The following is adapted from “Exit Right: How to Sell Your Startup, Maximize Your Return and Build Your Legacy” by Mark Achler and Mert Iseri.
Most of us know Travis Kalanick from his meteoric rise as the CEO of Uber, and his ultimate fall from grace. What most don’t talk about is his obsessive focus on controlling his own destiny. He had a hard-earned fear of fundraising from his first two startup experiences, and it drove all of his decisions at Uber as well.
At Uber, he and his partner, Emil Michael, played the game perfectly, wooing investors with their impressive traction. Uber went on to raise billions in capital, with a dual stock structure. While he left Uber with billions, Travis paid a heavy price in the decade before starting the company by not carefully managing his cap table.
These are costly lessons to learn, and every founder should reflect on their own journey before committing to a decision to fundraise. Before Travis even knew what Uber would be, he solidified his approach to fundraising.
He understood the value of a well-established plan as he moved forward in his new company. You also need this same understanding before you even think about fundraising, let alone an exit plan. Without it, you’ll miss the opportunity to exit the right way, on your terms.
To help get you started on the right path and ensure that you do not make an error early on that causes major ramifications in the future, consider the following four principles for fundraising early on in your journey.
#1: Know thyself
You should know what kind of business you want to build: a venture-backable business or a lifestyle business. A venture-backable business is a company whose business model and technology have the potential to generate significantly outsized returns—often 100x or more of the valuation of initial investment—fetching valuations above hundreds of millions of dollars.
In contrast, a lifestyle business is a company whose business may be successful, even immensely profitable, but lacks the opportunity to scale above a certain threshold. This may be due to limits in the overall size of the market, growth obstacles around staff and automated systems, or lack of flywheel network effects.
Many first-time entrepreneurs are blind to the important distinctions between these two types of businesses. Just because an entrepreneur is passionate about a given market, idea or product does not mean it will automatically be venture-backable.
There are plenty of examples of companies who need capital to operate, but don’t find venture investors to be a good fit for their long-term goals. No matter what you decide, you must protect your shares and treat them like the millions of dollars they will be worth in the future. Above all, make sure that whether you’re a venture-backable or lifestyle business, you’re staying true to your vision, goals and mission.
#2: A change in ownership means a change in expectations
Much of the startup media ecosystem is filled with headlines covering funding rounds and valuations. While the big numbers are flashy and intriguing, there is much more to fundraising than simply adding capital. It also adjusts the timeline of your future exit. The truth is if you raise money, you’re shifting the ownership structure of your business.
Many of the seed stage fundraising terms include preferred shareholders with liquidation preferences. These are the legal rights that determine how the payout from the sale will be distributed. With liquidation preferences, investors can take their money out first, and then the remaining funds are left for distribution.
In addition, it is common to see board structures that favor shareholders instead of the co-founding team. This means that investors can decide to replace you, the CEO, if you disagree with their decision to sell. Conversely, if you are too tired to go on, but the company is on a growth path, the board and shareholders can similarly fire the CEO for someone with higher ambitions for their capital.
This change in ownership comes with an implicit agreement and timeline for a liquidity event. Your new co-owner is going to want to come away with a return multiple on that investment on their time horizon, not yours.
#3: Conduct due diligence on your investors
Fundraising feels like an accomplishment. And it certainly is. You have managed to successfully sell shares in your company—a great vote of confidence in your future success. When it is all said and done, it feels great to see the wires come in. The horizon is bright, and the resource cabinet is stocked for the adventures ahead.
But don’t let the promise of a champagne toast overshadow the responsibility of the founders to do their homework. Both the founders and investors need to ensure they are making the right decision.
Investors are professionals at this—they invest capital for a living and know the red flags to look out for. Just like when your company is being acquired, the odds are stacked against you.
Your job is to suss out the red flags of your potential investors. Treat it like a true partnership. Remember you are hiring them to provide capital for your future. Not doing real, substantive due diligence can be disastrous, even for the most experienced operators.
#4: Avoid “dead equity” on the cap table
At the outset, cap table management is one of the most important decisions you have to make. Aside from selling shares to raise funds, there are other ways founders give up equity in their companies.
Whom you decide to give shares to is one of the most consequential matters in this process. How much are you going to give to cofounders? How much do you set aside for employee options? Who will serve on your board, at what price?
It’s imperative to limit the amount of “dead equity” you have on your books. Dead equity is the number of shares given away to people who are not actively building the value of your company. Be stingy with it, because every share matters in the end. The best operators ensure that every share of equity goes to people who are making that success possible.
Too often, though, founders give away too much stock up front. Whether to early partners, employees, or advisors, this can be a major mistake. Be on your guard!
Follow the principles for a bigger pay-off
If you make the right calls, you can walk away with a life-changing sum of money as a result of all of this planning. It is extremely exciting to see the dream you poured years of your life into reach even bigger heights.
As long as founders pay close attention to their partnerships, develop sound operating principles, and prepare themselves, things will work out. Remember, in the end, all shareholders, including both common and preferred shareholders, want the highest return possible.
For more advice on how to make sure you stay on the right fundraising path, purchase “Exit Right” via StartupNation.com below.