Process Leverage and Fundraising
In any negotiation, legal leverage is the pressure you place on the other party to achieve your desired outcome. While leverage isn't the only thing that matters, it is a very powerful, yet underutilized, tool. It is important to understand when and where to use leverage while fundraising. Many of my founder clients, especially first-time founders, don't think systematically about leverage.
You can generate leverage from numerous sources, however, when it comes to fundraising leverage, it's best to effectively use an investor's fear of missing out on an outlier company. Most venture returns are driven by a tiny number of companies, so investors understand the need to invest in those companies in order to make money.
The trick is to convince investors that your company will be one of these outliers. The way you do this depends slightly on stage, but always comes down to a mix of traction, vision, team, product and market opportunity. Founders that combine these elements in such a way, make their success appear inevitable and thus, have more leverage while raising money.
I used to think that founders were limited to these five elements when raising money, but the YC Series A Program uncovered that running a tight process will materially influence the leverage a founder has in any round. However, running a tight process is a deceptively complex task. It seems quite simple on the surface, but without conscious focus, founders invariably screw it up.
Process is important because it highlights the best opportunity to create a market for startups that favors the founders in the most important aspect of raising money: getting the right investor. A seemingly “good” market can influence price, but the quality of the investor is the most important target of leverage.
The difference between a market that favors founders vs one that favors investors is not the difference between an open and closed market. The difference is based on who has more information about -and control over- the process of the raise.
Serial Fundraising shifts markets to investors.
Early stage startups are normally operating in markets that favor investors. Founders usually pitch serially, as they convince other investors to meet and hear a pitch. Each time the founder walks into a meeting with another investor, the investor is in full control of whether or not to make the investment.
As founders prepare to meet with potential investors, chances are that information about the company has reached the incremental investor before the meeting. Networks of investors are often very small and collaborative, thus providing each investor with an information advantage. This company has either a) been passed on before or b) is gaining momentum.
In this dynamic, the investor has total ability to set the process and the terms. This is a great place for an investor to be. If the deal is slow, there's no need to act quickly. If the deal is moving quickly, the investor gets to enter a bid with significant knowledge of terms and capacity.
Parallel fundraising tilts markets to founders.
Founders who are able to reverse the information advantage create markets in their favor. When founders create the same starting point for a large number of investors, the investors are forced to operate in parallel. This means that any information investors get their hands on has less time to spread through the network, forcing investors to make their own decisions.
Investors are not able to get a sense of how quickly the market is moving, so they need to make decisions under the assumption that it is. If they don't operate under this assumption, then they'll lose the chance to invest in this possible outlier and someone else will grab it.
This kind of opacity creates a competitive dynamic in a group of people - investors - who are extremely competitive. The advantage is now in favor of founders.
YC took this idea further by batching companies. Their companies fundraise together, so they're willing to provide information about where the market is at any given time. It could be thought of as a union for startups where collective bargaining positions are created.
Investors are incentivized to stop founder tilted markets from forming. This gives founders significant leverage during the market's existence, and just before it is created. Founders can create this type of dynamic whenever they raise.
Series A Process
Now, let's talk about the big day, or “Demo Day”, rather. I've always thought founder tilted markets required an actual Demo Day, until being introduced to the Series A Program. What I've come to realize is that Demo Day isn't necessarily about the day or the number of investors. What's most important is the process Demo Day forces founders and investors to participate. This dynamic can be recreated by founders whenever they are raising by making sure the number of investors getting first time access to the company at the same time is greater than 1.
I typically advise founders to select 15-20 investors who they think will, one day, be the right partners for the company. There are techniques which can help founders figure out who these investors are, and it starts with other founders. Connect with founders in the same industry and find out who is helpful and who simply writes checks. Try and read posts from investors to learn what they are interested in, and what they are currently talking about.
Before the actual raise, founders should take the time to meet with a subset of those investors. By working through that subset, founders can identify who they'd like to work with. Founders must impress and capture the investors, but also be careful not to share too much information so that the investor is ready to make a decision. Part of this is done by communicating a clear timeline for when fundraising will begin.
Pre-fundraising meetings are incredibly valuable, but not to be confused with actual fundraising. I've had founders tell me the best way to raise an A is to have lots of social conversations with investors, and almost pretend like they're not raising at all. I do not recommend this strategy. Founders who have the most success raising are clear and actively decide when to raise. They share that decision with investors, advisors and other founders. These well-thought processes involve preparing stories, diligence items, setting up formal meetings with well-suited investors and practicing.
Founders that decide which investors they'd like to work with before starting the formal process can ensure that they have curated a network of entirely good investors. They've limited their risk of receiving term sheets from investors they do not wish to work with. The founders, at this point, have started tilting the market in their favor.
Tightly grouping meetings by stage is another advantage founders can utilize to continue to tilt the market. First pitches should occur within a one to two week time frame, partnership pitches in a different one to two week period. This ensures that investors submit their offers at the same time, before getting the opportunity to conspire or discover if others have passed.
The most common errors at this point - some founders allow initial meetings to lag for months, thus shifting the market back in the investors favor. The second error is founders creating artificially tight deadlines for term sheets. Investors do not like the latter, unless the driving power behind the deal and the company are too good to pass up.
Investors with more knowledge about the company and awareness of upcoming fundraising, will be motivated to move ahead of the other investors. Founder must manage this sequence carefully and make sure that their introductory meetings happen in a shorter time frame so funds are moving at the same pace.
Sometimes, there are inside investors who are good enough - and aggressive enough - to make a quality offer before the official fundraising begins. Balancing this tension varies by situation, and it's good to discuss with someone without interest in that round. These early offers may be good enough to accept without running the process.
Founders that do not accept any early bird offers must push the process forward. Tightly managing this process creates the same type of market founders will see on demo day, perhaps on a slightly smaller scale. The impact of arranging meetings in a week versus several months is truly amazing. Running a sloppy process, in which founders are disorganized or making overly aggressive timing demands, can destroy fundraising for a good company.
Work vs. Fundraising
Before we wrap up all this fundraising talk, one more word of caution: do not become obsessed with the process of fundraising. This can be a fatal mistake. It is easier to spend time theorizing and optimizing about when and how to apply leverage to specific investors than it is to focus on the foundations of a business.
Great companies push through and keep going, no matter how much they optimize. Inadequate companies twist themselves into knots, celebrate unproductive meetings and run out of money regardless of how much they raise.
Knowing when and how to raise is important, but founders should only focus on fundraising when it's time to raise. Spending any additional time is ultimately a waste, and could be spent writing code and talking to users.
Business Law Group is always happy to advise founders on the process of fundraising and gaining legal leverage. Call or schedule an appointment with one of our highly qualified attorneys and show investors whose boss!