As a startup closing your first round of funding, everyone is excited by your potential, investing in “the dream”. The plan is always to move smoothly from financing round to financing round, increasing your valuation all the way through IPO or being acquired.
But in reality, it never works out this way.
Every startup faces its low points. Markets and pipelines take longer to mature than originally planned, product/market fit proves elusive, and well funded competitors enter your space, scaring away potential investors. In these hard times, when you’re doing a great job executing but need a bit more runway to get to the next big milestone that will turn the story around, how can an investor can support you?
The best-case scenario from the Founder POV in the low points is to have an investor willing to reinvest above their pro-rata level in an uncapped or very high cap convertible note. By investing above their pro-rata in a high cap note, your investor not only provides you with more runway, but also signals to future investors that this was a round done from a position of strength.
The likelihood of them providing you this is a factor of their level of conviction and capability. How can you maximize your chances of landing an investor that provides this kind of support?
Build conviction over time
Investors won’t just blindly continue pouring money into your startup if things aren’t going well, as those with portfolios of startups are hyper aware of the risk of throwing good money after bad and of opportunity cost. But good investors balance this with the knowledge that even the best companies hit rough patches at times and need extra financial support. So how can you make sure to get classified into the latter category?
Build their conviction over time by simultaneously oversharing and meeting targets. Go ahead and tell them about the potential partnership with that huge channel partner that’s progressing, or about the VC whose term sheet is imminent. It will get them more “invested” beyond the money they put into your company.
And even though there is a lot of uncertainty around revenue and fundraising timelines, meeting targets according to plan in areas within your control, such as expenses and product development timelines, builds credibility that you can draw on when you hit a down patch.
The reserves question
How much total reserves do you keep per portfolio company? What is the maximum amount you can invest per company?
These are the type of in-depth questions that sound awkward when a VC is still evaluating if they even want to invest in you in the first place. But dry powder for reserves is arguably the No. 1 value add of VCs vs. other groups and is part of why any syndicate should always include at least one deep pocketed VC. So once you have sold them on investing, assuming they want you and you are juggling multiple term sheets, it’s fair to ask these types of questions.
Prepare for the rough patches
All VCs talk about the value they add to their portfolio companies beyond money. But what founders really need are funding partners that have the conviction and ability to support them even when the chips are down. As any early stage startup entrepreneur will tell you, the path to success is like a roller coaster, hitting new highs and lows one after the other. So be sure to prepare by getting the right investors on board and taking them along for the ride.
Jonathan Friedman is a partner at LionBird, Israel and Chicago’s most active Digital Health investor, and blogs about the Venture Capital Point of View at VCPOV.com.