A Common Fundraising Trap
The only way to get decent fundraising terms is by creative competitive tension among investors.
The other day, I was speaking to an early-stage founder who said, in passing, that he’s got only a few months of runway, but his current investors indicated they would invest. Something must have changed in my facial expression, prompting him to ask: “Did you want to say something?”
I did. I had just one question: “On what terms?”
The trap
I’ve seen this pattern before. It goes like this:
The end of the runway starts to approach
The founder begins preparing for fundraising and tells existing investors about this1.
They give the founder a warm indication that they’ll be willing to invest. It’s possible that they even indicate, without a firm commitment, what the terms would be, e.g. “the last round terms” or even a valuation.
The founder has many real problems: product, tech, sales, etc. So, they conclude it would be unwise to drop them and focus on fundraising from other investors. After all, they might not offer materially better terms than existing ones, but it will be lots of work.
They start negotiating with the investors, but the process is taking time.
A few months later, the company is almost out of cash.
The founder tries to close from current investors, as “agreed.”
If they invest at all, the investors impose harsh new conditions that the founder didn’t expect. They might use a recently lost deal or something similar as an excuse.2
At this point, the options are a lousy deal, shutting down the business, or making extreme cuts.
The founder chooses the lousy deal.
This is simply a transfer of wealth from the founder to the investors because of the founder’s inexperience.
The reasons for the trap
It does not happen because the investors are evil, manipulative or deceitful. The real reason it happens is because the investors are rational.
From the existing investors’ perspective, the rational thing to do is not to invest unless there is a chance they will miss this deal. If the founder does not create competitive tension by looking for other investors, the investors will still have an opportunity to invest later.
However, later, the founder will have less leverage, so it will be easier to negotiate a better deal for investors. Hence, the rational position is to indicate future investment but not commit to it.
A founder might think that it would be rational for them to invest now so that the company can focus on building the business instead of being distracted by the investment, but this is naive. If the founder isn’t trying to raise from other investors, they are focused on the business anyway.
The way to deal with the trap
The way to deal with this dynamic is to completely discount any indication of existing investors that they’ll invest. They may or may not. If the investors insist that they will and the founder just needs to go back to building the business instead of fundraising, the founder should invite them to wire the cash by the end of the week and see what happens3.
Therefore, when the business needs to raise money, the right thing to do is to create competitive tension by getting multiple term sheets4. Even if the founder ends up raising from existing investors, other term sheets will create competitive pressure that will help negotiate a better deal.
The lesson all founders learn during fundraising is that the only way to get decent terms is by creating competitive tension. If the company is running out of cash and the founder hasn’t created competitive tension, the investors who might be willing to invest will have no reason to offer the best terms.
Of course, building a good company and making constant progress while fundraising is an arduous task. That’s one of the reasons the pre-Series A stage of a VC-backed business is so hard: the team and product aren’t quite there yet, so both company building and fundraising fall onto the founder. That’s also why co-founders can make such a difference: they can keep things running while the founder CEO is fundraising.
May this post be helpful to those who are fundraising.
The same dynamic can play out if the founder speaks to only one external investor without creating competitive tension. One founder I know had two term sheets. He chose one, but then the investor tried to impose additional and unexpected terms during due diligence. So he went back to the other investor and closed with them. He would likely have to accept those “extra” terms if the second term sheet didn't exist.
Something always goes wrong in a startup, especially when the founder is trying to paint a rosy picture when courting investors. It’s normal and not a problem in itself, but it might give an excuse to investors to vary the terms.
Most likely, they won’t. If they do, consider the fundraising round closed and return to building the business. Either way, it’s a win for the founder: either they get the cash or see that the promise to invest later is hollow.
I once made a stupid mistake by dropping one potential investor because he insisted on having a board seat. Given the amount he was considering investing, I didn’t think it would be appropriate. However, it was a mistake because I should have obtained a term sheet from him and used it as leverage against other investors without disclosing that I never took it seriously.
creative competitive tension = FOMO :)