Venture Capital is Data-Driven and Not Introduction Driven by Mark Graffagnini

October 7, 2019 – Mark was an attorney at the largest law firm in Silicon Valley before founding his own law firm, Cara Stone, LLP, which is focused on helping startups outside of New York and Silicon Valley raise money and exit. In 2018 alone, he and his firm led over $1 billion in financing deals and exits, including one of the largest tech company public offerings outside of Silicon Valley. In addition, he is a partner in the venture capital fund, Callais Capital Management, based in Louisiana and looking at opportunities in the Gulf South and Midwest.

Since leaving Silicon Valley to found my own firm 10 years ago and focusing on helping companies outside of Silicon Valley unlock angel and venture capital, I have represented companies obtaining investment from individual investors, micro-VCs, angel groups, and larger VCs both on the coasts and in their local markets. My firm has worked with clients on fundraising processes that have raised over $1 billion in capital, and we average well over 20 early stage financing deals per year. Our clients have a very high degree of success raising capital in markets where companies tend to think it’s hard to find investors.  The reason is simple: we employ a highly sophisticated, data-driven process.

Founders and advisors almost universally overestimate the value of “introductions” to investors as the basis for finding angel and venture capital. They almost always undervalue deep research, preparation, and insight about prospective investors. This misunderstanding causes several founders and their advisors to fail at the fundraising process.

The most popular blog posts, books, and presentations on fundraising miss a critical understanding of the realities of the angel or venture capital market—both nationally and in their own backyards.

Private investing is a market with preferences for corporate legal structures, teams, round sizes, deal types, companies, metrics/KPIs and founder qualities. Like any market, these factors vary based on your location, industry, growth rate, and other factors. Introductions alone will not help a company get funded if its leaders have not taken the time to deeply understand the preferences of investors who prefer to invest in their arena.

Although a full plan and process for financing is beyond the scope of a blog post, I will focus on some data that is already available for the St. Louis (and larger Missouri market) and how companies can leverage this to start building a solid financing strategy. In particular, I will explain how a few metrics on the Missouri Venture and Angel Capital Report can provide help guide companies in the quest for capital.

Research on Valid Round Size

Founders need to look at the data in their market before deciding on the size of their round. There are numbers floating around about the “standard deal size”. These numbers vary from market to market. Pitching the wrong round size can be costly.

In Missouri, the average deal size across all angel and venture deals is typically between $1.2M and is as high as $4M, but the median deal size (the deal size most prevalent) is actually around $500,000-600,000. The averages include later stage, typically larger rounds. They often do not provide a good guide for any individual round. More often than not, companies without a fully developed product, customer acquisition strategy, and product-market fit, should be sizing their rounds closer to $500,000-600,000 rather than $1M+ rounds. In many cases, the round size will be lower if the company is in it’s very early stages. In other words, the median is usually a better guide for an individual round an organization might be seeking in a given market.

I have met founders outside of Silicon Valley without fully developed products, services, or any revenue seeking well over $1M in a single early round. They believe that this is the “right” amount of money to finish the product and gain a base of paying customers (break-even is a common term here). Unfortunately, only a very small number of founders can raise $1M to complete a product and test user acquisition and product-market fit. Almost all founders who successfully raise $1M+ to build out substantial product features and experiment with user types have either:
(a) had a prior exit/business relationship that enriched the investors they are targeting, or
(b) have their own family and friends rolodex that got them that amount of money.

Instead, founders should focus on smaller, meaningful milestones that can be achieved with smaller amounts of capital. Smaller rounds should focus on well-thought-out experiments on customer acquisition strategy (and costs), lifetime value (LTV) of customers, repeat customer behavior, etc. These metrics will be required in a $1M+ round. If a company has not leveraged money from smaller rounds to learn lessons about scalability that are persuasive, the company will have a harder time raising a $1M + or more round.

Determining how much to raise and which milestones to target is also data-driven and sometimes takes weeks or months of discussion and research. Founders who focus on these metrics prior to raising money are the founders who are more likely to see success. Founders should not fall into the trap of saying “we don’t have time to do that research and early experimentation because we are just seed stage” or “we are having a viral moment” or “we talked to [insert someone who had once lived in silicon valley], who told them that $1M is a ‘standard’ round size”. The best fundraising strategies are routed in numbers native to the market.  

Introductions for seed stage companies to Silicon Valley investors are almost always premature. If a company is able to effectively execute on strategies with smaller amounts of money, it may never have to raise money from Silicon Valley. I’ve had at least one client raise $28M from individual angels in Louisiana and go public without ever having to take institutional money from Silicon Valley. You can do this too if you do the research, are coachable, and execute well.

Research on Corporate Structure

The angel and venture capital investment market has spoken, the verdict is in, and the evidence is clear:

  • Since 2013, the number of corporations that have raised funds in Missouri far outweigh the number of LLCs that have raised money. This is not up for debate: sophisticated angels and venture capitalists require your company to be a corporation with a set of documents that are well-known in the VC world. Cara Stone helps multiple companies per year transition from an LLC to a corporation to take financing. If a founder meets with investors and approaches this question with “we will figure it out later,” then he/she has just given the investor a reason to put him/her on the backburner for investment.
  • Additional documents that will likely be required for investment include:
    • Restricted stock purchase agreements with vesting for founders (yes, investors want founders subject to investing) and all key service providers;
    • Confidentiality and invention assignment agreements;
    • Advisory agreements (if applicable);
    • Bylaws and the suite of other corporate docs.
    • Term sheets for the round.

I recently met a founder who was asking me for introductions for a $1M+ round to “get to break even” while her product was still in test mode. I asked her about her corporate structure. She told me that her company was an LLC and she was figuring out the terms of her operating agreement with her co-founder and still using pro bono legal services from an incubator. She was told that it wasn’t important that her corporate agreements were still in process because she was raising under a SAFE. This was a mistake. Waiting to fix corporate governance until a fundraising is an automatic disqualifier for a serious investor. Investing in early-stage companies is inherently risky. Abnormalities in a company’s corporate documents adds to the investors risk.

If company leaders do not seek out the right advice up front, the company will pay for it later in lost investment, increased cost, or inability to raise future funds or exit. Investment documents are sophisticated, so using providers who are familiar with deal terms, financings, and the growth process will reassure investors and help in your fundraising strategy. The best service providers can defer fees on the right opportunities, because they have the background to help companies put the right fundraising strategies in place to successfully raise money.

In the recent press about various IPOs that have failed or are troubled, corporate governance and incomplete or mishandled documents have also helped derail company exits. Companies are best served by advisors who will give them the hard facts and not the advisors who simply want to curry favor by telling them what they want to hear or making an inherently complex process seem easy.

Industry Research

Industry research is not just a general statistic for economic development leaders and government officials. A founder can handicap his or her chances of raising money in a market with reference to the total number of deals in their industry. For the past several years, Missouri has seen between 60 and 80 total deals. Other guidelines give you even more information:

  • The number of industry deals in a given market guide whether you should focus on in-market or out-of-market investors.
  • Once a founder knows how many SaaS deals in Missouri happen each year (for example, 25 in 2018), he/she can start using sophisticated research to find out who the investors were in each deal, the deal terms and the stage of company. The best investors already have this information so they can benchmark their opportunities. Founders need to work with advisors who understand these techniques and who can help them unlock that information to build out an investor pipeline.
  • Some investors are generalists (invest in many industries) and some are industry specific. Knowing this before you meet with a prospective investor is absolutely key to credibility.

With research, founders can develop sophisticated strategies to meet the right investors instead of asking for introductions to investors who may or may not be a good fit.

Conclusion

Introductions to VCs are easy and can work well when a company has millions in revenue and triple digit growth rates. However, introductions may damage the company’s chances of getting funded if the founding team and their advisors take a shotgun approach to contacting investors. Remember that there is only one chance to make a first impression. Beware of the people quick to open a rolodex and shoot off emails without asking questions or vetting the business model. The market metrics I mention here are just the surface level issues you should start with when building your pitch, financing strategy, and investor funnel. Starting with a data-driven approach will give companies an edge on those who are out there asking for introductions or who are taking a spray and pray approach to financing strategy. With the right tools and approach, companies can succeed in raising money and gain valuable insights that set them up for success after their deal closes.