What Not To Do as a Startup During Covid-19 and Beyond
Advice from Harlan Milkove, Managing Partner at Foundational. Foundational expedites the pursuit of early-stage capital by providing founders VC market intelligence. Their data-driven approach proactively aligns startups with the expectations of prospective investors to help them plan and implement more efficient venture capital raises that reduce roadshow times by months. They achieve this by analyzing transaction comparables, identifying best-fit investors, mapping out optimal warm-introduction pathways, and structuring rigorous fundraising processes.
1. Don't wait to start your process.
If your business is more substantial because of the pandemic's impact or otherwise hitting its milestones, this is a perfect market to raise in.
If you're focused on a space investors are questioning the future of, like office workers, consider this a time to network with future prospective investors and get their feedback. This is a good practice for any founder. It will give them more time to evaluate the most strategic fits for their board and make the fundraising process more straightforward, given that relationships will already be established at the time of the raise.
If you are a startup that isn't growing now, you are in a distressed position, and you are in the early stages, it is pretty much impossible to bring on a new equity investor. For companies growing through COVID-19 or even benefiting through the macro trends around it, it is an incredibly good time to raise because many companies around are out of the running. So if there are fewer companies for the funds to pick from, they will be in greater competition to back those in good shape.
For those who are successful in reducing spend, they could find interesting niches to benefit explore. For example, as a whole, tourism is an area that people don't want to touch right now from an investment standpoint. That said, the travel industry has needs. Their needs are probably going to need to rely on new technologies. So even though it is a shrinking market, there may be some incredible opportunities there.
Identify the strategy for your company and then take steps toward it. If you are in the middle in terms of things going horribly or things are going very well. If you are in the middle right now, these are probably challenging times because investors are perhaps a little more concerned about specific businesses. It is still an excellent idea to connect and meet with investors. Some of the feedback you will get will indicate where the market is going potentially for the next capital raise. It takes a lot of energy to get the relationship set up, even to have the first meeting with an investor.
2. Don't bark up the wrong tree.
One of the most challenging problems founders face in fundraising is identifying relevant investors. We've had to build our system to deal with this, and it's now our most important capability. Institutional funds have a specific mandate for the terms of deals they'll consider, and the types of companies they'll invest. Spending hours to get a warm introduction and meet with a fund that's not a fit will be emotionally draining and could lead to the process's overall failure. It is a good idea to sort out ahead of time what that landscape is to put the energy into the right ones.
3. Don't go to market with an unshoppable deal.
A deal is not viable:
-if the company is in a position of weakness with no tangible assets.
-If the ownership levels of the executive team are too low.
-The valuation is too high relative to the company's market maturity.
-Not enough of the company is being offered to new investors.
4. Don't raise too much on a capped convertible note.
Valuation caps protect the ownership percentage of convertible note investors. Funds that lead equity rounds typically desire at least a 10% ownership target for their first check. Given a round of financing can only dilute the company so much, typically 30% on the high end. If you raise more than half of the future equity round in advance, on a note, there may not be enough room left for the new fund later unless the valuation increases substantially.
We had a situation where a startup was raising $750K on a $2.5M cap, which is insane; they got horrible advice. You have committed yourself to convert a third of your company. Somebody is getting screwed. Either the founder is getting screwed because no future deal will be viable. Or, the noteholders will get screwed because they will see that the only way for the company to continue operating is for them to amend the note or get diluted in the new issue. All of this puts friction on closing the deal. People will do a cap note and another cap note because it is hard to raise an equity round at the seed stage. They are not doing their first equity round until Series A.
5. Don't set your own valuation too high in a non-institutional equity round.
Let's say you're not having a "lead investor" set deal terms because you have enough interested to close the capital on your terms. It's essential to establish a reasonable valuation based on transaction comparables and expected future fundraising timelines to not force a painful down-round later.
Companies are coming to us saying that they don't want to take a bad valuation right now. Don't wait. This is a once in a lifetime opportunity to get incredible deal terms. It can be dangerous to make assumptions about where the VC market is right now.