Once you receive the first signed term sheets, the power balance shifts from investors over to you. This is the best part of fundraising: creating FOMO and oversubscribing the round. This phase typically takes 2-4 weeks.
Get first term sheets
After hundreds of calls and discussions in the last phase you are now getting closer and closer to obtaining (signed) term sheets. It could be a few smaller investors signing your own term sheet elaborated in Phase 5
, or a lead investor sending over their own version.
Asking potential investors whether they would personally join your board can be a powerful way to get a first term sheet. Many investors feel flattered if you do this and are ready to accept some additional risk for this. Do not make any promises – the final composition of the board will be revealed once it is clear who will participate in the round. But it is ok to tell them that you feel they would be a great fit and could add lots of value. Discuss future strategic options and listen to their inputs. Investors don’t just consider ROI but also prestige and impact.
- Work hard to get a first term sheet! This will make a huge difference.
Negotiation of the term sheet
In many cases a lead investor will not sign your term sheet but bring their own version (or at least suggest some changes). Try to negotiate a version that is acceptable, taking into account the traction you have in the round and the potential value of a specific investor. Make sure that critical changes are aligned internally with your co-founders and existing shareholders.
Some term sheets you’ll get may include exclusivity: during a period of 4-8 weeks you will not be allowed to talk to any other lead investors. After all, the confirmatory due diligence and the elaboration of the legal contracts will result in substantial work and costs for the lead investor, and this is only done if such an exclusivity clause is in place.
In most cases we recommend not to sign a term sheet with such exclusivity. Stopping the discussion with other potential investors is highly risky and may result in the round falling through if an investor decides not to go for it. Obviously, the investor tells you that this happens “virtually never, or only if you have omitted relevant information” – but triple check this before signing any exclusivity. Other interested investors will most likely not be there anymore in case the round does not close.
Rather than an exclusivity clause, you may agree to pay an investor’s external costs up to a certain limit in case YOU decline at the end of the process to go with another investor.
While you can obviously get different term sheets from different investors, you will need to find terms that are acceptable for everyone participating in the round (and make sure that non-participating existing shareholders don't block them). Everybody in the round participates on exactly the same terms!
- Negotiate an acceptable term sheet version (if it is not your own).
What is needed to "create" FOMO?
There comes a point where you get very confident that the round will close. There is no mathematical formula to define when this point comes, but here is a practical example:
- You want to raise a Series A of USD 8m;
- USD 2m has been committed by your existing shareholders;
- A first potential lead investor has signed a term sheet over USD 3m;
- You are in discussion with 10+ additional investors who are interested in making an investment.
This sounds like a setup where the power balance starts to shift over to you. You are getting into a situation where you can play with the investors’ fear of not being able to participate in the round (i.e., “of missing out”) – FOMO. It is crucial to play this out empathically. If done well, you will soon be able to oversubscribe the round.
- Decide whether you are ready to "create" FOMO, or whether additional term sheets are needed.
How should you "play out" FOMO?
You should still have various investors who are in the DD process, evaluating whether they should participate. Now is the time to approach all of them, one after the other, with the following combination of an email and call:
- Email: “Hi X, we have received first term sheets and plan to close our fundraising round soon. Considering we think you would be a great fit, I want to make sure you have everything needed to make a decision. Do you have time for a short call over the coming days to discuss this? Thanks, [Your Name]”
- Call: Be euphoric, and tell the investor that things are going great! Repeat the message of your email – tell the investor that you would very much like to have them participate, but that it is crucial for you to get feedback asap. Ask how much time they need to come to a conclusion and ask what you can do on your end to maximize the chances that they invest. (Note: the investor may ask you who has provided the term sheet – read the next subchapter to learn about this).
Make sure you stay close to each investor, trying to get as many term sheets as possible.
- Approach all investors and set deadlines.
Don't build syndicates (yet)
Interested investors will most likely ask who sent you a term sheet / who else will participate in the round. Parties who have signed a term sheet may also propose to actively support you in finding other investors and building a syndicate.
While we are great supporters of transparency, bringing investors together comes with big risks:
- Negotiation power: If investors start to discuss among themselves, you lose control. It is much easier for you to tell an investor “ term X or Y is acceptable for other investors”, rather than having them discuss this among themselves. Much better to keep this in your own hands.
- Risk of dropouts: Let’s say you have three renowned investors who are all interested in participating. Two come to a positive conclusion and provide a term sheet. One gets negative input from an independent “market expert” involved in their DD and decides to pass. This will negatively influence the other two investors, and potentially make them pass as well or double check the issue brought up with additional requirements in the final DD phase. We have seen many times that any red flag brought up by an investor can lead to emotional reactions among others.
We recommend telling investors that you are in advanced discussion with other great investors, and that you will get back to them asap with concrete information about them. Keep the discussions as independent from each other as possible.
You should now start to get additional commitments, and soon reach the minimum investment target (which leads to around 15% dilution, as discussed in Phase 3
It is crucial to keep pushing strongly to reach the upper cap (which should result in a dilution of around 25%). First, additional liquidity will increase your runway and reduce the risk that you don’t reach the defined value inflection points. Second, funding gets much easier now: it typically takes at least 10x more time to get the first 10% of the needed funds than the last 10%.
- If you have a solid basis of investors but not enough to fill the round, you may consider equity crowdfunding.
- If you have too many investors who want to participate, you may be tempted to increase valuation. Don't do it. You will lose the investors’ trust. You should rather select the very best investors. The way to do this is described further down below.
- Push push push to get the round oversubscribed!
Thoughts around secondary transactions
Some of your existing investors may have indicated that they would like to sell (some of) their shares. Similarly, founders may want to cash in a (small) part of their shares. Selling shares from one party to another is called a “secondary transaction”.
We advise not to bring up the topic of “secondary transactions” until a financing round is fully subscribed. Financing should always flow into the company itself rather than investor’s or founder’s pockets in the early stage of a startup.
However, once the financing needs of a startup are covered, it is ok to consider a secondary transaction. Here are some insights on how you should go about this:
- Early stage investors: It is ok to pay out FFF or business angels. However, if they want to go for this option, they should sell all their shares, not just a part. There will be administrative work to make it happen. At the same time, this results in a smaller cap table. That’s positive – big investors especially hate fragmented shareholder structures.
- Founders: While early stage investors should make a basic decision (sell all or nothing), in the founders’ case things are very different. They need to stay highly incentivized! So while it is typically accepted by investors to sell a fraction of their shares in a (later stage) financing round, anything more than this will leave room for questions.
- Are there any shareholders who would like to sell their shares? Or founders who would like to sell (a small part) of theirs? Bring this up if the round is oversubscribed.
How to choose the best investors
Once the minimum investment size is passed, you are in a great position to finalize your investor due diligence. The best way to do this is setting up a call jointly with your co-founders and/or board, telling the investor that you are excited to introduce them to other key members.
While this call should be a friendly “get to know each other call” rather than a “tough due diligence call”, try to bring up the following questions:
- Vision alignment: “What is your objective with the company in two years? What kind of valuation would you like to see in two years? …”
- Future financing rounds: “Are you planning to invest again in potential future financing rounds? If yes, what do you need in order to do this? Who would be ideal future investors? Do you know any of them? …”
- Exit: “What would a successful exit look like for you? If a trade sale, do you know some of the potential buyers? If an IPO, do you have any hands-on experience with IPOs? …”
- Other support: “Do you plan to be a passive or active investor? If active, where do you think you could add the most value? How? …”
- Due diligence: Understand if they have additional DD needs, and if yes, the timeline, costs and likelihood that this will go through (“looking at the last 10 investments in a similar stage, how many who were at a similar stage fell through?”)
- Legal: Propose that your corporate lawyer will work out an investment agreement and an update of the shareholders’ agreement based on the agreed terms. Would this work? Would a lawyer need to be involved on their side or will the review process be done by the investors themselves? Important: How quickly can the money be transferred once the agreements are signed?
All these points should go into your final decision. And obviously – besides all the facts asked above – it is equally important to listen to your gut feeling to decide which investors are a good match.
- Evaluate and rate all the investors who would like to participate in the round.
How to build a great board
Financing rounds are the ideal situation to strengthen your board.
Your board should be a meritocracy, with annual voting. You will want to have 1-2 founder seats, 1-2 investor seats, and 1-2 independents. Define a maximum of 5 seats – this should be large enough for early stage companies.
So besides the questions asked to all potential investors above, here are additional points you will want to consider:
- Leadership: Understand how the board member sees their role in a board. What are their priorities? How do they react if things don’t go as planned? How do they communicate?
- Network: This is a key part of selecting board members. They should be able to make tons of relevant high-level intros. Understand how good the candidate’s network is. Especially the network of (potential future) investors, B2B partners in your industry, other startup CEOs who could be helpful, and experts in your field.
- Board setup: Discuss what an ideal board would look like. Also consider adding a key independent board member to maximize the chance of reaching your next value inflection point. We will come back to this in Phase 10.
- References: It is crucial to check references of future board members. Find other boards the investor has been a part of and ask whether it would be possible to talk to them. Ideally also talk to a company which did not succeed.
- Personal match: This is crucial – you will work closely with this board member over the coming years. Make sure the energy is good.
Just like you will want to get 1-2 great new people on board, you may replace some board member(s) who are not bringing in as much added value anymore. Potentially you will also need to reduce the number of co-founders in the board. We strongly propose leaving some room in the board to get a great independent member. This will be further discussed in Phase 10
- Evaluate potential board candidates, and develop a clear vision of what an ideal board for the coming two years should look like.
Take an internal decision on how to structure the financing round
Based on the previous phases you should have a good overview of how the structure your financing round.
The terms should be clear and agreed on by everyone. They can be sent to the lawyer to work out the investment agreement and updated shareholders’ agreement.
It should be clear for you how to set up your future board of directors. Define who will leave and who will join the board.
Some parties may not yet have finalized their (confirmatory) due diligence. Define actions, responsibilities, timelines, and reimbursement.
Based on all these inputs, the lawyer(s) will start their work in the next phase. Ideally the startup’s corporate lawyer takes the lead to work out a “fair” contract based on the defined terms. Depending on the investors, they will want to bring in their own lawyers.
Ideal number of investors
We have experienced many different setups – from one single investor doing the entire round up to dozens of small ones doing so. Both options have pros and cons. If you have the luxury to choose, we would go for 3-4 investors who can all participate again in the next round.
Don’t say "no" to anyone
Similar to a recruiting process, where you don’t want to lose the second best candidate before the first one has signed a contract, you do not want to lose any investors at this point. Tell them that certain decisions are taking longer than expected and keep them on hold until you have signed the investment agreement (see next phase).
If the minimum investment has been reached but the maximum investment hasn’t, you may foresee a "gobble up period" in your investment contracts. This makes things a bit more complicated, but enables you to have additional investors participate in the round on the same terms. The duration of the gobble up phase is typically a few months.
- Elaborate a document on how to structure the financing round.
- Align with your co-founders, board, and key shareholders to prevent bad surprises in Phase 9.