The secret equation of startup funding

Many founders walk into investor meetings blind. They know the address and the name of the investor. That’s all.

But they bring a pitch deck and have rehearsed numbers. They pitch, high five and wait for the call back. The phone is silent. Instead they get an email. It’s polite. It says something along the lines of: we think you are really interesting but the timing is not right. Let us talk in another six months.

I have received these emails myself and I have sent them. Lately, I have decided to do it differently. To tell the truth. The truth is that getting funding is not just about delivering an energetic pitch. Unfortunately, many founders don’t know any better. After 3 years of startup investing and raising funding for about 14 startups, this is what I know:

Getting funding has an equation. And few people know it. The equation has clear elements and weights. Those who know the equation can harness it’s power. But before exposing it. Let me put funding into the right perspective.

Resources are the blood of a startup. Founders use resources to create something from nothing. The resources founders need are people and money. Collaborating people are one of the strongest forces of the universe. Humans became the dominate species because of our superior ability to collaborate. No other species has ever organized thousands of individuals to do anything. Humans do. And in the process we built the Great Wall, traveled to the moon and created Wikipedia.

Likewise, collaborating startup teams can do a lot. I’ve seen it. Teams of men and women who focus solely on the common purpose of building their startup. The founders of an on-demand laundry and dry cleaning startup called Washa sacrificed the activities young people normally do. Instead they moved in together and started washing clothes. All day, all night, every day of the week. Just washing, folding and delivering. They were like a machine.

The team is the machine. Money is fuel. Without fuel, companies grow slowly. Most big companies have taken generations to built. Fuel applied to a well functioning machine make it run faster. Fast is what we want. Humans are impatient.

Money for startups is called funding. Most startups I meet chase funding. Not everyone should. Fuel only makes the machine run faster. Fuel to a broken or incomplete machine is a waste. Even dangerous. But if the machine works, funding will have positive effects. Conclusion: only raise funding if you got a machine that works.

Most funding comes from institutional investors. Getting funding from institutional investors depends on more than just the pitch. If founders understand what those things are, they can increase their odds. If founders know which things matters the most, they can (almost) control the outcome.

What matters and how much below:

Equation of funding

Getting funding is a direct function of getting the decisions makers (usually the partners) to be positive.

The attitude of the partners is a function of two things: 1) the status of the person proposing the investment and 2) the attractiveness of the investment itself.

1) The status of the person proposing the investment is a function of: A) the person’s level of seniority (associate, analyst, principal or partner) in the firm and B) the person’s level of expertise within the space of the investment.

2) The attractiveness of the investment itself is a function of: C) the attractiveness of the startup and D) the attractiveness of terms.

A) The person’s level of seniority is a function of: I) the person’s track record and II) the time the person has been with the firm

B) The person’s level of expertise within the space of the investment is a function of: III) the amount of own startup experience in the space IV) the amount of investing experience in the space

C) The attractiveness of startup is a function of: V) the strength of team and VI) the size of the opportunity

D) The attractiveness of terms is a function of: VII) how well the investor is protected in a downside scenario and VIII) how much the investor profits in an upside scenario

The equation can be deconstructed further, but this level should do for now.

Now that we identified the variables, let’s assign the weights.

First level. What is most important? The status of the person proposing the investment or the attractiveness of the investment itself? The obvious answer is the attractiveness of the investment itself. Even the youngest associate would get internal support for the next AirBnB or Uber, right?

The problem is this: We only know that AirBnB and Uber were good bets in retrospect. Both startups got turned down by a lot of investors. Let’s take the opposite example. Would a senior partner ever get support to do a really bad deal? Well again, good and bad are assigned in retrospect. In reality senior partners advocate for really bad deals all the time. Most venture backed startups fail miserably and somewhere along the way senior partners were involved.

My current calibration tells me that the two sides weight about the same. Experience tells me that founders don’t know this. Conclusion: founders should pay a lot more attention to the left side (green) of the equation than they usually do.

Second level left side. (1) Because the status of the person proposing the investment weights 50%, it’s relevant to look at the elements making up the status level. Who should the founders seek out?

Is it most important to convince the person has a senior position (A), or that the firm’s expert in the space (B)? In my experience, experts work as gate keepers. They can say no. That makes the expert extremely important but unless he also has high status in the firm, founders cannot solely focus on him. Conclusion: founders should focus on the person with the highest status while making sure the expert is supportive.

Second level right side. History decides if an investment was good. However, certain things seem attractive to investors at the point of investing. Those things can roughly be divided into the attractiveness of startup (C) and D) the attractiveness of the terms. Which is most important?

In this case, the weight is clear. The attractiveness of the startups is by far the most important. Founders know this. In fact, founders think their startup can justify almost any terms they propose. In most cases, sky high valuations. They are wrong.

At Accelerace Invest we have turned down investment solely because of the terms. I know that other investors do too. Even though terms are secondary, the terms still matter. Most founders are ignorant of the economics and business model of an institutional investor. When founders forecast their ownership in the cap table, they tend to assume that investors will be happy if they get a return. Again, they are wrong.

The return for the whole fund most beat the “market”. And in most cases founders don’t even think about the return of their investors. But they should. Not to be nice. But to ensure they get funded.

If founders don’t know what an attractive financial structure of a deal looks like to an investor, how can founders negotiate wisely and get to the best deal possible? They can’t. Conclusion: founders should understand the economics and business model of their investor.

Conclusions made:

  • Only raise funding if you got a machine that works
  • Founders should pay a lot more attention to the left side (green) of the equation than they usually do
  • founders should focus on the person with the highest status while making sure the expert is supportive
  • Founders should understand the economics and business model of their investor
Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

w

Connecting to %s

%d bloggers like this: