Startup Cheat-Sheet: How to Close Your First Investor

So, you need money.

Let’s face it, the startup world fetishizes fundraising. Pitches have become a form of entertainment. Tech press sensationalizes funding announcements.

But despite all the buzz, you should think long and hard about whether raising money is the right move. For many companies, it’s not.

Fundraising will eat a huge chunk of your time, lock you into a cycle where you must continue raising ever larger amounts of money to survive, and dilute your ownership and control as a founder. If you can build a profitable business any other way, do it.

But if you are truly setting out to build a high-growth startup tackling a multi-billion dollar market, then teaming up with the right investors is key. More than just providing capital, great investors contribute know-how, credibility and connections.

Before closing your first check, you’ll need a feel for the milestones that investors expect at each round of funding. You’ll need to understand the pros and cons of the various investment instruments and when to use them. And you’ll need a working vocabulary of the terms you’ll be negotiating.

So, here’s your cheat-sheet.

Investment Rounds

How much money should raise, and when? While the definitions are fluid, early-stage investing is usually framed in three buckets: Pre-Seed, Seed, and Series A. Here are finger-in-the-air approximations for each:

• Pre-Seed. You’ve already created a prototype and are now building your minimum viable product (MVP), but want to raise $50k to $500k at a low ($1m to $2.5m) valuation to give you up to 12 months of runway to launch your MVP and test the market for product-market fit.
• Seed. Your product is launched, you’re generating over $50k monthly revenue, and you want to raise $750k to $3m (at a valuation of $3m to $10m) for 18–24 months of runway to add a few key hires, really dial in product-market-fit, and figure out how to produce consistent, double-digit month-over-month growth.
• Series A. You’re generating $100k to $200k in monthly revenue and are growing 10% to 30% month-over-month. Congratulations, you’re now in Series A territory. At this stage you’re probably ready to raise $4m to $15m (at a $15m to $50m valuation).

These are merely rough rules of thumb, and they’ve been changing significantly from year to year. To Jason Calacanis’s point, the definitions are less important than the headline goal for each round, which can be summarised as minimum-viable product (round 1), product-market fit (round 2), and sustainable growth (round 3).

Since this post is about closing your first investor, it’s worth highlighting that angels (much less VCs) don’t invest in business plans anymore (unless you’re Elon Musk). You need at least a prototype, and preferably a minimum viable product and some initial customer traction, before you spend time and energy trying to raise pre-seed funding.

Visualization by Anna Vital.

Investment Instruments

With those funding milestones in mind, let’s survey the investment instruments at your disposal and consider when to use each one. (It goes without saying though that I’m not a lawyer and this isn’t legal advice — just my notes as a fellow founder.)

Equity round

An equity round or “priced round” is when you and your investors agree on a valuation for your company and issue new shares to those investors. This often involves negotiating additional terms such as liquidation preferences, anti-dilution rights, boards seats, etc. It's the most complicated (and therefore most time consuming and expensive) method of the three, and for that reason is usually reserved for Series A rounds, and most certainly involves attorneys.

Here are a few very basic terms, though there are many others:

• Round size. The total amount of money you raise in a given round. If you’re trying to raise a $1 million seed round, for example, then the round size is simply $1 million.
• Valuation. The agreed-upon value of your company at a certain time. It’s the number most negotiated by founders and investors since it determines the investor’s ownership and the founder’s dilution.
• Dilution. When additional shares are issued to new shareholders, the existing shareholders end up owning less of the company than they did before. This is called dilution. For example, if you raise a $1 million round at a $5 million valuation (thereby giving the new investors $1 million worth of shares), the new investors will then own 16.7% ($1m/$6m) of the company, diluting the existing owners by 16.7%.

In short, equity rounds are usually reserved for Series A.

But they are getting easier and cheaper. Here’s a blog post from Yokum that compares several sets of standardized equity seed round documents.

Convertible note

The convertible note circumvents much of the complexity of equity rounds, though it introduces some complications of its own. The convertible note is a debt instrument that converts into equity at a later point, usually at a subsequent equity round. This makes it a good candidate for pre-seed and seed investments that are intended to convert into equity at Series A.

Rather than set an explicit valuation, the convertible note typically features both a valuation cap and a discount rate (though it can have just one or the other) which determine how many shares the investor receives when the note converts into equity.

However, since the convertible note is essentially a loan, it also includes a maturity date (when it has to be paid back) and interest rate. Therein lies the catch 22 of the convertible note: it can lead to a founder/investor conflict if the maturity date is reached before a conversion event has occurred, since the startup would at that time be obligated to repay the investor.

Here are the terms you need to know:

• Maturity date. The date when the convertible note is due and the company must pay back the loan. Two years is common.
• Interest rate. As a debt instrument, the convertible note usually accrues interest. 5% to 7% is common.
• Cap. The maximum valuation at which the investor’s capital will convert into equity. This is the most negotiated term.
• Discount. The discount rate applies if the valuation in a subsequent equity round is below the specified cap. See the example below.

While equity rounds used to be the only way investments were done, the relative ease of the convertible note led to its widespread adoption for early-stage startup investments around 10 years ago. But you have to watch out that the maturity date doesn’t came back to bite you.

For further discussion of the equity vs. convertible note debate, see these posts from Jason Lemkin and Mark Suster.

SAFE

Wouldn’t it be great if there was an investment instrument that offered the simplicity of the convertible note without the maturity date risk and loan-that-isn’t-intended-as-a-loan awkwardness?

There is: it’s called a SAFE, or Simple Agreement For Future Equity. It features a cap and discount just like the convertible note, but it’s not a loan and it doesn’t have a maturity date or interest rate. There are only two terms to negotiate with your investor:

• Cap. The maximum valuation at which the investor’s capital will convert into equity. (It works exactly like the cap on the convertible note.)
• Discount. The discount rate applies if the valuation in a subsequent equity round is below the specified cap. It’s typically around 20%. (Again, just like the convertible note.)

Since its creation in 2013 by YCombinator, the SAFE has quickly become the go-to instrument for early-stage fundraising in Silicon Valley, and increasingly across the U.S. (though it’s still a novelty outside the U.S.) I recommend using it unless you have a good reason not too.

For more about the SAFE, see: https://www.ycombinator.com/documents/

Understanding Cap and Discount

We briefly defined the cap and discount when talking about the convertible note and SAFE above, but they can take some effort to wrap your brain around. Here’s an example to better understand the interplay between the cap and discount.

Let’s say someone invests $1 million in your startup on a convertible note with a $5 million cap and a 20% discount. Here’s how it would play out in both an up- and down-round scenario.

• Up-round: If you were to later raise an equity round at a $10 million valuation (well above the cap), the note holder’s $1 million investment would convert at a $5 million valuation, since the cap on the note was $5 million.
• Down-round: On the other hand, if you instead raise an equity round at only a $4 million valuation (i.e. below the cap), then the 20% discount rate would kick in, causing the note holder’s $1 million investment to convert at a $3.2 million valuation (e.g. $4 million * 0.8).

Parting Tips

Whichever investment instrument you choose for closing your first investor, it’s important to follow the rules, file the right forms, and keep your affairs in order. Here are three important things to keep in mind.

1. You should only raise money from accredited investors. While there are occasionally legal workarounds, startups can generally only accept investments from accredited investors—individuals with a net worth (excluding their primary residence) over $1 million, or who earn above $200,000 annually (or over $300,000 collectively with their spouse). This is intended to safeguard people who are not financially sophisticated from making risky investments. See this post from Cooley for more.
2. You must file a Form D with the SEC when you raise money. This applies not only to equity rounds, but to any form of investment including the convertible note and SAFE instruments mentioned above. The deadline for filing the form with the Securities and Exchange Commission is 15 days after the first investment. It’s a PDF form that you or your attorney submit online using the SEC’s “EDGAR” system, with whom you must first register to get a username and password (which they call a CIK number and access code, respectively). For more information, see the SEC’s guide to filing a Form D. If in doubt, seek legal advice.
3. Be intentional about managing your cap table. Short for “capitalization table,” your cap table is an overview of who owns what at your company. As you issue founder shares, accept investments, and grant options to employees, having a single source of truth is crucial for making informed decisions about your business. This can be a spreadsheet (here’s a template from Venture Hacks and instructions on how to use it), or you can use a cap table management system. I use eShares and recommend it; Capshare, Captable.io, and Gust also offer cap table solutions. Stay organized, but don’t overcomplicate things.

Go Get ’Em

Now that you know what investors expect at the pre-seed, seed, and Series A level, and are familiar with the common investment instruments and their key terms, you’ll be able to hold your own when closing your first investor. In my experience, my early backers have been some of the most supportive people I’ve ever had the privelege of working with. I hope you’ll be able to say the same.

Good luck!

Other Startup Cheat-Sheets

This is the second post in my Startup Cheat-Sheet series. Here are others:

1. How to Incorporate Your Company
2. How to Close Your First Investor
3. How to Create a Winning Pitch Deck
4. How to Hire Employees & Advisors
5. How to Get Into an Accelerator
6. How to Run a Crowdfunding Campaign
7. How to Track the Right Metrics
8. How to do Cohort Analysis
9. How to do Inbound Marketing
10. How to do Outbound Marketing