Question and Answers with Babson's WINLab

We held a question and answer session with the entrepreneurs from the Babson WINLab cohort. We thought it would be good to publish some of the notes from that session. As with most sessions like this, the answers are based on my own opinions and experiences.

Question: Is there a formula, methodology, or best practice in determining how much equity to give to or how to otherwise structure a business relationship with the following entities, particularly when we are still an early start-up and do not yet have much in the way of assets or cash flow:

  • Members of one’s senior management team (who are not drawing a salary yet)

Answer: If you are not paying a senior member of the team and they are not a founder, you are putting your company at risk. Particularly your intellectual property. Even if you pay them minimum wage, that would be better (minimum wage plus equity). Here’s a rule of thumb: estimate the value of your company and translate that into what you would have to pay them (like if you would pay them $100,000 over a period of time and the company is worth $3,000,000 then that’s about 3%). All equity, including for the founder(s) should be on a four year vesting schedule. I’m also a big fan of twelve-week trial periods before even discussing equity or a permanent position.

  • Venture capitalist, angel investor

Answer: These investors will negotiate a valuation of your company with you and then their investment determines the percent of your company you give to them. Be very careful about the terms that are offered. A valuation of $5 million is can be a worse deal than one that values the company at $4 million if the terms are bad. Also, try to create an option pool of stock before you enter into these discussions. Most early stage investors will want you to create that pool before they price their deal.

  • Joint venture partners

Answer: This kind of relationship is the trickiest of all. Typically, this arrangement is with a strategic partner who is providing something important like manufacturing or distribution. Negotiate the deal as though it will fail. There are investors who are excellent at negotiating these deals, but even so, I’ve seen this go really badly. Try to test the relationship out beforehand with a trial period.

Question: What’s the ideal timeline start to finish when engaging an investor? e.g. Number of months? Number of meetings?

There is no good answer for this. Some investors are scouts who like to identify companies early and watch them. Others like to invest with their group after diligence has been completed. Some of us like to do both. A key indicator that your meetings are progressing is that the investor is making introductions for you. If they just want to meet and get an update, that’s not a good signal. Always vet your investors by getting them to tell you about what they have invested in and why. You want to make sure that the investor is actually active. I think we could make a decision tree for this process.

Question: What’s the ideal number of months of runway when engaging in first investor conversation?

Answer: You should have conversations early to gauge interest and to get feedback on your idea. As for runway, the more runway you have, the less stressed you will be. It’s better to negotiate from strength. I’d say six months or more when you first raise. This is why it is important to know how you are going to fund your earliest days. I am a big fan of the “side hustle” which could mean that you have a day job while you’re testing your idea. Perhaps having a consulting business in your current field could be a good way to generate some living expenses. It is very difficult for first time entrepreneurs to raise outside risk capital so really think about how you can support yourself.

Question: How much traction should you demonstrate prior to engaging in the first investor conversation? E.g. following, size of community, sales, etc.

Answer: This answer depends on the market you are serving and probably the market you are trying to raise funds in. Overall, you want to demonstrate product/market fit as early as possible, so what are you demonstrating with your earliest sales or pilots or first customers? A big part of product/market fit is testing whether someone will actually pay for your product. Get to real customers fast.

Question: When launching an early product if you have to choose maximizing the number of users vs. maximizing revenue (e.g. free service vs. charging) what should you choose in the eyes of an investor and what considerations should you weigh?

Answer: Take a long hard look at the "freemium" strategies. A lot of edtech companies tried Freemium and it didn’t work, but a lot of consumer companies were fairly successful. Make sure that the difference between free and paid is valuable - and that you see the path to monetization. There’s a lot to consider with this. I’m not a big fan of a Freemium strategy. Also, chasing users can often lead to a lot of churn for your customer base, and that’s not helpful.

Question: How important is it that early round is local to the startup (e.g. Boston doesn’t have tons of investors that go after consumer facing brands)

Answer: Your earliest investor should be ideally (1) someone with credibility in your space so their “signal” is valuable and (2) local so that other investors feel as though someone is close by to advise. Part (2) isn’t necessary if you have (1) that is really strong. You can attract local investors if you have strong interest by people considered subject matter experts. Anecdotally, funders who invest in women and other underestimated groups are less bound by geography.

Question: How do investors view existing equity allocation? (e.g. if you engage with a vendor for development and pay in equity or a revenue share)

Answer: A good investor looks at the cap table (and we often find weird things on it). The founding team should still have a lot of equity after the first fundraising round. Equity instead of pay is a bad idea for anyone who works on a day to day basis for the company. It is also against MA employment law. People do it all the time, but it puts your company, your intellectual property and more in jeopardy. Giving vendors equity instead of pay often doesn’t work out because the vendors aren’t motivated to do something when they aren’t getting paid. I’ve seen that go very very badly.

Question: If there is no co-founder yet, is it too early to start talking to investors (e.g. no tech lead)

Answer: Many studies show that companies with co-founders outperform solo founder companies. Find a cofounder. It’s really hard to do, but as a CEO you are going to have to recruit top notch people to make your company a reality, so start by finding an awesome co-founder. Preferably one that you have worked with in the past. Have a trial period of about twelve weeks and make sure that person understands the risks.

Question: What red flags make an investor run away fast?

Answer: Liars. Lies usually are found out. I don’t like assholes, either. But Silicon Valley apparently does.

Question: On what criteria should entrepreneurs evaluate investors? Personality? Track record? Area of expertise? Valuation & optimism in conversations?

Answer: The first question you should ask any investor before spending any time with them is how many investments they have made. Then have them tell you about their most recent investment or two. Ask about their portfolio. Ask about a situation where they didn’t invest. There are a lot of fake angel investors out there. Ask them where they usually get their leads. Vet them before talking to them so you do not waste your time with someone who isn’t really an investor. Ask entrepreneurs they have invested in about them. Do the work.

Question: What red flags should we look for that would make us run away fast?

Answer: Run away from people calling themselves investors who have a consulting company in the area that they think you need the most help in!!

Question: Is there a typical expectation on when the next funding round should happen? Is it Ok to go for another round right after one year of funding?

Answer: Funding should be anchored to your needs and plans for growth. Most companies don’t raise enough in the first round because it is hard, so they do bridges. Experienced entrepreneurs raise the right amount, but that’s because they can since they have done it before. The more time you spend raising money, the less time you have to actually get shit done, so think about that. When working on your first raise, start talking about your next raise in terms of what you want to prove before raising and how much you think you’ll need to raise. You’ll get good feedback.

Question: Is it important to show a full management team line up including marketing and business development when we go for fundraising?

Answer: You want to have the most impressive team you possibly can when fundraising. It is the most important thing, but make sure that the team is real. Depending on your industry, you don’t need to have everyone in place, but the essential people should be in place and then you have advisors to back you up. Sometimes entrepreneurs focus on subject matter experts, but I want to see people who have operating experience on the team and as advisors.

Question: Do investors prefer to see revenue before funding? Is there a difference in Angels vs VCs in this regard?

Answer: Depends on your product. If you can have revenue today and therefore (1) show that someone thinks your product is worth buying and (2) decrease the amount of money you need to raise - then why wouldn’t you have revenue? Right now, most products have difficult pathways to success, so revenue is very important. VCs are also looking for proof of product/market fit but they are also looking for something to solve a big problem. They might have ideas on market pathways.

Question: What role does platform buildout and other business IP play in determining valuation?

Answer: Not sure about platform buildout, but have a roadmap for how you see the product evolving or developing. Some investors are very interested in the tech. Each (good) investment group has someone who will ask the deep tech questions. IP is a good barrier to entry but I see market size and revenue playing more of a role in valuation. A word of caution though, it is always easier to add a feature to your product than it is to talk to your customers. Don’t hide behind product development. In most cases you can go to market with an incomplete product, especially if you are solving a big problem.

Question: How common are SAFEs vs. convertible notes? How common are uncapped notes/SAFEs in general?

Answer: Everyone does notes in the beginning it seems. Equity during a seed stage is rarer nowadays. SAFEs are more common on the West Coast. I have invested in two SAFEs and I think they are annoying. Uncapped notes are a lot less common than they used to be. There are a few theories why that’s true but I think the main thing is that the time between a seed round and an A round is getting bigger and investors don’t want to be exposed. That’s also a reason why notes are not necessarily a good idea. If you have notes out for a long time, the discount and interest starts to accumulate. Also, the longer you have a note out, the more likely you are to have an investor to ask for modifications. Next thing you know, you have lots of different notes and you’ve spent a ton on lawyers.

Question: What opportunities for warm intros are there in the Boston ecosystem, and beyond?

Answer: Warm intros are everywhere. Through LinkedIn, you can do a lot of research. Your advisors should be so highly engaged that they reach out on your behalf. If you aren’t getting people to introduce you, then something isn’t resonating with them. Hone your business case. But we need to stop talking like warm introductions are the only thing. Let’s talk about how to do an awesome cold approach to an investor. There are many investors who want to get more inbound contacts.

Question: Investors seem to be leery of investing in early stage hardware companies. How can a founder mitigate these concerns?

Answer: The issue with hardware is that it is very capital intensive. I have made several investments in this area. Is there a way for you to decrease the cost of the rapid prototyping that you need to do to get to a product that works and can be sold? That also means that you need to have the engineering talent in house. If it is complicated to make, you cannot outsource your product development.

Question: Where is the best space for questions like these (above) outside of today’s discussion?

Answer: Other entrepreneurs who are a couple of steps ahead of you are the best. The Capital Network has excellent programs on finance.

Babson WINLab-2.png