Former senior associate at OpenSpace Ventures
Series A fundraising is like dating. After the first date, founders should hope that they can go on to subsequent dates.
So, you’re thinking of raising a Series A? This is likely the question entrepreneurs will have in mind after going through the rounds of raising their seed financing. You are now thinking about what it takes to raise from institutional investors, perhaps for the first time in the company’s lifetime.
Yet, Series A fundraising is probably one of the hardest fundraising processes – only 10% to 15% percent of seed companies in Southeast Asia get to raise Series A. This is not surprising – companies have to show for the first time how their businesses are no longer just ideas but are now real.
A. GETTING THE MESSAGE RIGHT
With relatively early metrics, it is hard to get over the natural investor skepticism. Thus, instead of prescribing a checklist for Series A fundraising (which can be easily found online), here are the underlying messages that investors must hear so that they know a company is ready for Series A: having a strong narrative, a set of strong investment fundamentals and a strong founder worthy of backing. These are further explained below.
1. Strong narrative
Unlike the seed round, Series A assumes that the company has a proven market-product fit. Therefore, entrepreneurs should line up all the possible reasons to show that this is the case. This can be done by showing a pattern of sustainable growth and a market that is ready for adoption of the product. In preparing the narrative, please do use authentic figures. Good investors will be able to see where numbers are manipulated or false, and a non-compliant founder might be subject to legal claims arising from legal documentation entered into with an investor.
(a) Sustainable growth
If a company is growing really fast (typically more than 100% year-on-year growth) – with signs of improving sustainability (profitability or otherwise) – it is likely the case that the company is ready for Series A. That sort of growth suggests not only that a strong market demand exists for the product, the company is also well-placed to deliver the product (for at least a foreseeable period of time). Thus, it is important to show strong repeat and return profiles of customers if that is possible.
If the company is operating in more regulated sectors in which the path to monetisation is longer, it may make sense to show that the company has achieved enviable milestones that positions it for success after the Series A. If your business operates in a regulated sector, it is crucial to take a realistic view of regulation early on, before raising a Series A round. Investors will expect to be shown an understanding of the regulatory regime that the company is operating in, and the steps taken to address any major regulatory risks.
(b) Ready-for-adoption market
Is the market addressed by the company the right market?
It takes a deep exposure in the region to be fully aware of natural advantages or inefficiencies a company can take advantage of. For example, a company can take advantage of limited direct or second-degree competition. In other cases, it could just be a first-mover advantage due to inherent market failures waiting to be exploited.
If the company has exhibited traits that suggest the market will favour it, investors will find it easier to be convinced to back the company. It may sometimes be helpful to draw comparisons with other markets to support the business case for the relevant market, but be careful that Southeast Asia is different from other markets.
2. Strong investment fundamentals
It is not enough that the company is great; founders need to look out for what investors are also looking for. At the end of the day, Series A investors are looking for companies with strong risk-return profiles. Beyond demonstrating success in factors that are directly related to the day-to-day operations of the business, investors want to hear that:
(a) there is strong upside to the business, and
(b) there is liquidity in sight at the end of the investment journey.
This is easily broken down by showing that the company is addressing a huge untapped opportunity and has a visible exit potential to monetise such early-stage investments.
(a) Huge untapped opportunity
Beyond strong topline growth and a ready market, a large untapped opportunity is imperative for the company to demonstrate the upside potential. On one hand, there are markets that are so fast-growing that even taking a small share of that would be great for the company.
On the other hand, there are relatively slower markets where companies should demonstrate their ability to take a larger portion of. This is typically the case when the sector is more established, such as e-commerce and, therefore, some market leadership is needed to muster confidence that the company will succeed even in red ocean competitions.
In general, investors prefer companies which are addressing fast-growing markets but with nascent small market shares as this is a less combative position to manage against incumbents. Either way, however, companies should demonstrate that they will be well-poised to take a sizeable share of the market at some point.
(b) Visible exit potential
Is there someone who will buy this? Is this idea listable in the public markets? These are questions investors will ask because, after all, they need to monetise their investments. To help them with these questions, a company needs to demonstrate that there is a pot of gold at the end of the rainbow.
In this light, it is also important to ensure that the legal documentation does not unduly impair any viable exit. Many entrepreneurs are focused on growing their businesses, and may concede important long-term goals such as an exit in order to bring in capital at an early stage. As such, any exit terms (including drag along terms) set by early stage investors should be carefully scrutinised to ensure that one’s chances of raising further capital are not jeopardised.
3. Strong founder
Beyond all the logic behind fundraising, nothing beats the founder (or co-founders) pitching the business to investors face-to-face. Investors are very keen to get a good sense of the key persons of the businesses they are potentially investing in. Are they in it for the long ride? Are they able to weather storms? These are perennial questions investors will ask in their minds when meeting the founders. They can only trust the people they are investing in. Thus, investors spend a lot of time getting to know the founders and testing them with their domain expertise, their previous fundraising experience, and their leadership and confidence levels to answer these questions.
(a) Domain expertise in the field (including competitors), explained in simplest terms
Nothing beat showing that founders truly know the field, that they know the inherent problems of the market they are addressing, and that they are on top of the competition that they will be battling against.
(b) Previous fundraising experience (including valuations), cash raised and duration before company runs out of cash again
Surprisingly, investors want to invest in companies whose founders can negotiate well for the company, as well as achieving key performance indicators regularly. After all, the dynamics of the current fundraising is a predictor of future fundraising.
At the same time, investors are looking for entrepreneurs who can manage their cash positions well. Unless there is a strong reason otherwise, a company raising cash sooner than expected is typically a red flag: it puts to question the company’s ability to keep to its projections.
(c) Ability to project leadership and confidence
As a company transitions to Series A, it will only expand and get complicated.As more hiring is needed, it is only natural that investors will only seek out founders who are able to encourage others to follow them and to inspire them. It also goes without saying that investors want to work with founders who are confident about their story and able to inspire more investors to invest in them subsequently.
4. Preparation and perseverance
Unfortunately, raising Series Ais not easy. Entrepreneurs are bound to face rejections because every investor, by virtue of his/her experiences, will have a different perspective on different subsectors. Arguably, the fundraising process is a test of founders’ preparation and perseverance, which are key qualities that investors like to see in founders.
It is thus important to know the profile of investors and, at the same time, maintain a strategy that allows an entrepreneur to engage several parties at the same time.The best way to know investors is by looking at the portfolio of the companies they have invested in and talking to entrepreneurs about their experience with them. The best way to manage several conversations at the same time is to prepare the materials that investors would typically want to ask in any diligence. These include:
(a) introduction deck that details the company’s product (and any competitive advantages), addressable market, team and performance to date (these can be furthered with a detailed deck);
(b) financial model with recent months’ management accounts;
(c) operating metrics dashboard (including repeat/retention data to show momentum to date) and pipeline (if relevant to show predictability of the future);
(d) teams’ credentials and organisation chart; and
(e) complete and executed documents detailing previous financing rounds and commercial arrangements, such as employment agreements and option schemes.
All of these can be best managed with a good document management system – best implemented from day one. This is especially the case when founders are speaking to different investors, and it is not convenient to send ad hoc e-mails one at a time. Do note that there are systems that provide for the management of different investors, each with a different set of requirements. However, the documents above are perhaps the core documents that every investor will ask from a founder raising Series A – be prepared!
B. LEGAL CONSIDERATIONS
While negotiating the early days of a start-up, founders should pay attention to the basics in terms of their legal obligations. It is tempting to do it the “cheap” way, but there is a balance that can and should be struck. Some easy things to do correctly include:
(a) Ensuring that all key employees have a binding employment contract, with provisions that ensure that any intellectual property generated by that employee as part of their employment belongs to the company. Please note that this should also apply to co-founders of the company – it is easy to overlook arrangements between co-founders. Be very firm in how you contract with any party who helps develop the core products of the company: ensure that the company owns the work done and not a third party. If this is not done at an early stage, it can be extremely costly to resolve this matter at a later stage.
(b) Ensure that all transactions regarding shares in the company is documented clearly. Be very clear about who is entitled to a share in the company and who is not. Avoid making verbal promises of equity in the company – always make sure that the terms of any such commitment is set out in writing. Do check in with a lawyer at regular checkpoints to ensure that your company’s capitalisation table is clear and unambiguous.
(c) Ensure that any proprietary intellectual property generated by the company is adequately protected. Speak to an intellectual property lawyer to understand
(i) what intellectual property can be protected, and
(ii) the legal protection available.
Ensure that a plan is developed to protect the intellectual property. Some of these protections are costly and not viable for a very early stage company – but it is important to have a plan.
Getting into the process
You are now all prepared for the process. You have sent out your pitch deck and made a few presentations. Then you receive your first term sheet. What do you do?
C. THE TERM SHEET
The article on “The VIMA term sheet – A roadmap for a start-up’s relationship with investors” will provide further background on the term sheet and the key points to look out for. The following are a few thoughts on how to approach term sheet negotiations.
(a) The first term sheet received in any fundraising round should be celebrated. This is a show of confidence in the business proposition and the team. However, bear in mind that it might not be the only term sheet received. Be conscious about exclusivity clauses and other provisions which prevent the seeking of alternative terms. Remember, a term sheet is not a binding document – it is essentially a tool which opens the door for further discussions in respect of an investment. It is also possible to ask different investors if they would like to participate on terms proposed by another investor.
- Do not just focus on the valuation, look at the terms and the investor holistically. It is true that investors would want to invest in companies at competitive valuations (often described in the form of multiples to revenue or other key metric) so that they can exit from such investments with much more flexibility on the range of multiples later on, assuming the company is growing fast. However, it is also important to recognise more the value-add of the investor in the long run that would help the company succeed later on, than winning short-term battles on valuation from less savvy investors who cannot shift the needle for the company.
- Do not “shop” the term sheet to other investors in an attempt to prove that a certain valuation has been provided. It is tempting to do so, but doing so will likely be in breach of confidentiality obligations as agreed with the investor.
- Approach negotiations tactfully – there are certain matters which investors feel strongly and deeply about. Likewise, there are matters which matter to entrepreneurs and reasonable investors fully expect a negotiation around these terms.
- As always, consider approaching a lawyer for advice on the term sheet. One issue which often crops up in document negotiations is where one party seeks to materially depart from a term which was agreed to in the term sheet, because that party did not fully understand the impact of agreeing to such a term.
D. DUE DILIGENCE
Due diligence is a process by which an investor is provided with further (and more detailed) information and supporting documents relating to the company. Most investors will commence the formal transaction process with this – a “deep dive” into a company.
It is fair to say that there is no common standard by which all investors will approach due diligence. It is, however, generally important for the company and the founders to provide all information which an investor asks for. Be cautious about how information regarding proprietary intellectual property is provided – for example, it would be fair to have a meeting whereby the details of the proprietary intellectual property is shared in detail, but the investor would not be able to print information detailing the intellectual property.
As noted above, it is useful to use an electronic data room to share information with potential investors. This allows the company to track the dissemination of information, as well as to cut off access to any investor who has dropped out of the process. In our view, the cost of a data room is worth investing in – a founder will realise the benefits of an organised process as he or she progresses along these negotiations.
In general, the due diligence process is something which will demand time and attention from a founder and senior management of a company. Plan for this time commitment and use the time effectively. Investors will appreciate an engaged management team and where information requested is shared in a timely manner. This can be useful when negotiating core terms in the definitive documentation.
Last but not least, do not withhold information from investors out of a fear that they might walk away. The legal consequences of doing so when the investors find out after they have made the investment will far outweigh the consequences of being upfront and pro-active about issues.
E. NEGOTIATING DEFINITIVE DOCUMENTS
The article on “The “BIG 5” issues – An investor’s perspective” will provide further guidance on the clauses all parties should focus on. The following are general principles of good negotiation techniques:
(a) Negotiate with a purpose and not emotions – understand the true value of what is being negotiated for. It is a lawyer’s job to advise a founder of all possible consequences of a particular negotiation point, but the founder will need to make the call as to whether this is something which is likely to happen or is merely a theoretical possibility.
(b) Understand that the terms set out in a Series A document may be superseded if a Series B is raised. These are terms which are suited for a Series A transaction but a later stage investor may have the negotiating power to demand different terms. Recognise that this is dynamic and plan negotiations with this in mind.
(c) Be involved in the negotiation process – a founder knows the company best. Use professional advisors as a tool and a trove of experience, but it is often not wise to be fully reliant on them to determine what is best for something the founder and his/her team have built.
F. FINAL VERDICT
1. Should I still raise a Series A?
Think harder. The truth is – not all companies should raise a Series A. It is unfortunate, however, that raising capital has sometimes become a vanity metric. However, many companies fail to realise that external money can mean investor expectations that may diverge from the entrepreneur’s expectations. It is normal for investors to ask for rights that would help them monetise their investments, including dragging the entire company for sale (more about this in subsequent chapters of this guidebook).
Thus, we always advise companies that they should only fundraise if they believe the investment from a set of investors have principles aligned with the entrepreneur and will truly supercharge the company in so many ways that capital alone cannot deliver. Does the investor have the operational value-add or network to shift the needle for the company? Will it be easier to raise the subsequent round of financing with the investor on the cap table? These are legitimate questions on the investor’s ability to game-change the trajectory of the company.
Also know that Series A is perhaps not the only path if the company is running out of cash. If the entrepreneur feels his/her company has not demonstrated the proven market-product fit (and get into discussions on valuations in which a possible down round is likely), it is useful to consider a convertible note (more about this in Chapter 3 of this guidebook) or consider a sale of the company while the company is still small and start all over again. This is one option that is typically unexplored by many due to the unfounded hype generated by fundraising. Other options such as bank loans (especially if the company is profitable or if capital is stuck in the account receivable) or family and friends should be considered.
2. Parting thoughts
At the end of the day, Series A fundraising is like dating. After the first date, founders should hope that they can go on to subsequent dates. Nothing beats a founder who can demonstrate knowledge in his own company, conviction in the problem he is tackling and confidence in his team without nice documents and projectors. We have heard of Series A raises that closed in six hours! Venture capitalists are in it to know if it all makes sense to invest in the market, the product and, more importantly, the team.
Thus, it is truly important to think deeply about the business and how to communicate it. Founders spend a lot of time mapping their stories and conveying them in the clearest way possible. Having a tight process to support this arduous endeavour (especially the realities of it) will be very important to the founder’s success!
Kurt was previously a Senior Associate at Openspace Ventures, a Southeast Asia Series A/B fund with more than $225 million assets under management. He is currently pursuing his MBA at Harvard Business School.
Disclaimer: This article is intended for your general information only. It is not intended to be nor should it be regarded as or relied upon as legal advice. You should consult a qualified legal professional before taking any action or omitting to take action in relation to matters discussed herein. This article does not create an attorney-client relationship and is not attorney advertising.
Published 29 May 2020