by Scott Kupor
Pitch Essential #4: Go-to-Market
The go-to-market section is often the most underdeveloped section of the pitch for an early-stage company. That is, how will you acquire customers, and does the business model support customer acquisition profitably?
Many entrepreneurs make the mistake of skipping over this at the early stage because the current funding round is not likely to get them meaningfully into market. But it’s important to include this in your pitch, even if just at a high level, as it is foundational to the long-run viability of the business.
Are you planning to build a direct, outside sales force, and can the average selling price of your product support this go-to-market? Or are you planning to acquire customers through brand marketing or other online forms of acquisition? If so, how do you think about the costs of such activities relative to the lifetime value of a customer?
You don’t need to have robust financial models at this stage of your company’s development, but you ought to have a framework that gives a VC enough fodder to understand your thinking around customer acquisition.
As with the product section, walking VCs through your go-to-market strategy is a great way to show them how your mind works and how deeply you understand your audience.
Returning to our friends at Okta, the original go-to-market for the business was to sell to small and medium-size businesses (SMBs). The theory was that SMBs were more likely to be forward thinking about adopting new technologies and that the SAAS model lent itself better to this market. That is, because SMBs likely had smaller IT teams and budgets than did large companies, the ability to rent software and outsource the running and maintenance of the software to a third-party vendor would be a compelling sales proposition.
Yet as the company began to execute against this plan, they learned that selling into the large enterprise market was actually a better place to start. Why was that? It turned out that the larger a company was, the more likely it was to have lots of individual SAAS applications being utilized across disparate departments, and thus the value proposition of the Okta software resonated best with these companies. At this earlier stage of development of the SAAS market, the SMBs just hadn’t deployed enough SAAS applications to take advantage of the automation the Okta software provided. As the SAAS market began to mature and the SMBs started to invest in more SAAS applications, the SMBs also ultimately became good customer prospects for Okta.
You are not expected as an entrepreneur to have all the correct answers figured out, but you do need to have theories grounded in reasonable assumptions against which you can then apply real-world experience. Again, strong opinions, weakly held.
One side note on the context of adaptability: A hallmark of startup companies is that they often “pivot”—this is a euphemistic way of saying that the original product, go-to-market, etc., didn’t quite work in the way you expected, so you decide to change that aspect of the business and try again. Some pivots can be minor adjustments, while others might be wholesale changes of direction.
One of the most amazing pivots of all time comes courtesy of Stewart Butterfield. Andreessen Horowitz invested in 2010 in a gaming company called Tiny Speck, run by a great entrepreneur by the name of Stewart Butterfield. Tiny Speck set out to build—and ultimately did build—a massively multiplayer online game called Speck. It was a great game in many respects, but Stewart later concluded that it couldn’t sustain itself as a long-term business.
With a few months of cash remaining from our original investment, Stewart approached the board (Accel Partners was also an investor in the company and represented on the board) with an idea: in developing Speck, the company had built an internal communications and workflow tool that they found significantly increased the efficiency of their engineering development processes. Stewart wondered whether other organizations could also benefit from this product, so he sought permission from the board to “pivot” into this business with the remaining cash on the balance sheet.
I’m happy that we were smart enough to say yes to Stewart’s request. That pivot is now Slack, an enterprise collaboration software company that is valued in the billions of dollars.
I can assure you that not all pivots work out this way, but I mention this story in the context of the VC pitch to underscore a few important points. First, VCs understand that, despite the best intentions, most businesses go through some set of pivots along the way, whether small tweaks or almost complete restarts. So, as you pitch, you are not expected to be clairvoyant, nor do VCs expect that everything you say in the pitch will materialize as you have forecast.
Second, though—and this is really important—you do need to demonstrate to the VCs that you are the master of the domain you are proposing to attack and that you have thought about every important detail of your business in a way that shows depth of preparation and conviction.
For example, if you are pitching a VC and she suggests that your go-to-market plans are all wrong and should instead be done differently from how you have pitched, the wrong reaction is to immediately abandon your plan. While that may ultimately be the right path to take, the fact that you could be so easily convinced in a meeting, where the VC has spent a total of one hour hearing about your business while you supposedly have spent nearly a lifetime doing so, would raise some serious questions about your preparedness and fitness to be a CEO. A thoughtful, engaged discussion on how you came to the conclusions that you did and a willingness to listen to the feedback and incorporate it into your thinking, as appropriate, would be a far better response than pivoting on the fly.
Pitch Essential #5: Planning for the Next Round of Fund-Raising
For the final part of your pitch to VCs, you should clearly articulate the milestones you intend to accomplish with the money you are raising at this round. Remember that a VC is likely projecting ahead to the next round of financing to gauge the level of market risk she is taking by funding you at this stage. Are you raising enough money to accomplish the milestones you set out such that the next investor will be willing to invest new money at a substantially higher valuation than the current round? “Substantially higher” is very market dependent, but in general you want to aim toward a valuation that is roughly double your prior round. That momentum will be well received by both your current investors and your employees.
If, at the time you present the milestones, you or your VC feels as though the milestones are too much at risk, you’re likely to have a discussion about raising more capital at the current round, lowering the current valuation, or finding other ways to increase the confidence interval around your forecast progress.
Remember that most VCs are building a portfolio of companies as part of a fund, and thus they are looking for some level of diversification across a number of investments. Thus, while they may be investing $10 million in your current round and reserving some additional dollars to support future rounds of financing, they are not assuming that they will be the only investor throughout your company’s life cycle.
This is why VCs care about the achievability of the milestones you are laying out; in most cases, they don’t want to be, or can’t afford to be, the only capital provider at the next round of financing, so they are trying to estimate the risk of you (and them) getting stranded at the next round.
If all else fails and you forget everything we just talked about in the heat of the moment, remember to go back to first principles: How do I convince a VC that my business has a chance to be one of those outsize winners that can make her look like a hero in front of her LPs?
CHAPTER 9
The Alphabet Soup of Term Sheets: Part One (Economics)
Now, let’s assume your startup story is compelling enough that you receive a term sheet from a VC. This is an exciting moment for many founders . . . and then their eyes start to cross. What do all those terms mean? How do you evaluate them? What’s standard, what’s not; what’s a good deal versus a bad deal?
As I mentioned at the beginning of this book, the term sheet is where information asymmetry between VCs and founders comes into play the most, and often at the expense of the founder. This is because VCs have been through this process many times and have negotiated hundreds of term sheets. By contrast, founders only get a few shots on goal in a lifetime and likely can count the number of term sheets they have negotiated on one hand. This is normal, but it puts the founder at a disadvantage that I would very much like to correct. It is my goal in this chapter and the next to unpack the term sheet, including some explanation of how VCs think about various terms so that entrepreneurs can be informed and clear about what their term sheets mean for them and their business.
The term sheet is a magnum opus, by any measure, and there are a lot of mechanics to understand. I’m going to simplify the very long term sheet into two big buckets—economics and governance.
This chapter, the economics bucket, includes the sections that talk about the size of the investment, valuation, antidilution treatment, liquidation preference, the size of the employee option pool, and vesting of options and founder shares. Not surprisingly, these items occupy a lot of the attention of both parties in the negotiation. And they are certainly important. But the other big bucket probably has much greater long-term ramifications for the success of the company.
Chapter 10 details the governance bucket. This addresses who gets a say in what happens in the company.
One more note before we dig into the term sheet. I created a standard example of a term sheet for you, which you will find on this page. It’s a sample term sheet for a Series A financing for hypothetical XYZ Company to be led by Venture Capital Fund I (VCF1.) Please reference it as we go through chapters 9 and 10.
Now, just as a Broadway playbill gives you a cast of characters and a short description of each role, let’s go through the various terms of a deal. We’re starting with the economics section of a term sheet—the money decisions.
Security: Preferred Shares
We mentioned earlier that one of the benefits of a C corp is that we can have different classes of shareholders with different rights. Well, here it is: VCF1 is going to purchase Series A preferred shares of the company. These are distinct from common shares (which is what the founders and employees typically hold) and they are also different from potential future series of preferred stock (that will likely be labeled “Series B,” “Series C,” ad infinitum). As you’ll see as we progress further in the term sheet, the whole reason for creating a new class of stock is to give it “preferred” economic and governance rights relative to those enjoyed by the common shareholders.
Aggregate Proceeds
This one’s pretty easy—the term sheet says that VCF1 is going to invest $10 million into the company in exchange for a 20 percent ownership interest. The second part of the section is intended to make sure that, to the extent the company has any other debt outstanding, in connection with this investment, all those notes will convert into equity under the terms of this financing. The reason VCs care about this is that notes (or debt) are generally senior to equity; that is, if the company were to go out of business, the notes would get paid back out of any remaining proceeds before the equity. So, if a VC is going to invest in the company, she doesn’t want other monies to be ahead of her in the event of a potential liquidation. By forcing all the notes to convert into equity in this round, the VC ensures that everyone is in the same position with respect to the distribution of proceeds in the event of an exit (at least until we start talking about liquidation preferences shortly!).
We touched briefly at the beginning of the book on debt and mentioned that many startups raise convertible debt in connection with their initial seed financing. Recall that convertible debt means that the instrument starts out as debt but can be converted into equity based on the occurrence of certain events. In most cases, the debt will convert into equity in connection with an equity financing round, typically in a Series A financing like the one we are discussing here.
More about Convertible Debt
There are several flavors of convertible debt. In its most basic form, the debt converts into equity at the same price at which the Series A investors purchase equity. This is referred to as an “uncapped” note, meaning that the valuation at which the note converts is not restricted and will be determined based upon the Series A equity price. Investors, understandably so, are often hesitant to purchase this debt because they are investing at one of the riskiest stages of the company’s life cycle—companies generally are using this seed capital to begin building their first product—and are not getting paid adequately for this risk. Rather, they are paying the same price ultimately as the Series A investors, who have the benefit of putting their capital at risk at a slightly later stage of maturity of the company.
As a result, most convertible debt has one or both of the following features. “Capped” notes establish a ceiling on the maximum price at which the debt will convert into equity. For example, a convertible note with a $5 million valuation cap means that in no case will the debt convert into equity at a price higher than $5 million. If the Series A round valuation comes in below the cap—say $4 million—then the debt holder gets the benefit of that lower valuation. And if the Series A valuation exceeds the cap—say $10 million—then the debt holder converts at the $5 million cap, in this case a full 50 percent discount to the Series A investor.
The second feature is a conversion discount, with or without a cap. For example, the convertible note may provide that it converts at a 10 percent discount to the Series A financing valuation. In the case of an uncapped note with a 10 percent discount, the nominal conversion price will move up or down with the Series A price but always remains at a 10 percent discount to that price. If you coupled a cap with a 10 percent discount, then the conversion would follow the same principles as the capped note above: the note holder would get the benefit of the discount up to the point at which the cap provides a more favorable conversion price.
Why do entrepreneurs choose to issue convertible debt at the seed stage of financing versus raising traditional equity? Oftentimes, entrepreneurs do this for cost and simplicity reasons; the standard convertible debt documents are pretty simple and don’t require much legal time and expense. The other benefit of convertible debt is that it allows both the entrepreneur and the seed investor to punt on the question of valuation at this early stage of company development. Rather than having a big negotiation around pricing at the seed round, the parties essentially defer that discussion until the Series A financing. However, once you start to introduce the cap concept into a convertible debt round, it’s no longer the case that you are truly deferring that valuation discussion. In effect, you are agreeing on the maximum valuation at which the debt will convert into equity; this sounds awfully similar to agreeing on a valuation!
One very common mistake that we see entrepreneurs make is to raise too much convertible debt in the early days of the company such that they end up giving away too much of the company to outside investors. Why does this happen? For a couple of reasons.
First, as noted above, the main feature of convertible debt is that it allows an entrepreneur to raise money quickly and with much less legal expense than would be typically associated with an equity financing. This is because the legal instrument is very simple to document and is often set up to allow the company to raise additional capital relatively easily beyond the current investment. In contrast, equity financings typically require execution of a myriad of documents, and amendments to those documents typically require consent of the existing equity holders.
As a result, convertible debt financings can often have multiple, rolling closings, whereas an equity financing typically has only one closing. While this distinction may sound trivial in theory, in practice it has real consequences. We see many entrepreneurs who decide to raise $1 million in a convertible note and close on that money ve
ry quickly. But commonly some other investors will come along a few months later and indicate that they, too, would like to join in the financing. Most entrepreneurs acquiesce to this, since more money is typically better than less. And then the process has a way of repeating itself a few more times, each in relatively small dollar increments, but with the end result of the entrepreneur finding that she has over time raised $2.5–$3 million on the same financial terms on which she set out originally to raise $1 million. Depending on the way the note was written, each new financing round might require the new investors to execute a separate note, but this is a relatively trivial process and does not create an obstacle to these rolling closings.
The second feature of the note then becomes more apparent to the entrepreneur when she decides to raise a regular equity round of financing from a venture capitalist—her Series A financing. Although the notes may have a valuation cap or specify that the notes will convert at some fixed discount to the Series A equity, because the actual conversion price is not known until the Series A financing price is agreed upon (which of course occurs sometime in the future when the Series A investor agrees to a deal), the actual effect of the notes on the company’s equity capitalization is also not determined until such time as the Series A financing happens. In contrast, when an entrepreneur does a regular equity financing, the actual dilutive effect of the transaction is made clear at the closing of the financing when the new shares have to be issued to the new investor; thus, the entrepreneur knows exactly how much of the company she ultimately still owns.
As a result, a fact pattern we see very often at the time of a Series A financing is that the entrepreneur is surprised to learn that she has sold much more of the equity than she anticipated through a series of these convertible notes. Not only can this be upsetting to the entrepreneur, but it also can be problematic for the Series A investor. After all, the new investor wants the entrepreneur to be highly motivated in the form of owning a lot of the equity of the company—what better way to align incentives than to have the entrepreneur get rich alongside a great investment return to the venture capitalist? But if the entrepreneur owns too little of the company at such an early stage of the company’s life, the likelihood is that either she will become demotivated over the coming years or the VCs will need to grant her more equity down the road to maintain her economic interest.