“If we land this one customer, we will be cash flow positive this year,” Robert told me.
Robert is a smart, experienced executive who started a business which solves a costly customer service problem. He is selling to the industry he worked in for the last twenty years. He has a great idea and knows his market. The product he built is premium priced. He knows the buyer and how to close him. Robert came to me because he needs funding.
“Let’s assume you close this prospect. What then?” I asked.
“The customer would quickly overwhelm my small team,” he admitted.
Convertibles Are No Angels
“We would need to hire fast so we could on board the customer properly. We will need to get this right from the very beginning. So I guess, in spite of the sale, we do need to raise money,” he said.
“How much?” I asked.
“I would like to raise $1 million, but I think we can get to cash flow positive with $500k,” he answered.
“What pre-money valuation are you shooting for?” I asked.
“We want to avoid the valuation issue completely. So we are aiming to offer the investment as a convertible note,” he said.
“Do that and you will not attract high-quality investors. Sophisticated angels avoid convertible notes. It is all downside with a capped upside. That’s why they stay away from them,” I explained.
“You need to set a valuation and sell common stock. Your goal should be to attract the right investors and close the round with a clean cap table.”
“How do I do that?” he asked.
Make Angels Want In
“What valuation are you thinking about?” I asked.
“We were thinking 4 to 4.5 million,” Robert answered.
“I don’t think this is an unfair price. But what if you offered the shares at a $2.5 million valuation? Given the business you are showing me, combined with your team’s experience, this would be considered an attractive price. Sophisticated angels would quickly see they can make money by investing in your deal,” I said.
“It sounds like the price is too low,” he said.
“Maybe it is. But how much time do you want to spend raising money versus building your business? Give potential investors a good deal in this market and you’ll close faster. More importantly, you will have the luxury to be more selective in who you take money from.
“Getting the right investors on board at what they consider a good price sets you up for the next round. So not only do you raise this first round, but assuming you land the deals you’re talking about, you guarantee the next round,” I explained.
Guarantee Your Next Round
“Why is it a guarantee?” he asked.
“Experienced angel investors know when they invest, there will be a follow-on investment. In almost all cases, it is for an amount equal to their initial investment. If they get a good price from the start, then they will want to be sure to maintain their equity stake through the second round,” I explained.
“This means, if you raise $750k in the first round, you are assured it is worth a second round of at least $750k. Sure, you gave up more equity initially by discounting your value, but you end up with the right investors and the matching follow-on round.”
“Sounds good to me,” he said.
“Go away and do the math. Talk to your partner. I think you’ll conclude the additional equity you give up due to a lower valuation in this round will be well worth the long-term price of the business. You’ll spend more of your precious time building the business, and you’ll have the right investors helping you do it.”
How to Get This Deal Done
- Decide on your lead investor. You know who this person is already. This is the first big close.
- Work with the lead investor on his deal first and then on the term sheet you will offer the other investors. The lead investor should get stock options in addition to the equity for his investment. He will be the investor who is lending his credibility to your deal and opening up his network. These are all high-value activities for which he should be compensated.
- Decide on how much you will raise and a close date.
- Make a list of potential investors based on their backgrounds and how they will help you get to revenue.
- Put your fundraising pitch together. Set appointments. Pitch the company and the term sheet. Drive everyone interested to the close date.
The sooner you raise the money, the sooner you can spend full time on building the business. Get it now!