run and there's a fine line between building relationships with VCs and giving them too much information.
Because of my history with Jules, I knew he was interested in Buddy Media, not just the space. I had no idea how interested until he flew to New York to have dinner with me, Kass, and Ian Sigalow from Greycroft Partners, a current investor. That relationship was a primary reason that Kass and I chose IVP over several other great firms that any tech startup would kill to work with.
Jules isn't a partner at the firm. He looks like he's the 20-year-old love child of Julianne Moore and Tyler Ferguson. As an associate, or 'investment professional,' at IVP, he's supporting the general partners who ultimately make the investment decisions. Associates source ideas and deals for the firm, meet with entrepreneurs, draft investment books and conduct due diligence. But that's the only way to learn the business and become a great, great investor. As far as grunt work goes, it's not bad. Associates bet their credibility and their future on the companies that they go to bat for. I clearly want my companies to succeed for what that means for my employees and me. But it helps to have your interests aligned with an associate who wants you to succeed so he can look like a stud.
Associates like Jules are the ones I find most important to me as the entrepreneur. Associates like Ian Sigalow at Alan Patricoff's Greycroft challenged us when our business model needed work and has been invaluable to me as a friend and mentor. (No surprise, he's now a partner there.) Others like Softbank Capital's Karin Klein -- now at Bloomberg -- and Joe Medved spent countless hours providing advice and honing our financial models.
In any relationship, communication is key. Great VCs understand this. I knew where IVP stood at all times. They expressed interest in the company. The interest seemed to grow the more I shared. All questions and concerns were communicated clearly. There was no BS. And they closed in three weeks from signing a term sheet, which is truly amazing.
On the other end of the spectrum were firms that wanted to lock us up. They were interested in getting us to sign a term sheet so they could do their due diligence and figure out if they wanted to do the deal, which they heard was going to be a hot one. Do not sign term sheets that lock you into an exclusive negotiation period without being 100% confident in your gut that the deal will close. Many firms will throw awesome terms at you -- a high valuation, more management options, founder-friendly preferences (I'll explain those later) -- only to come back a month later and change them, or, better yet, pull out all together.
One of the firms I most expected to get a deal done with tried this with me. It turned me off completely. We had developed a nice relationship. I told the partner clearly that I was interested in getting a deal done. But the deal terms being floated were complicated and they were desperate to get me to agree to a deal. Here's one that came in via email: 'Would you consider a participating security with a low threshold for kick-out (2.5x maybe)?' What does that even mean?
As it turns out, any kick-out is a bad way to start a relationship. Setting a low threshold for that kick-out sounds even worse. I didn't even know what a kick-out was, and despite Roger educating me -- it has to do with the elimination of some anti-founder terms if our value exceeds a certain level when we sell or go public -- I still don't completely get it.
I don't blame the partner for trying. But the constant attempts to get exclusivity rather than simply get a real deal done killed any chance we had of working together. It also didn't help that this one firm complained about the valuation. Complaining about valuations is like complaining about the weather. Valuations are what they are. It's pure market dynamics. If four other firms say the valuation is X and the other says it's X times 0.7, there's not much I can say other than it is what it is and the market has spoken.
If a firm says it wants to work with you but tries to lock you up, that's a sign. It's a sign that the VCs are not confident in their ability to get a deal done. They aren't confident that they are the right firm. They aren't confident that they bring the most value to you. This is called a shotgun wedding: they come in fast and hard and try to get you to commit. In my experience, this doesn't work. You need to go on a few dates. You need to spend some time together. And if it feels right, go with your gut. If you feel nervous or pressured, pull away and keep looking.
How do you respond to the aggressive advances? I don't know if there is a single right answer. But I usually keep it short and say stuff like 'As I said yesterday, if you're interested, just put your best foot forward and let's go from there.' Or even, 'As you know, this is a competitive process. I really look forward to working with you and just ask that you put together the best offer that works for you.'
LESSON 5: Though I do not have the conclusive scientific evidence, VCs are people too. But don't trust them.
Even worse than a firm that demands exclusivity is the firm that talks to every company in a space so it can use the information to fund one and compete against the others. That also happened with our last round. The associates and partners of one of the firms had courted Buddy Media for more than a year. They invited me to their CEO forum, which I enjoyed greatly. We had one phone call and at least two meetings at my office. They attended our events. I was truly excited to work with them. Genuinely excited.
After we met, they requested additional information from me. I didn't have all of the information prepared yet, and I needed board approval to disclose it, which I told the firm and thought we were on the same page. A few weeks later, I sent an NDA so that I could share the information. I told them clearly that they would get no information without an NDA. One of their partners called me to inform me that they were far down the road with one of my 'competitors' -- this is just a few weeks later, which shocked me! -- and wanted me to tell them why they should invest in Buddy Media and not the other company.
'If you have conviction that Buddy Media is the best company in the space, I don't understand why you wouldn't take the time to demonstrate that to us without sharing any highly sensitive information,' he emailed me after I told him I had no interest in meeting further. That's like asking a spurned date to prove why she should date you. No thanks.
My job is to grow my business, not to sabotage other deals.
I go back to IVP for this lesson. The firm respected our desire to talk to several other firms and never pressured us to sign something to lock us up. Not once did it try to force an exclusive negotiation.
How powerful is this approach by a VC? So powerful that we decided to do a deal with IVP at a valuation that was about 10% less than the other term sheets' average. We also went with IVP for other reasons that are important to mention:
- The terms were very simple and friendly and treated the management team, employees and existing shareholders with respect for the business we built. They agreed to receive the same preferences as the other investors and were not asking for additional rights. They wanted to join the party, not crash it.
- They had just announced a new $750 million fund. I have raised many rounds at various stages of the fund life. I assure you that being at the beginning of a large fund like this is much better than being at the end. If you are the first investment in a new fund, which we were for IVP, the firm has plenty of ammo to support you in the future. If you are at the end, you're on your own. You can't always control where you are but given that we had options, this was a nice bonus.
- I knew many of their current CEOs, all of which have enjoyed working with IVP, including the Twitter team, Mark Pincus of Zynga and Howard Lerman of Yext, which, coincidentally, shared a building with Buddy Media when we both were startups.
- They had funded two of the most important businesses in social media at valuations that seemed high at the time but now seem low -- Twitter and Zynga. They clearly have a knack for picking winners. Going with a firm that has a track record of helping to build winning businesses improves your chance of winning as an entrepreneur. I have found that winners invest in winners and losers invest in losers. The difference between the best firms, like IVP, and the decent firms is enormous and demonstrable.
What are the terms that are important to me as an entrepreneur? The first is valuation. The offer needs to be in the ballpark (plus-or-minus 10% of where I think the market bears). The second is the participation preference. When money is invested into your company as equity, there are many ways to structure it. Investors can buy common or preferred stock. Most investors will get preferred. And certain rights usually come with the preferred stock that the common shares don't have.
When preferred stock is 'participating preferred,' it typically means that the investor gets his money back first and participates pro rata in the proceeds based on his percentage interest. It's what I often call 'double dipping.' 'Non participating preferred' typically means that they get their money back or they convert to common and participate pro rata based on percentage interest. They are protected on the down side while participating based on their ownership percentage on the way up.
How does this play out in real life?
Say a company raised $28 million at a $100 million valuation and sold the business for $500 million down the road. The new investors own about 22% of the company on a post-money basis (28 divided by 128). With 'participating preferred,' the new investors would get $28 million back first and then 22% of the rest, or $103.8 million, for a total of $131.8 million. If they get straight preferred, the new investors would get 22% of the $500 million, or $110 million. That's a difference of $21.8 million. And guess whose pocket the $21.8 million comes out of? You got it. Kass and me, my employees who busted their arse to make it happen and the early investors who took a much higher risk early on. The same argument holds true if we sell the business for a lower number or a much higher number.
IVP was the only investor of all the term sheets that came in with straight preferred stock at first. Brilliant move on their part, I thought. It showed real commitment to the deal as well as to Kass and me. All of the others wanted distribution preferences, at least partial participation preferences and other anti-founder provisions. This showed me that IVP was as excited about my business as I was.
Jules from IVP flew to New York to deliver the term sheet. We grabbed a late bite on the Upper West Side and walked through the details. I'd encourage all VCs to deliver the term sheet in person. It's a great way make sure the terms are fully understood. Jules' excitement was contagious. As he presented the term sheet, it was as if he was receiving the money and not the other way around.
You wouldn't date a woman for a year and then ask her to marry you by getting on your knees and giving her a huge five carat diamond ring with a thorny prenuptial agreement attached via fishing wire. So why would any VC give an entrepreneur a term sheet saying how excited they are to work with you, with a high valuation and include terms that say 'Screw You'? The answer is simple: most entrepreneurs don't know any better.
Typically, when you push back on terms, the response is, 'We get this in all our deals.' Your response as an entrepreneur should be, 'Well, we don't always get what everything we want in life.' Remember, it's your company. You're going to be the one flying around the world chasing the deals and putting your personal relationships and health at risk so that you can make some money to live the life you choose and be free of the day-to-day boredom that dominates most people's lives at work.
They put in the money. You put in your time. They value their money. But you should value your time much more than their money. They have dozens of deals. You have one. If one of their deals go bad, they have others to create awesome returns. If your company goes under or you do a bad deal, you lose five to 10 years of your life, and if you're like me, a lot of hair on your head!
Of course, the market ultimately determines the terms. If the only way you can get money is by doing a deal full of catches, then do it. You don't have much to risk. It's only a piece of the upside or a share of whatever's left on the downside. But know it's worth exploring every option before you sign something like that.
In addition to the financial investors, I had a strategic partner and investor very interested as well. Earlier this year, the world's largest marketing services firm, WPP, decided to get serious about social marketing and, after an exhaustive review of all the players in the social management system space, selected Buddy Media as their exclusive partner.
Typically, I don't like mixing business partners and investors. This often creates strange bedfellows as strategic investors often ask for stock with separate rights and protective provisions to hold up sales, preferred treatment and more. I decided to move forward with a $5 million WPP investment, despite working with all of WPP's direct competitors, for several reasons:
- The investment was very important to WPP. They did a similar deal with Omniture in 2009 that ended with a $2 billion acquisition by Adobe. The model seems to work for them and motivates them to help grow our business and theirs.
- I really didn't need the money. This wasn't a case of becoming a WPP company. They agreed to join as a follow-on to the Series C financing with no additional rights. I felt comfortable that this was both an offensive and defensive deal for Buddy Media and my good friends at WPP's competitors would understand that I'm running and business and need to make the right decisions for the business.
- WPP was committing to Buddy Media in good faith, not locking us into an exclusive relationship, and agreeing to let us grow the business the way we needed, both legally and in spirit. So we let them in as a powerful partner that could streamline and accelerate the way we work with their 140,000 employees and hundreds of agencies.
The Buddy Media Series C fundraise was a great process. But I'm glad it's over. Raising money is hard on the company as the CEO and key employees need to spend a lot of time tending to it. And it's hard on the family as vacations are cut short, business travel increases and long-hours talking to lawyers create grumpy mums, dads, sons, husbands and friends. But if you are going to be a great entrepreneur, you need to dominate the fundraising process. You need to feel as comfortable selling shares of the company as you do your product.
In the end, the founder has three main roles at the company. The first is to make sure the company does not run out of money. The second is to make sure the company does not run out of money. The third is the make sure the company does not run out of money.
You work for a living. The people funding you invest for a living. They're better at getting what they want in deals because they do it for a living. But entrepreneurs can make up some of that gap by educating themselves, getting smarter through experience, talking to other entrepreneurs about what works and what doesn't and who are the good guys and gals in the VC world and who aren't. Only then will founders be able to take back the power in the process.
Michael Lazerow is the CEO of Buddy Media, which is based in New York. You can read his complete bio here. For those founders who want to offer their own lessons and learn from peers, he has set up a private Facebook group called 'Founders Only.' It can be located at http://on.fb.me/aw0JvC. The group is open only to those founders currently running a company -- not investors -- and aims to aid in knowledge sharing.
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