The Hourglass

As my journey with LayerVault was just beginning, I lacked an understanding of how venture capital worked. Over the next four years, I received a crash course in its purposes and its intricacies.

The most important thing to realize is that, once your raise venture capital, you put a drop-dead date on your company. You can always pay back your debts and buy out your investors, but I have never seen this happen in modern technology companies.

Think of your company as an hourglass. The sand is balance on your bank account. Your burn rate is the diameter of the valve connecting the two bulbs. The valve is adjustable; new hires increase the diameter, lay-offs decrease it. You have until the sand runs out to develop positive cash flow, raise more money, or get acquired. When you run out of sand, you go belly up and have to lay everyone off.

For this reason, many founders dislike venture capital. They believe that they, and only they, should be in charge of the fate of their company. I understand this sentiment: I used to feel the same way. However, great companies are not built by individuals. You need a team. When applied correctly, I believe the structure that venture capital imposes can add positive pressures to a young startup. You are forced to declare goals and directions. You have a team that wants you to succeed.

The problem with understanding something is that you don’t understand something until you have experienced it. I had read the book Venture Deals twice, but didn’t have much of a context. The book is great, and you should read it. But Venture Deals lacked an explanation of the Why’s of different operations. Hopefully this blog post will explain the reasoning behind the different types of financings and certain thresholds. It will primarily be geared for young SaaS companies, because that’s where my familiarity lies.

LayerVault would raise a seed round and a Series A. We failed to raise a Series B or meaningful successive financing. As a result, we exhausted our operating capital and had to close down.

Keep in mind that this stuff is constantly evolving as well. As of the time of this writing, these are the best practices the industry has agreed upon. Macro-economic forces and the general shape of your company can change these things slightly. Also keep in mind that consumer-centric startups will look a lot different than B2B/B2D startups. Generally, you should assume that you will be held to the highest standards for your company type. There are always other deals for the good VCs.

Why do I raise money?

I covered a little about this in the previous post “My company was not special, and neither is yours.” Essentially, you should always keep raising money as an option but not the option. Outside capital should be taken in when there’s a large opportunity that you might miss.

Now, let’s cover generally the three different ways of raising money as an early-stage company: as a convertible note, a priced round, and as venture debt.

What is a convertible note?

Convertible notes (also known as convertible debt) is considered the easiest way to raise money for early stage companies. They are a lot less work than a priced round, and generally deal with smaller dollar amounts. If you’re just starting off, this is probably the thing you want. It lets you put add a few zeroes to the company account quickly and get back to work.

A convertible note can be thought as a slightly more complicated I.O.U. When you take on convertible debt, you are promising to either grant the debtor shares of your company at a later date or pay to back the debt. Investors want convertible debt to convert, they do not want to be paid back.

Convertible debt will almost always convert into shares of the company at the next priced round. The terms of the note determine at what rate this happens. Seed investors take a bigger risk in you, so they acquire shares of the company for a cheaper price.

For the nitty-gritty of the mechanics of these transactions, read the Venture Deals book and the post on FundersClub. The term that you’ll be negotiating the most over is the “cap” on the note. The higher the cap, the less equity will eventually be claimed by your seed investors.

An interesting thing about convertible debt is that investors actually own 0% of your company while the note is outstanding. They do, of course, hold debt in your company. That debt accrues interest. If you’re worried about the interest of your convertible debt though, things are going very wrong or very right.¹

Also note, these convertible debt can also be used as a quick in-betweener between priced rounds for mid- and late-stage startups. That is outside of the scope of this blog post, and also outside of my experience.

Y Combinator is also exploring some new options around early-stage financing for their companies, and it’s worth taking a look at. You can read up on them on their page, Startup Documents.

A convertible note is a quick-and-dirty way of financing your company, and likely the way that you will finance your early stage idea or side-project. Once you raise money though, you can’t keep calling it a side project.

What is a priced round?

A priced round is usually done at the Series A level or later. You can also do a priced round as a seed investment, but this is less common.

A priced round, also known as an equity round, is a transaction where an investor buys shares of your company. Usually, these are a new class of shares with special provisions. (By default, the only class of shares in a company are common shares.) The name for these new shares usually shares the name of the round. For example, your Series A equity round is the sale of Class A shares of your company.

These new shares can be created by the company at any time, based upon rules in the bylaws and corporate charter. Usually, they are only created to fulfill a pending transaction: like the closing of a financing round. The existing shareholders get to make something out of nothing, and then sell those new somethings for cash.

Priced rounds are not free though. Usually the new shareholders (your new VC pals), want their stock to have special provisions like liquidation preferences. The mechanics of all of this are outside of the scope of this post, as others have explained it much better than I. For further reading, please refer to Venture Deals. You shouldn’t begin worrying about the mechanics until about 3 months before you begin your Series A fundraising process.

Priced rounds are considered more complicated because there are more moving parts. It’s likely that your first priced round will be where the company’s bylaws are set, a corporate charter is established, a board is created, and convertible note holders will get converted. It will represent the first time you have people other than the founders and early employees holding equity in the company. All of these things need to be negotiated and figured out before the money is wired. This is where having some good lawyers will come into play.

Equity rounds are categorically different than convertible debt because, once the deal closes, you have some new teammates.² Most major company decisions are now held via board votes at quarterly board meetings. It’s more structure, the stakes are higher, but you’re also being held to successively higher standards. The price of failure becomes that much greater.

What is venture debt?

Venture debt is probably not for you, save for some very specific situations. I have seen some companies companies with large Kickstarter campaigns use venture debt as a way of financial initial production runs of early products.

Generally though, venture debt is “most dangerous” way to get money for your venture. You’ll pay a high price down the road for taking on the capital, and you run the risk of losing everything if you mess up.

Probably best to avoid venture debt as an option, unless one of your seed investors tells you to consider it.

When can I and why should I raise a pre-seed round?

At the time of this writing, the seed stage market has become flooded with new blood, so an even earlier stage of financing has appeared. In fairness, this “pre-seed” money has always existed at incubators. And the name isn’t exactly indicative of any stage. Thus, “pre-seed” can usually be used interchangeably with “pre-idea.”

Pre-seed financing is not necessary for getting a business off the ground. We did not raise any pre-seed financing with LayerVault. Pre-seed financing is built quite a bit around reputation and pedigree of the founders. Pedigree can come in many shapes and sizes: alma maters (think Harvard, Stanford, MIT), past companies (Facebook, Twitter, Google), large online followings, personal introductions, and the like. Because you don’t have much to show in the way of a product, soft metrics are more likely used at this point.

At this point in your company’s life, capital is not likely the thing you need. You probably need the most help with laying the groundwork and getting your fundamentals right. The best pre-seed investment funds or accelerators will help you do exactly that: get your corporate structure setup and minimize the legal bills for you down the road. The capital is more-or-less an afterthought. On the west coast of the US, Y Combinator is probably the best. On the east coast, check out some upstarts like Notation Capital or TechStars. Outside of the US, or in parts outside of New York and San Francisco, I can’t make any recommendations.

Pre-seed money is only given to whole or partial founding teams. It’s money to go explore an idea.

The money you receive at this stage should be spent sparingly. Use it to pay initial hosting bills and for some reasonable equipment. Personnel-wise use it to pay for rent and ramen, not much more. Your team size is between one and three individuals.

Pre-seed capital should be used to decide on an idea and build a proof-of-concept. This proof-of-concept should be used to drive the seed stage fundraising process.

With your pre-seed capital, you need to prove that your product should exist.

When can I raise a seed round?

A seed round should be raised once the idea has been decided on and a proof-of-concept has been built by the founding team. The goal of seed financing is to build a prototype, refine the prototype into a product, launch the product, and achieve product-market fit. That should scare you a little bit.

The time between your seed round and a Series A is a very formative time in your young company. Loose ideas are now getting implemented or culled. You begin tracking metrics, establish a regular customer interview process, and spend the first half of your time marching toward a launch.

Around half-way through your seed capital or before, the product should be out in the world. It should be receiving real usage, and traction is present. Initial customers and earlyvangelists start telling their friends. You bring on an employee or two to help with building the product, but any external communication is still handled by the founders.

Launching early and getting feedback quickly is paramount. The founding team raised the seed capital to build a product with traction, and now they’ve done that. The earlier you launch, the earlier you can start getting feedback. Put a price tag on your product so the feedback forces customers to vote with their actions and not their words. Keep trial periods short³ (if your market permits it) to keep feedback loops tight. You should know every single customer by first name, and be emailing them weekly.

You should still be very stingy with what you spend your money on. You should be recruiting on vision and not on cash compensation. If you can’t convince someone to join the team without offering them a market-rate salary, they are probably not right for your team at this stage. Although your bank has a few zeroes in it, resist every temptation to increase your own salary. Founders should probably keep 50% of market rates during this time. Enough to pay for rent, ramen, and beer.

Around the close of your seed round, your company should still be no more than your founding team. As you make your way to a Series A, expect your headcount to double bringing the total size of your company to six or so.

With your seed financing capital, you need to prove that people love your product. The trick is, your product doesn’t really exist when you raised your seed capital.

When can I raise a Series A?

In the perfect world, the day your Series A closes is the day you achieve product-market fit. Your churn is super-low, and your product is starting to work. Your product alone has fueled growth to this point, but now you need to start filling in the gaps. Establish lightweight processes around support, marketing, sales, bookkeeping, and everything else the engineers aren’t doing. The time after a Series A and before a Series B should be categorized by the founding team offloading responsibilities to those better-equipped to handle vital business functions.

The one thing that I don’t think should be delegated to other members of the team are routine customer checkups, sometimes known as “customer success.” The founders need to know and internalize the sentiment of their product in their customers’ eyes.

The individuals brought in at this stage need to be highly functional, and should be compensated as such. They should be able to take over entire functional areas of the business and build them out. They should be very good at what they do, and able to help out with other parts of the business as necessary.

The money for a Series A will be used to find a “distribution channel” that makes economic sense for your business. A distribution channel is a repeatable way to bring in high-quality customers for your business. This distribution channel could be door-to-door sales, online ads, sponsorships, giveaways, referral programs, affiliate programs, direct sales efforts, or all or none of the above.

When you’re closing your Series A, it’s been about 3 years since you had the initial idea that drove the creation of this company.

With your Series A money, you need to prove that people not only love your product, but there’s a viable and repeatable way of selling it.

When can I raise a Series B?

LayerVault was never able raise a Series B, so my knowledge and familiarity of the process is close to zero. That being said, I have at least a passing familiarity with this stuff.

With your Series B capital, you need to prove that more money into your distribution channel means more money (eventually) out.