Every week as SmallBizLady, I conduct interviews with experts on my Twitter talk show #SmallBizChat. The show takes place every Wednesday on Twitter from 8-9 pm ET. This is excerpted from my recent interview with Victoria Yampolsky, CFA, @startup_station. Victoria is the President of the Startup Station, a comprehensive financial resource for early-stage startups. She specializes in the financial modeling and valuation of pre-revenue companies. Since 2015 more than 1,000 founders learned the basics of financial modeling, valuation, and startup financing. Victoria holds a Degree in Computer Science from Cornell University and an MBA from Columbia Business School. For more information, visit https://the-startup-station.teachable.com/.
SmallBizLady: When are you ready to fund raise?
Victoria Yampolsky: Each founder, and their respective startups, faces different obstacles when traversing the path towards fund raising. On the one hand, the longer you are able to wait, the more valuable your company will be to an investor. On the other hand, very few founders can operate on just their savings alone, especially if they live in big cities. Therefore, the point at which you must seek outside funding is determined by your own personal situation as well as whether your company meets the minimum funding requirements set out by your investors.
SmallBizLady: How do you look for investors?
Victoria Yampolsky: There are two steps to conducting an investor search.
Step 1: Identify which investor type is right for you. You should consider the investment amount (angel or VC), the level of involvement (active or passive), and their role (financial or strategic).
Step 2: Evaluate how you can access those investors in the most efficient way. Personal connections are the best. In the absence of those, you can
- Search investors databases;
- Participate in pitch competitions;
- Utilize equity crowd-funding platforms;
- Apply to angel groups; or
- Join an accelerator.
SmallBizLady: What do investors look for?
Victoria Yampolsky: Investors don’t invest in products. They invest in businesses and, specifically, those businesses that have the potential to make them the most money. Some investors have additional objectives such as to support women-founders or to only invest in green technologies. However, making a profit is still the driving force. Typically, investors look at the following five criteria when evaluating prospects: market size, product, traction, ability to scale, and team, including their track records.
SmallBizLady: What should you have ready for fund raising?
Victoria Yampolsky: Preparing for the fund raising process is comprised of two parts.
- Financial: Every fund raising package includes an investors’ presentation, financial projections, and an executive summary. Other supporting documents may also be required.
- Legal: The chosen method of financing dictates which legal documents must be drafted. Equity requires the most legal work and takes the most amount of time, while convertible debt and SAFE agreements are faster and cheaper to execute. Do not try to save money on legal fees. A great lawyer will save you time and money.
SmallBizLady: How important is it to have financial projections for a pre-revenue company?
Victoria Yampolsky: Creating financial projections for a company with no financial history is NOT easy, but VERY important. Here are the six reasons why all early-stage startups need a financial model:
- Set realistic sales goals;
- Estimate all costs and working capital needs;
- Identify internal interdependencies;
- Decide which expertise you need;
- Identify the break-even point and capital requirements; and
- Determine the company’s valuation.
Finally, it helps to convince investors that your business is feasible and that you have a tool to evaluate your strategy.
SmallBizLady: How can one credibly value an early stage company?
Victoria Yampolsky: Any valuation, including one for early-stage startups, is driven by financial model assumptions, or revenue, cost, working capital, and fixed asset drivers. The more time you spend thoroughly on translating your business plan into a financial plan, and on determining what these drivers should be, the more credible and realistic your resulting valuation will be. Consequently, holding all other variables equal, you will more easily be able to impress investors, negotiate a fair deal, and get funded faster. Numbers do matter!
SmallBizLady: What are the most common traditional startup financing vehicles?
Victoria Yampolsky: There are three most common traditional startup financing vehicles: equity, SAFE (simple agreement for future equity), and convertible debt.
Equity refers to the percentage of company ownership. Convertible debt is a loan that converts to equity based on certain rules and upon certain triggers. In the event of non-conversion, convertible debt must be repaid, together with accrued interest, on its due date. SAFE converts to equity, similar to convertible debt, but has no debt component. In the event of non-conversion, it simply remains outstanding.
SmallBizLady: Are there any pitfalls in using convertible debt as a form of financing?
Victoria Yampolsky: Convertible debt is a complex hybrid instrument, not traditionally used for startup financing. There are three main issues startup founders must be aware of:
- Unfavorable conversion terms: a valuation cap and a conversion discount.
- Incentives misalignment: When convertible debt converts, its holders are incentivized to push for a lower valuation to get a higher equity percentage.
- Cash flow pressures: When convertible debt does not convert and must be repaid, it creates cash flow pressures for a young company at the time it needs cash the most.
SmallBizLady: How do you choose the best startup financing vehicle for you?
If you can credibly value your company, we recommend that you use equity. It aligns everyone’s incentives, and you can track the company’s milestones with multiple equity rounds.
If you cannot credibly value your company, we recommend that you use SAFE. With this vehicle, you can delay valuing the company until a later date when the conversion happens, and you have more info. You will also not have to repay the investment (AND the accrued interest) in the event it does not convert, like what would be the case when convertible debt is used.
SmallBizLady: What are the top three deal terms founders should be aware of?
Victoria Yampolsky:
- Valuation for an equity investment and conversion terms for SAFE and convertible debt.
- Anti-dilution clauses for an equity investment which protect the equity stake of initial investors in future rounds of financing and may make it very hard to raise money again.
- The number of seats for the Board of Directors and voting rights. The Board of Directors makes decisions critical to the company’s future. Every seat means power and the necessary voting percentage indicates a minimum threshold that must be met for a certain decision to pass.
SmallBizLady: What are the three most common fund raising mistakes?
Victoria Yampolsky:
- Raising money before you are ready. If your company does not meet the necessary funding criteria for a given round, you will not be able to raise funds and simply waste time. Do your research and know when the time is right.
- Not signing a founders’ agreement with your co-founders as well as offering equity to friends as a form of payment for favors. Not having a proper legal foundation and/or a crowded cap table may make it very hard for you to raise money. Investors don’t like unnecessary complications.
- Starting to look for investors when you actually need money. Building relationships and trust takes time; thus, it is wise to contact prospective funders months before you actually need the financing. Starting a fundraising process too late may create unnecessary financial pressures and may lead to sub-optimal decision-making.
SmallBizLady: When should you walk away from a deal?
Victoria Yampolsky: While there is an element of negotiation for every deal, not every deal should be accepted. Here are a few reasons that would justify you walking away.
- An unfairly low valuation.
- Unfavorable conversion terms.
- An unreasonably high number of board seats.
- Unjust restrictions on companies’ operating, financing, or investing activities.
- A full-ratchet anti-dilution clause for a non-bio-tech company.
A good lawyer and finance professional will help you make the right decision. Good luck and get funded faster.
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