Anyone who has ever been involved in a job search (i.e., 99% of us!) is familiar with how much time it takes to find a job. A similar dynamic applies to the startup company that decides to pursue outside funding. This is true regardless of the form of the investment being sought (SAFE, convertible note, common stock, preferred stock, etc.). It is also true regardless of whether investment is being sought from venture capital funds housed within large corporations such as Oracle and UPS, from free-standing VC firms, or from angel investment groups or individual angel investors.
At the end of the process for clients raising money for the first time, after everything has been signed – and the wire transfer has cleared! my clients invariably say the same thing: “I had no idea it would take this long and take up this much of my time.” This is true across the board, whether the first round is a modest angel investment or an eye-popping VC raise.
There are two parts to the time aspect. The first aspect is the time commitment; it is time consuming to research potential investors, prepare quality pitch materials, meet with potential investors, undergo due diligence, and then negotiate the deal. A founder or CEO who believes that he or she can continue to run the company effectively while engaged in a serious search for funding should re-examine that belief! Many options are available to free up the necessary time, with the specifics depending on the circumstances. The important point is that a senior executive who is already buried in work needs to plan for the fact that some work must be off-loaded or delayed in order to fully pursue funding.
The other aspect is the length of time elapsed from beginning the search for investment to closing the deal. Most startups pursuing funding for the first time don’t realize what a drawn-out process this generally is. They may be led to believe it is a quick process when a company raising money in a short timeframe gets written up in the business press. The notice in the press is because such a short path is the exception rather than the rule.
To help understand the timeline involved, here is a breakdown of the steps required to successfully pursue funding:
- Prepare proper investor materials. This typically includes a business plan with detailed pro forma financial statements, a one or two page executive summary, a PowerPoint pitch deck, and a private placement memorandum or other documents that must comply with securities law.
- Identify and connect with interested investors. The amount of time for this phase is highly variable. One advantage of pursuing VC investment is that the universe of possible investors is discrete and not too difficult to research. On the other hand, the work required for a company pursuing angel investment is typically a more time-consuming process, since the universe of possible investors is much larger and more difficult to identify and research.
- Perform due diligence. The amount of time involved in due diligence varies significantly from company to company. Key factors that affect the timeline for this phase are: i) the length of time that the company has been in business (a longer term of existence increases the number of issues and documents that need to be located): ii) the thoroughness of investor due diligence investigation (consistently thorough for VC investment, more variable for angel investment; and iii) the degree to which the company has properly organized its records to allow for easy access.
- Negotiate deal terms. This is typically done by means of a non-binding term sheet, preferably prepared with the involvement of experienced legal counsel. The most obvious issues are valuation of the company, the amount of the investment, and the resulting percentage of the company that the investor will own. However, many other issues need to be discussed, such as: a) rights of investor shareholder to approve specified transactions; b) liquidation preference for the investor; c) investor representation on the company’s board of directors; d) information rights of the investors; e) tag-along and drag-along rights; and f) no-shop provisions. The term sheet typically has a binding no-shop provision but is otherwise non-binding. Despite being predominantly non-binding, it serves as a vital communication device to ensure that the parties are indeed on the same page and working toward the same goal.
- Negotiate binding documents. The specific binding documents that will be required varies, but typically include a stock purchase agreement, shareholders’ agreement, and investor rights agreement at a minimum. If the parties have taken the time to develop and agree on a detailed term sheet, this phase consists of formalizing what has already been agreed to, and should move quickly. However, in many cases, the parties either have am incomplete term sheet or they have mistakenly skipped the term sheet phase entirely. In those cases, the real negotiating doesn’t start until the parties start exchanging drafts of the final documents, which makes this phase more protracted.
One important consideration is to note the difference between angel and VC investment. VCs are investment professionals who come to work every day with the objective of finding promising new companies to invest in and make the investment happen once a suitable candidate has been identified. Furthermore, the VCs face pressure based on the expectations of the fund investors. Angel investors, by contrast, are wealthy individuals who may put little or no emphasis on closing a deal quickly. I have seen angel investments take months longer than expected because of the angel taking extended out-of-country trips in the middle of the negotiations or becoming preoccupied with personal matters. Rule of thumb: VC investment takes twice as long as you think it will, and angel investment takes three times as long!
As a closing note, did you know that there is a Johnston corollary to Murphy’s Law? The corollary is this: everything takes longer and costs more. Raising money is a perfect example – it typically takes far longer than the startup anticipates, and it involves spending money to prepare investment materials, hire experienced legal counsel, etc. However, the company that realizes this in advance and plans its timeline and budget accordingly will find the process much smoother and less disruptive than a company that learns these lessons after the fact.