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February 13, 2008

Follow-On Financings: Act Like a Pro, Raise the Dough

With the capital market turmoil raging, many argue that 2008 is going to be a tough year for start-ups to raise money, particularly follow-on capital in the form of a Series B financing (not surprisingly to any veteran viewers of Sesame Street, Series "B" follows Series "A" rounds of financing).

Series B financing processes are all about credibility.  Does this management team have its act together to build a great, valuable company?  As such, behaving like a pro during the fundraising process is critical.  If the management team demonstrates they can run a great fundraising process, they can run a great company.  If they look like this is their first time through the process and they are scrambling to react to questions and requests for materials, their ability to successfully execute on the business plan will be heavily discounted.

For VCs, the Series A is a “hopes and dreams” investment thesis.  Do I believe the vision and this management team's ability to bring the vision to life from nothing?  The Series B investment thesis is all about “metrics and momentum”.  The management team needs to provide a compelling case that their company and their category has tremendous momentum, in fact accelerating momentum, and that the Series B money is going to be used to cement their leadership position in a valuable market.  It is not a speculative bet.

In a first meeting with a management team, typically lasting 60-90 minutes, a VC firm’s job is to decide whether to have a second meeting.  If so, the VC firm will typically articulate to the management team the key issues or concerns there have with respect to the business that they'd like to understand better and see addressed.

If a VC firm is interested in continuing the process after the first meeting, they’ll typically invite the team back for a second meeting with a broader group of the partnership and try to understand the business at a deeper level in the context of the key issues.  If there is interest in doing “real work”, the due diligence process begins and it is "game on".  Note to entrepreneurs:  if a VC keeps meeting with you and isn't doing "real work", it's a yellow flag that you are on the back-burner of their "top new projects" list, of which there are typically no more than one or two.  Typical materials that are asked for to assist in due diligence in a Series B process include:

  • Capitalization table
  • Management team bios
  • 3-5 year Financial plan and model – the CFO should be prepared to walk through; which should include a 10-15 page PowerPoint presentation on the business model, key metrics and assumptions and how those metrics and assumptions impact the financial model
  • Historical financials, audited and unaudited
  • Note that the financial model should be packaged in an Excel file in such a way that can be send to VC firm associate/principal to tear through and tweak assumptions and run sensitivity analyses
  • Sales pipeline – VP Sales should be prepared to walk through
  • Management team references
  • Customer references
  • Partner references
  • Technology review – VP Eng should be prepared to walk through, ideally with PowerPoint presentation as guide and architecture document as back-up
  • Major contracts
  • Product roadmap – VP Marketing should be prepared to walk through; ideally with PowerPoint presentation as guide
  • Exit valuation comparables and scenarios – CFO should have matrix of public company and private exit comparables that show typical revenue and EBITDA multiples

A thorough but efficient diligence process typically takes 4-8 weeks from first meeting if everyone is focused on it.  A few pieces of good news should be sprinkled in during the process to underscore the momentum story (e.g., “By the way, we signed X” or “By the way, we were 50% ahead of plan last month”).

At the end of the day, the fundamental VC math a firm will need to be sold on for the Series B goes as follows:

  • What is the post money valuation on this round?
  • How much additional capital will be required, if any, and what’s my blended post money going to be across the two rounds
  • Multiply that number by 5-10x. 
  • Can I convince myself and my partners that I can generate that exit valuation based on the industry comparables during a rational market period over the next 3-5 years?

If the answer is "yes", you get the term sheet.  If no, rinse and repeat with next the VC firm!

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Two comments. Any CEO with a Series B coming up in the next 6-9 months would be wise to simply use this post as the ‘road map’ for his or her actions. Instead of learning what VCs will require from trial end error, using this road map would allow a CEO to provide exactly what’s expected on their first Series B VC visit. And rather than waiting until the Series B time arrives, they should today put a list on the wall of the items Jeff lists and figure out now how they will achieve each item over the next six months.

Second, preparing a company for a Series B (which I’ve done a number of times, often in the role of interim COO) reminds me of preparing for a ‘phase review’ when I was a product manager years ago. Though some people dreaded preparing for such a phase review, I found that if my product development program (including the go-to-market component) was under control, then providing all the data requested at a phase review was not difficult. Similarly, for a start-up company, the data Jeff says is required for a Series B is really the data you should normally have to operate the business in the Series A phase: an accurate sales pipeline; customer references; a product road map; financial projections; market analysis / potential, etc. are really all things that should be part of your normal operations. If that’s the case, then pulling together the Series B process is a reasonable process.

Jeff,

Great post!

As an entrepreneur, I am seeing that it helps to be proactively prepared with the fundraising (Series B) documents. Well before they are actually required.

dd

Great article. I am guessing it has gotten even more difficult in the last few months.

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