Steps To Engaging Investors From The VC Perspective (Part II)
Our very own London (70 Wilson) Labs Manager Kim van Haalen interviewed William Mercer, Venture Director and Investor at Zag to discuss the fundraising process from the investor perspective. This is Part II (Part I here) of a III-Part series focused on the initial investor outreach and meeting, to the follow-up process and then on to quick tips.
Kim van Haalen: After the initial outreach and first call, it’s on to the second meeting. Who is in the room?
William Mercer: The goal of the first meeting after that initial call is getting to know you. If we need to move quickly, I try to include as many members of our investment committee in that meeting so I can get a second and third opinion. I might also bring in a specialist, someone who knows something about the industry.
KVH: If there’s just one person in the second meeting, can founders assume that’s not a strong buying sign?
WM: It really depends on how big your fund is and how many staff. Earlier stage investments require less due diligence and research and it wouldn’t be economically viable to spend days of work on each prospective investment. From my point of view, it’s really just convenience. I don't want to have that meeting again. As Director, I have lots of autonomy and I don’t have anyone underneath me. But in other funds it might be the Associate or Principal first, and then you get to meet the Partners at the end. So it can take a few more meetings. It really depends on the investment vehicle and fund.
KVH: What are you specifically looking for during this second meeting?
WM: If an investor wants to meet you in person again, that’s a clear buying signal. The questions are usually different from the first call. I'd like to see progress or what's changed since we last spoke. I also like to test your assumptions. With one startup, I might go heavy on traction. On another, I might focus on go-to-market. But always the most important thing for me is understanding the founders, their experience, connection to their product etc.
KVH: Can you give an example?
WM: Sure, so for example, if you've got someone who's worked at Rolls Royce for 20 years and wants to create a new car brand - that makes sense to me and makes me think ‘Okay, I should probably listen to this conversation’. But if that same person says he or she is going to create a media platform for influencers, I would see more risk because it’s not core to their experience and there’s no evidence of a passion for marketing tech.
KVH: What can a founder expect after this meeting?
WM: Generally, if we have any further questions we’d just give the founder a quick call e.g. have a call with the founder to understand their valuation. We will then have an internal investor committee meeting during which we discuss this opportunity. The next step is either for us to make an offer, or politely thank the founder for their time.
KVH: What sort of further due-diligence do you perform?
WM: At this early stage, we don't really perform the level of due diligence that you’d put in a larger round. What we really want to see is evidence of traction. For later stages and / or larger rounds, there’s much more sophistication.
That being said, we do perform some legal due diligence, mostly making sure that, for example, you haven’t gone to prison for fraud etc. As part of our standard term sheet agreements we will ask you to give warranties that the information supplied is correct and you’re not trying to deceive us. We’d look at financial performance and projections as well, however those things are usually already discussed during our meetings. At the stage at which we invest, we’re really just making a bet on you as a founding team.
KVH: Do you ask for referrals from customers or other investors?
WM: At this early stage, rarely. We are investing based on a hypothesis. However, if I were speaking to a company who’s predicting that 90% of their revenue will come from one big company / customer, then we’d at least like to see a letter of intent. Or if your entire cash flow is based on you ‘almost closing’ a large corporate client, we might want to speak to that client and say ‘Hey, we're about to put some money in just want to check you on the same page.’ And yes, if other investors are coming in on the round we’d want to speak to them as well. But we never really go too much in depth at this early stage. Again, it’s about the founder and our faith in that person and team.
KVH: If a startup is this far in negotiations with you, what could still be reason for a no-deal?
WM: Valuation and terms can still be deal-breakers. The terms are not always what the founders wanted. For example, in the terms, we have the right to stop you from paying yourself a certain salary because we want to prevent you from taking the money we just invested and taking a 6 month holiday to Vegas. We also have the right to stop you from purchasing an asset more than £100,000. We have the right to follow-on invest and we can appoint a corporate finance advisor to investigate sale options. Generally, term sheets in venture capital are rarely ‘nice’ and have protective clauses for the investors.
KVH: Then wouldn’t it make sense to share the terms earlier on, to save everyone time?
WM: Sure. I’d say good founders do this so they can prevent wasting time speaking to not-suitable investors. Feel free to be really upfront, but I’d also suggest to wait until after you’ve been invited to that in-person second meeting so you have some buy-in and enthusiasm behind you. Say something like, ‘Just letting you know, we’re only speaking to a handful of investors and we just want to make sure they are the right ones. In order to speed up the process, can you send over a copy of a standard term sheet so we can have a look’. Both you and the investor want to minimize the amount of meetings if it will lead to no deal. You have to look after your own time here. Don’t waste your time on junior investors who haven’t learned how to say ‘no’ yet. Furthermore, one can only take a certain amount of rejections and/or misfires before they reach a desperate state. Back to the dating analogy, that would be that friend who says ‘I’m gonna be single for the rest of my life’. You don’t want to reach that stage in your fundraising journey and it will negatively prime subsequent funding discussions.
KVH: Should founders share their valuation upfront?
WM: Always come with a valuation in your head, but you don’t have to share it just yet. Although some investors will be happy if you do, all investors will try to negotiate you down. So what I would say is have your valuation ready for when someone asks. If I ask a founder what valuation they have in mind and they don’t know, they will lose credibility. Why raise money if you don’t know what your business is worth? Also, keep that number firm, don’t try and justify or qualify it with a rationale.
If you have no clue what your valuation is, a good rule of thumb is that, generally, you want to give no more than 10-20% in your first round. So at a pre-seed raise of £150,000, your valuation is generally between £1.5M and £2M. Giving anything more than 20% will affect how much skin in the game you have as a founder later on. Work back from your cap table; so if you envision raising an A, B, C, D round later on, try to figure out how much is left for you in the end.
I’d say 75% of the decks I see don't include a valuation in their deck. Of course, as an investor, it’s nice if a founder includes it because it will avoid me wasting my time with delusional valuations. Sometimes you want to invest, and the founder gives you an insanely high valuation like £5M pre-product and pre-traction. Unless your product is reincarnation-as-a-service, that just doesn’t make sense.
KVH: If you decline a team on the grounds that they’re ‘too early for you’, which we hear a lot of, is it wise for the founder to keep updating you on progress?
WM: It’s an interesting question. I believe, as humans, all of our decisions are emotional and we rationalize them later. Once I've attached a negative decision to you, it’s hard to get rid off. So if it’s been a ‘no’ once, it is unlikely I will invest down the line.
However, I do have a startup in my portfolio who I initially passed on and they came back with impressive progress. If you email me three months later saying you’ve signed half the Fortune 500 as customers, I think my response would be, ‘great to hear from you, let’s grab coffee’.
But I’d be careful with updating investors with uninteresting progress. Even if the investor has politely declined, if your initial meeting did not go too well (which you will have felt, too), it will be hard to rebuild the credibility. You only get one first impression. Also, keep in mind that investors talk to each other so if you’re really not ready, better hold off until you are.
KVH: Can you share a bit more about how investors collaborate?
WM: Investors share dealflow all the time. If I see a startup that’s not for me but I know another investor that might be a better strategic fit, I will pass it on. Investors frequently invest alongside each other as if things go sour and the startup needs more cash, it’s good to have someone on the cap table who can put more money in.
KVH: One of the most-frequently used investor rejections is “your market size is not big enough”. What are your tips in navigating this potential issue?
WM: Market sizing is a bit of a finger in the air. But as an investor you just know instinctively if it’s right. For example, if a startup comes to me proposing they’ll sell toothbrushes to Eskimo’s, I know that’s going to be A) a small market and B) a tough sell as I don’t think Eskimo’s have large quantities of disposable cash nor an urgency to buy toothbrushes (apologies to Eskimos if I have incorrectly gauged their purchasing power parity).
On the other hand, if you’re selling to the whole world (no niche) it’s likely going to be very competitive, which is also a red flag. Often, founders come to us with unrealistic market sizes. For example, I recently spoke to a startup claiming their market size was 7 billion people, which is just idiotic. Approach it with a bit of research and lots of pragmatic common sense.
KVH: In your opinion, what is the biggest misconception between funders and founders?
WM: What always surprises me is the amount of founders who are oblivious to the investor’s need to make a financial return. Investors are not saintly, they are capitalists. So unless you can convince them that they can make serious money, they won’t be interested.