We love hearing about companies raising money. While big numbers are usually the only things we focus on, few people ask about details. How much of the company was given away? What were the terms? While these topics aren't as exciting as the amount of money the company received, they are important.
Before you raise capital, you should be aware of some tactics investors might use on you. It's easy as an entrepreneur to get offered a huge sum without knowing the details that go along with it. While your lawyer is there to help you through this, ultimately you need to understand the basics yourself. Here are three tricks to watch out for when you pitch to investors. Be prepared for these and your investor will realize he's not playing ball with an amateur.
1. The pre- and post-money trick
When negotiating a deal, one of the greatest points of emphasis is the valuation of the business. In early-stage companies, it's hard to get the valuation down to a science. Investors all have different ways to go about this. Common practice is evaluating the company based on revenue, the team, market size, and other factors. Because investors know the value of the company will be a top priority to you, some will make it seem like they are giving you a fair valuation. In reality, some investors will trick you by replacing the pre-money valuation with the post-money.
To give an example, let's say you want your company valuation to be $100 million. You are asking your investor for a $20 million investment. So, the pre-money valuation you want is $100 million and the post-money valuation that you want is $120 million. When an investor tells you they are valuing your company at $100 million, that's great as long as they are talking about pre-money. If they're talking about post money, their valuing your company at $80 million.
This trick is easy to avoid by just asking when an investor talks about valuation if they mean pre- or post-money. This way, there's no confusion and you'll make sure both of you are on the same page. Also, your investor will realize you know what you're doing, so they'll think twice before trying another move.
2. Paying for the investor's lawyer fees
Raising capital can ratchet up the fees your lawyer takes. This is especially true when your company gets to the venture capital stage. Part of the money you raise from a round of funding will be used to pay your lawyer for due diligence during the deal. Depending on how much negotiating takes place, you could be dishing out $25k-$30k in lawyer fees.
As an entrepreneur, it's important to make sure you are not responsible for paying your investor's legal fees if you can avoid it. When you get a term sheet, make sure there isn't a provision stating that you'll be covering legal work for both parties. There are hundreds of points that lawyers want to argue about, but in reality don't affect the deal. When both parties want to avoid paying a fortune, they'll resist arguing about useless points and focus on closing the deal. If you're responsible for covering all the legal expenses, your investor doesn't need to worry. They can argue for as long as they want, because you're picking up the tab.
Make sure you read the term sheet beforehand, and insist on your investor paying his own legal expenses. You'd hate to have to shell out $50,000 on legal fees, only to have your potential investor pull out of the deal.
3. Stringing you along
Investors hate saying no. So, many times they won't give you a direct answer. They'll tell you that they are interested in investing and then keep delaying the next steps. This is the worst situation to be in as an entrepreneur. When an investor says yes, that's amazing. If an investor says no, hopefully you find out why and then move on to the next one. You don't waste any more time. It is when an investor says maybe that kills the entrepreneur. You're going to spend time following up with updates, and sending more information. In some cases, investors are waiting for someone else to bite before they commit. Many times though, they just don't want to say no.
If you get caught in the middle ground as an entrepreneur, you need to force yourself to move on. Keep the investor on your monthly update list, and make sure you don't burn any bridges. At the same time, understand that a maybe is essentially a no. Pitch to the next investor, and focus your resources elsewhere. If an investor needs more time, that's totally fair. Just don't waste time trying to convince them.