Seed funding · Investor pitch

Help with tough investor questions (raising SEED round)

John Duffield

May 12th, 2014

Received some tough but good questions from investors and wanted to see if the group has come across questions like this before... perhaps others who are either raising funds now or in the future may benefit from them. Please offer any insight you can into these few questions (in no particular order):

Quick qualifier - we have full 5 year financial projection and the investor deck drafts in place already

1. Sales, Sales, Sales
- we are a sales-driven B2B product, we will have a large sales force by year 5 end.
- investor wants to know how we will hit our numbers (new clients per sales person per month)
- how else can I indicate / sketch out that we will hit these numbers? Should I map out the regions where we operate, list how many customer, list how many calls and meetings should be achieved per month to close deals etc etc. 
- show how we could partner with other players who have large target clients on the roster for other services?

2. What is the seed investment worth in value two-to-three rounds later?
- one investor is interested in hearing about dilution. How do I factor that in?
- our goal its to have the initial seed be a convertible note into the Series A six months later.
- we have the financial projections, but how do I calculate dilution amount?

3. What is the discount of the convertible note into round 2 ( series A)?
- how do I position this? 
- if the seed investor doesn't invest further cash then what should we negotiate the discount to be on the convertible note? Standard metric?

4. How do we calculate our pre and post-money valuation?
- we're currently in private beta, we're trying to build value so instead of giving up X% equity, we want to offer a convertible note.
- how do we determine a current value: (tally our hours spent + personal cash injected) X some multiple to determine current value?

5. Sensitivity Analysis (failure to meet projections)
- investor wants to know what happens if our costs double and our sales half
- is this common question? Is there a good way to show this? 
- so far I have a table that shows what happens if our sales are half and our product is sold for half.

6. Your before & after industry data
- investor wants to know what impact the product has had on clients
- after X beta / pilots we've had X transactions which have had X% lift of revenue etc etc
- we're so early with so little data how do we say we're preparing for this. Was thinking outlining our process for collection and analysis at least.

Rob G

May 12th, 2014

2. what's the seed round worth 2-3 rounds down the road?  that's a good question.  There's no way for you to know so again i suspect s/he is after how you view your relationship to your investors, or they are an inexperienced investor.   Dilution will be impacted most by any anti-dilution provisions in the deal. Like in any sales cycle be sure you ask questions of the investors until you are sure you understand their objection/questions.  Make sure the investors know that you are interested in their success, but their success requires that the company is successful AND that the deal is structured in such a way as to attract follow-on investors not to scare them away with nasty anti-dilution provisions and liquidation preferences, etc. i am by no means experienced with convertible notes, but 6 months seems short to me, but i've not done one before - in general i don't like what looks to me like a ticking time bomb of a loan being called on a conversion date.  if you don't get the funding in time to pay off/convert the note then what?  typically you renegotiate the terms of the note and you are not in a good position to do that. 

3. see if you can reach John Seacrest on FD.  John runs the Seattle Angel conference and they use a convertible note as their investment vehicle.  He knows a lot about the ins and outs of convertible notes and how the details affect both companies and investors. also check Fred Wilson's blog to see if he has any pearls of wisdom on this. 

4. pre and post money valuation.  the main idea behind a convertible note is that it kicks the whole discussion around valuation down the road when 'professional money' comes into the deal and you let them set the valuation.   Valuation in early stage deals tends to be more of a function of what general bucket you fit into, i.e. where you are located (bay area V seattle V boston, etc,) the team and the traction you've achieved to date rather than specific metrics.  seed stage B2B SaaS companies that are at stage x (credible team in place, product in the hands of some customers, starting to get some traction etc.) in Seattle is say $4-6M, in the bay area that same company may get valued at more like $8-10 or $12M. Valuation seems to be based more on the profile the company fits and location than it is revenue dollars or number of customers or the rate at which some metric is growing.  Again, if this is a discussion of a convertible note then valuation is somewhat moot.  Hours worked wont get you there. 
5. again, i think s/he is just testing your thought processes and preparation.  this is where all your hard work to address #1 comes in.  with a detailed model you can do plenty of what if modeling.  Hopefully you are in a market you and your team know well and you have some advisory board members who know the space well.  use your market expertise to set your assumptions in your financial / ops model.  Now you are in a position to tell investors, "this is our expertise, this is what we have seen in our 18 years in this market, this is what we have confirmed from 6 beta customers and 2 market surveys, here's our competitive analysis.  Our forecasts use this $$ which our experience tells us is a reasonable if not conservative number.  we think it is unlikely that we would be in a situation that we would need to cut our price by 50%, but if that happened here's the results."  etc. and on this question specifically, don't be afraid to tell investors that in your experience the prospects that we are targeting are not that price sensitive - they are more interested in x, y and z .  don't be afraid to push back. 
6.  this is why investors are so interested in traction - it helps answer so many questions.  the truth is you won't know how you have impacted the customer until your customers have finished an implementation and they've been running it for 12+ months. That could be 18 months from now. 

Rob G

May 12th, 2014

this is quite the list. Is this investor an experienced angel or ?
1. sales, sales, sales: obviously at this point everything is speculative.  Even if you were up and running with a 5 year track record, forecasting sales in a B2B environment is tough.  If this investor is experienced then they are simply looking to see how you think, not that you can somehow guarantee results.  The only way for them to see this is to verify the inputs that support your forecast and see that you are through - do the inputs and assumptions makes sense and are they reasonable?" and "what if this happens - how does that affect the numbers?"  Our internal roadmap (for our B2B2C SaaS company) is a very detailed spreadsheet that builds all of our revenue and expenses from the bottom up and it is driven by sales first and everything else depends from that.  Our forecast is detailed in year 1 by month and years 2-4 are are monthly, but simple multipliers on the prior year - it's way to complicated and not real valuable to try to include such detail in years 2+.  The first year is detailed by month and includes every component we can think of (within reason) by market segment and our segments are very focused. since we are sales driven that means, for example, "how long will it take me (alone) to find, recruit and train the first sales person (in our case, outside sales), how many prospects can this one sales person reasonably connect with +month 1, +month2, etc., How many deals can this 1 sales person close in +month 4, +month 5, etc. We flow that through to revenue ($$/deal at X price). We include a couple of multipliers in this stream to account for the experience level of this sales person, our ability to support him/her, his/her sales effectiveness as they gain experience with our product, etc.  The objective is to make this as real-to-life as possible and then make the assumptions very conservative.  Then you add the 2nd sales person, the 3rd and so on until it is time to hire someone to manage them.  There's plenty that went into our analysis, but the short version is we decided to hire direct "doers" first and then bring in or, preferably, promote a sales manager and then a VP later. I believe in selling in teams so we blend in inside sales people starting in month x and factor in what the ideal team looks like ( on average 2 inside / 1 outside).  this reflects our need to have a lot of fact-to-face contact with prospects/customers in year 1 and keeping the high-value outside sales person in front of the customer as much as possible and have inside focus on prospecting and non-customer-facing sales activities.)  One page of this 41 tab spreadsheet is a personnel tab that lists out how many of each skill set we think we will need in each month.  Many are zero and many are fractional (contractors), but sales is the engine that drives revenue and revenue/traction is everything to investors.  Very closely coupled is the dev team and associated costs to build a product that can somewhat keep up with the sales team. Product status is also an input to sales forecast as it affects how fast we can sell.  Viral:  we know that we will start to see our model morph from mostly outbound sales to substantial inbound leads and inside sales as the market learns about us, but from a forecast perspective we discount its effect to zero - we don't know how to forecast viral uptake so we don't bother.  We know and investors know that it will happen, but we get extra brownie points for not reflecting it in our forecasts.  We then look at every cost component and all the personnel we need to support an early-stage, growing company again, focused almost exclusively on sales and product (dev, test, support, hosting costs, etc.).  so we have detailed tabs for revenue, personnel, salaries, benefits, etc. that all roll up to an income statement and balance sheet and statement of cash flow, again, in painstaking detail for months 1-12 and they monthly, but less detail for months 13-48.  we don't bother beyond 48 except for some very rough ball-park on total revenue.  This exercise takes time (several solid weeks in our case), but it is invaluable.  Investors expect the CEO to know the numbers cold and they want to understand how you think.  It gives you a "what if" tool to visualize what happens if you raise or lower you price or hire 4 testers in month 6 instead of 2, etc.  Most importantly it forces you to get real with all the numbers instead of just wishful thinking.  I also use it as a recruiting tool.  Smart developers, sales people, etc. also want to know that the CEO knows the details and isn't just whistling in the wind.  under NDA i can walk a potential new-hire through the appropriate portions of our financial model.  Most times all they need to see is the fact that the we have done our homework, the numbers look conservative and the numbers (inputs) make sense.  It puts their mind at ease. 

Michael Barnathan Adaptable, efficient, and motivated

May 12th, 2014

1. What's your month over month sales and usage growth? How large is your total market, and what % of it do you seem to be scooping up each month? They want to see traction - not only growth, but how much the growth is growing - so they can estimate when you'll hit particular milestones.

2. This is kind of related. They should have a valuation in mind for you based on your sales and usage (if they don't, you should try to come up with a realistic one). How much do you think each user is worth? Multiply that by your projections for #1 and you have a projected valuation. Multiply it by their percentage stake in the company to get their share. Now factor in how much investment you want to take at that point - take their share in the projected pre-money valuation and divide it by the post-money. That's what they (and you) are going to get diluted to.

3. Not experienced with convertible notes, sorry.

4. Pre-money valuation depends more on the traction you've achieved (users and sales, users and sales...) than the time you've invested. Post-money is simply pre-money plus whatever you're raising.

5. They're trying to protect their downside risk, so they're asking you for pessimistic scenarios. I've never heard of an investor doing that particular one, but it's probably a good exercise - how *would* you recover from that? Or would that be a sign to pivot?

6. If you can't get hard numbers, you can at least give them some qualitative user feedback - investors like user feedback since it's an indicator of product-market fit.

All investors differ, but usually in seed they understand that you're pretty early and haven't hit serious sales or revenue targets yet. What they're looking for early on is potential to scale, an idea of how to do it, and a team that can execute well on that idea.

Joanan Hernandez CEO & Founder at Mollejuo

May 13th, 2014

Hey John!

To understand dilution, please take a look at this info graphic.


Dave Lemley Consulting Technologist

May 12th, 2014

minor points on using the convertible note in the seed round, if they're worth anything:
2 b 'we want to do series A in 6 mo' -- at a minimum.  try to see if you can get the term to be longer, up to a year.  This is the time frame you will have to raise your series A.  Give yourself some more time if you can.  And look for language about any minimum amount to be raised.
3 ' rate...'  -- 20% is common.  So in that case they will pay 80% per share of whatever price is set at the series A
4 '... pre/post money...' -- the convertible note in the seed round means you won't be worrying about setting valuation until later, at the Series A (which is why its simpler to close).  However there is usually stated a price cap at conversion, which is effectively what the investor who issued the debt would have been willing to pay for the equity had they done so, and it will effectively be the max of what your series A investors will be willing to pay, so scrutinize that.
Disclaimer:  we didn't use convertible notes for our seed round; only later on as a bridge, so by all means do double check anything I have written here.  And remember, it is debt, not equity until it converts, so you are starting out insolvent.