This XSeed blog was written by Venture Partner, Jeff Thermond, and originally appeared on Forbes.
I have seen several recent startup pitches covering different markets, having different technologies, and built with teams of differing calibers, all of which shared one unfortunate trait: The founders’ funding plans looked a lot like a Bridge to Nowhere.
What I mean is that the next round of financing had not been thought of in advance, or if there was a plan, it was from a fifteen year-old playbook and the entrepreneurs had faulty information on the current market, which led them to present a plan that would go nowhere.
Whatever the cause, a poor funding plan is a bad impression to leave in a first meeting. If the idea and the team seem top flight, investors can try to help the entrepreneurs fix the problem. But if not, it is a common reason for VCs to pass.
Here are some thoughts on why entrepreneurs must have a results-focused operating plan, be aware of what the next round of investors want, and require the team to be well prepared to mind the gap.
According to mattermark.com, the number of Bay Area seed deals from 2013 to 2014 dropped by almost 50%, while Series A deals fell by approximately 15%. We have all heard that there is a “Series A crunch” and these numbers seem to back that up. Anecdotally, at XSeed we have seen a big rise in the number of Seed Extension pitches, which further proves that getting through the Series A keyhole is becoming increasingly tough.
I believe that there are three tasks that every entrepreneur must get right as he/she plan to raise the company’s first institutional capital. And the entrepreneur has to get all three correct.
The first task is to be milestone focused, not activity focused. As an illustration of the difference, consider these two hypothetical answers to what one is going to do with the seed round money.
“Well, we still have some development to do in order to get to first release. And I know we’ll have to find a bigger space. And there are two killer developers just waiting to see us get funding before joining.”
“We’ve got to get to Point X (more about this in a minute) to be successful. The way we figure it is we have to get X number of paying customers at an ASP of Y in order to show growth.”
Although not wholly complete, the second answer is clearly goal and milestone focused whereas the first is much more activity focused. I understand that every entrepreneur is thinking about all the various things that need to be done after the check cashes, but investors are solely focused on what is to be accomplished. Talking in terms of milestones to investors is a great way to stand out from the crowd, and convince general partners that these entrepreneurs are people with whom they want to work.
The second task is to be aware of what the next round of investors will want to see, and have a plan to get there with the seed round. I have seen two or three highly recommended engineers come in with a plan that feels like this: “We propose a new way to do X. It’s going to take us at least a few million to get to our first release product. With luck, we’ll be in production with our first customer and then raise another round to fund our go-to-market.”
That used to work. My first startup did not get a product out the door until after our third round of funding and our lucrative acquisition. But that idea is ludicrous in today’s software-centric, SaaS oriented world.
The Series A funders we feed deals to expect SaaS deal to be doing $2MM-$5MM ARR as they exit their first round of institutional money. They also expect low single digit churn, a high LTV/CAC ratio, and rapid growth. And they can afford to be picky because the ratio of seed to Series A deals which was roughly at par in the Bay area in 2010 has consistently been above 1.5 since then, and twice above 2.0 (data courtesy of mattermark.com.) So long as seed rounds outnumber Series A rounds by a fair margin, Series A investors will continue to be patient and wait for the best deals to come to them.
So entrepreneurs can imagine the impression one makes when walking in to a VC, pitching and being completely unaware of this. In such a case, where a management team has no future funding plan and isn’t aware of the need to have one, investors write the deal off quickly as being incapable of adapting to today’s playbook.
The third fundraising task is to both see and mind the gap. What gap am I speaking of? Simply: the up to six month gap that exists between when a team finally hits its success metrics and can pitch seriously to a Series A investor, receive a term sheet, make it through due diligence, sign documents after lengthy revisions, and the Series A check hits the bank account of the startup.
An entrepreneur cannot be out fundraising with less than six months until Zero Cash Day (ZCD). And I’m assuming a brutal assessment of your ZCD calculation. If you have venture debt from your bank and it is in your account, do you really think they will let you go below the amount you owe in your account? It is not likely.
So now we can put it all together: First, entrepreneurs must find out what milestones the investors in the next round are going to expect. Better yet, find out what milestones get them to hurry up with scheduling meetings and doing diligence, and build a plan to achieve those. Secondly, figure out what it takes to get to those milestones. Then add a buffer (20% is a good place to start) because entrepreneurs exhibit systematic bias towards underestimating how long it will take to get from point A to Point B. Finally, add a six month burn rate to cover financing efforts.
Constructing a plan in such a manner and communicating how the team thought about the plan will position the company for success. As a leader, you will stand out from the crowd for being milestone driven, understanding of how each stage of investing works, and having reduced the risk of running out of money.
In the end, a company still has to win. Raising money is not the same as winning, but one cannot win without capital. If entrepreneurs follow these guidelines, they can spend more time thinking about winning because fundraising will take as little time and effort as it might otherwise.
Ignore these guidelines, however, and entrepreneurs will either not be able to raise money or it will likely come on substantially worse terms.