YC Partner: What preparations do startups need to make to raise funds?

Talk: Geoff Ralston, YC Partner

Compiled by: Deep Tide TechFlow

Preparation

We plan to hold two fundraising lectures. The first will be hosted by me and will provide a high-level overview. The following week, my partner Kirstie will dive deeper into the fundraising mechanisms and share her findings.

Before we begin, I recommend checking out resources on fundraising at the library, including Paul Graham's fundraising essay. While some of these resources may be outdated, they can help you understand the basics of fundraising.

Additionally, I have written a guide on seed fundraising, which you may find useful if you're interested. There are also many other helpful resources, such as videos on starting a school from last year and guides on how to start a new company.

Fundraising Challenges

Starting a business is very difficult. And fundraising can be one of the trickiest parts, even for those eager to try.

In reality, the market is not as fair and open as it seems; it often feels strange and frustrating. While some founders might tell you, "Oh, fundraising is easy. I started going up the hill, and people just handed me cash," that is the exception, not the rule.

When you are fundraising, you will hear a lot of "no" responses, and most people will not support you. They will tell you why your startup will fail, why your product won't work, or why the opportunity you describe is simply not real or viable. Sometimes their points are valid, but you cannot take them too seriously because you must persevere to survive.

The key to successfully raising multiple rounds of funding is to be filled with perseverance and belief. No matter what you hear, no matter how many times you hear "no," or why your startup seems destined to fail, you must maintain your faith.

Fundraising Process

First, you need to clarify your startup story, that is, why your product or opportunity will be significant for the future. This may involve adapting to market needs, growth, and so on.

Second, you need to find the right investors, do your research, and communicate with other founders. Organizations like Y Combinator can provide a lot of help.

Next, create a spreadsheet listing everyone you need to talk to and reach out to them or get introductions.

Then, you need to continuously pitch your story and plan, refining it to attract potential investors.

Eventually, you will meet the right investors, who may resonate best with you or be willing to provide funding upfront.

Once you agree on the terms, you can deposit the money in the bank and get back to work.

The Purpose of Venture Capital and the Necessity of Fundraising

Why does venture capital exist?

First, due to market demand, most people need money.

Second, the returns can be substantial, although not always. Many people trace the beginnings of Silicon Valley back to when Bill and Dave founded HP around 1957, starting with their $583 without ever raising venture capital. This is possible, but it has been shown that building a high-growth startup often requires a significant amount of startup capital. Georges Doriot, a Frenchman, invested $70,000 around the same time, turning that into $350 million after Digital Equipment Corporation grew into an epic company. This also spurred the development of the entire industry.

Why is fundraising necessary?

Because you need funds to cover various expenses, hire staff, rent office space, and drive company growth, as starting a business means constant growth, as Paul Graham said long ago. To grow, you almost always need startup capital, although sometimes there are other support mechanisms, but it is hard to rely entirely on them. Additionally, having funds is a competitive advantage, which is why most startups typically raise money.

Timing of Fundraising

The timing of fundraising has always been a question for entrepreneurs. Generally, people believe that the best time to raise funds is when you need money.

However, the reality is often different. In fact, the best time to raise funds is when you do not need them. When you are in a position with plenty of money and great prospects, investors see the biggest opportunity and are more interested in your company.

Of course, this is not always possible. However, throughout your entrepreneurial journey, if you can reach profitability or have good prospects, funds will naturally flow in.

Conversely, when your company is in trouble and desperately needs funds to stay afloat, investors will sense your desperation, leading them to be more cautious and conservative, even steering clear of your company.

Therefore, entrepreneurs need to plan and prepare in advance, clarify the amount of funding needed, and seek investment after reaching significant milestones or profitability to secure a better negotiating position and higher success rates when fundraising.

How to Determine a Startup's Funding Needs?

One rule of thumb is to consider the thought process that can help you decide how much to raise.

Assume that when you raise funds, this is your last chance to do so, so you should raise enough money so that you do not need more and can become profitable.

However, this is not always possible, depending on the size and needs of your startup.

So, you should at least know how much you need to spend and do some math, such as calculating the average cost of employees.

For example, an engineer might require $15,000. Another commonly used rule of thumb is that a round of seed funding can support about 18 months, regardless of how long you need, during which you will need to raise more funds. During this time, you must achieve compelling milestones or reach profitability, and then you can hire more people as needed.

How to Increase the Probability of Fundraising Success?

If you are an entrepreneur, you need to ask yourself if you would invest in yourself if you were an investor. Are you strong enough to turn ideas into reality and build a successful company? This is important because investors will invest in you as a person, not just your product or service.

They will also pay attention to the credibility of your startup story and whether it resonates. Your story must represent a huge opportunity because what venture capitalists care about is returns. If you do not have a compelling product appeal and a persuasive story, you need to revisit your narrative and product to increase the likelihood of investment.

Take time to define the core concept of your story and build a pitch or sales talk around it. As a founder, you must learn to be a salesperson, pitching to investors, partners, and customers.

Even if you have a good story and an attractive product, it does not necessarily mean you can secure funding. Choosing the right valuation can increase the chances of success; an overly high valuation may lead to a failed fundraising round, while a too-low valuation may result in excessive dilution.

Finally, deposit the raised funds in the bank, get back to work, and do not overly optimize fundraising, as this may impact the company's growth and long-term success.

Fundraising Mechanisms

Convertible securities are indeed a common fundraising method, especially for startups.

Investors may agree to this method because they believe in your company's future prospects but do not want to immediately own equity. Additionally, convertible securities are simpler and more convenient than directly issuing stock, requiring fewer documents and lower costs.

However, it is still advisable to carefully read every relevant document when using convertible securities to understand your and the investors' rights and obligations to avoid potential risks and disputes.

Deep Tide Note: Convertibles are a financial product also known as convertible bonds or convertible securities. They are a hybrid that contains characteristics of both bonds and stocks. Typically, they are issued first as bonds, but the holder can choose to convert them into the company's common stock. This conversion usually can only occur within a specific time frame and may be subject to certain conditions. Convertibles typically offer higher yields than pure bonds because the holder has the right to convert them into stock. Additionally, if the stock price rises, the holder can also gain extra profits from the stock appreciation. On the other hand, if the stock price falls, the holder still retains the bond's value, providing a certain level of risk protection.

Dilution Issues

Dilution refers to the reduction in the percentage of ownership you have when you sell a portion of your company's shares. For example, if you sell 20% of your company, your ownership decreases by 20%. If you raised $1 million at a post-money valuation of $4 million, it means you just sold 20% of the company because that amount exceeds the total value of the company at 100/(400+100), which is 20%.

However, convertible bonds actually make it difficult to calculate the actual dilution because you have not sold any shares yet. Therefore, there are some representative dilution scenarios, but they do not reflect actual dilution. Understanding actual dilution when using convertible bonds is very complex because it depends on how much additional money you raised, other funds, and the option pool, among other factors. If you raised a significant amount of money on many different convertible bonds, understanding actual dilution becomes even more challenging.

To address this issue, we developed a tool called AngelCalc that can help you calculate the actual dilution situation. Using this tool, you can better understand the price you actually receive during the conversion process, including some factors you may not have anticipated, such as future option pools. In summary, dilution is a complex issue that requires careful consideration when using convertible bonds to avoid unnecessary risks and losses.

Other Fundraising Methods

Additionally, there are other fundraising methods during the financing process, such as crowdfunding mechanisms like Kickstarter, AngelList, and WeFunder, which often serve as auxiliary means to complete a funding round or fill funding gaps.

Angel investors and venture capitalists are two different types of investors. Angel investors are typically wealthy individuals who invest using their own funds. Their reasons for investing are similar to those of venture capitalists, but they may also invest out of passion for something. Therefore, when you talk to someone who plans to invest their own money, you will hear different conversations, and their decision-making process differs from that of venture capitalists.

In addition to angel investors and venture capitalists, there are many other fundraising methods, such as Kickstarter, AngelList, and WeFunder. These platforms often play a supportive role in your fundraising process and can sometimes help you complete a funding round or fill funding gaps.

Moreover, we have also heard of ICOs (Initial Coin Offerings), which are a very complex fundraising method. They typically require specific networks and technical support such as cryptocurrencies, while also involving various regulations and rules. Therefore, if you want to conduct an ICO, you must thoroughly understand and research the relevant regulations.

In the fundraising process, discussions are generally conducted in rounds. You can start your company with credit cards or raise funds from friends and family. Additionally, there are seed rounds, convertible securities, and stock trades, each corresponding to different stages of fundraising needs.

Ultimately, if everything goes smoothly and you are not acquired, you may consider going for an IPO (Initial Public Offering). This requires meeting a series of strict requirements and regulations, making it a complex process. Therefore, throughout the fundraising process, you must be cautious and have a deep understanding of the entire ecosystem.

How to Meet with Investors?

Let’s talk about how to meet with investors and conduct fundraising activities.

First, you need to do your homework. Understand what projects the investors have invested in and know what your audience cares about. If you do not do this, your negotiations will be at a disadvantage.

Second, simplify your pitch and capture their attention as much as possible. Building a compelling story from the start is one of the best ways. If possible, bring a prototype or demo.

Additionally, remember to listen. You are not there to monologue. Listening to investors' feedback is very useful.

When pitching to investors, you may find yourself at a disadvantage right from the start. Therefore, practice is crucial. Most venture capitalists have a review process, so do not expect to secure funding in the first meeting.

Before fundraising, you should also decide whether you need a deck. A deck is not a necessity, but it may be more comfortable for some investors. Create a story around your narrative, product, and future rather than creating a story around the deck.

Finally, if you really need to negotiate, know who you are negotiating with and try to be selective. Remember to delay negotiations and do not try to go head-to-head with professionals during negotiations.

Fundraising is not the goal; creating great products is key

The most important thing you need to do is create great products that customers love, which has almost nothing to do with fundraising.

Therefore, trying to extract more benefits from fundraising is gradually losing significance and often backfires.

Now there are many fundraising professionals who can do anything, claiming to have raised an astonishing $400,000.

However, most people should not take them as templates; they should figure out who the right investors are and reach agreements with them while not being a bad actor to avoid ruining deals. When you get the money, act cautiously, do not gamble, think carefully about your story, and state it plainly without exaggerating or pretending to know things you do not.

Fundraising is just a small step toward achieving company goals; you need money, but you need to do better in wisely choosing investors, finding those who can help you build products, establish relationships, and reduce risks.

Finally, completing fundraising is just the first step to doing real work; the true goal is to build a great company.

International Entity Fundraising

If you are an international entity looking to raise funds in London or the U.S., the advice may vary depending on the situation. For most U.S.-based venture capitalists, they are usually less willing to invest in overseas entities or may hesitate significantly. Therefore, if you plan to seek funding in Silicon Valley or other regions in the U.S., I strongly recommend creating a U.S. entity, as it is easier and cheaper. Conversely, if you establish a business in London, the UK, or other foreign regions, there is a dedicated venture capital community there that may understand your business better than the U.S. market. Thus, it is crucial to make deals when finding the right target investors. Overall, this is a complex equation that does not allow for too many detailed answers.

Why Merging Before Fundraising is Not a Necessary Step?

Many people think that merging should be considered before raising funds. This line of thinking is incorrect. If you want to raise funds, you should first become a limited liability company or convert your company structure into an LLC. Otherwise, people will not invest in your company. If you have already become a limited liability company, then merging is no longer a necessary step, as this process can bring many obstacles. Conversely, merging now is very simple, so it should only be done when necessary.

When is Stock More Desirable than Convertible Stock?

Some companies have successfully raised up to $30 million through convertible bonds. Convertible bonds are usually a quick and simple option, so when speed and convenience are your top priorities, convertible bonds are a good choice.

However, from an investor's perspective, stock is more attractive. When you purchase stock, you actually own a piece of the company and have the right to profit distribution. In contrast, purchasing bonds only buys a promise from the company, with no rights attached.

As you raise more funds, stock becomes more useful because it means the company has more trust assets to manage. If you raise $5 million to $10 million, you might consider forming a board to discuss how to use that money with others.

In this process, you need to find experienced people to help you solve potential problems, as they have seen similar situations many times. If you are just nurturing seeds and trying to break into the market, convertible bonds may be a better choice because you do not have enough time and energy to deal with legal matters, while convertible bonds can provide a more convenient solution.

In summary, when you raise more funds and become more formal, equity is often the better choice.

How to Provide Information to Investors?

When providing information, do not exaggerate the facts. Do not try to cover up issues by deceiving or withholding data. However, when discussing the company's development plans, you need to tell an impressive and credible story.

The right way is to only purchase the company's stock. If you do this, you need to clearly understand that you are now the trustee of this funding and must be responsible for it. Therefore, when you write down the contents of the safe and sign it, you need to remember that this is all the company's money.

Traction refers to attracting people to use your product; if no one uses your product, you will not have traction. Typically, one point to note is the growth rate. If you want to connect with investors, the best way is to be introduced by other investors who have already invested in your company. Besides that, you may also need to use cold emails and connect with other founders, telling a credible and impressive story.

When raising seed funds, you need to clearly explain how you will use the funds. You can talk about what milestones you have achieved, what revenue levels you have reached, and what employees you still need to hire, etc. In summary, it is important to provide clear, accurate, and credible information to attract more potential investors.

How to Discuss Financial Projections with Investors?

Regarding financial projections, if investors ask for a five-year forecast, we colloquially refer to such people as "novices," because who can have a five-year forecast now? The best practice is to provide a 12-month or 18-month plan and tell a good plan for future rounds, Series A and Series B.

You cannot make complete, utterly nonsensical long-term financial projections. If investors ask you to do so, they are not very smart. Or they are not very good investors. However, this does not mean you cannot talk about your opportunities. You can share customer needs and potential market sizes, but do not treat them as long-term financial projections. You just want investors to imagine how much revenue you might have if you had a certain percentage of customers and potentially become a billion-dollar company.

How to Handle the Company's Dilution Rate Issues?

For each stage of the company, you need to consider the company's dilution rate. A dilution rate of 10% to 20% for seed funding is relatively appropriate, and if it exceeds 30%, it starts to become a bit squirrelly. Series B is usually 20% or less, but it depends on the company's operating conditions.

How to Handle Investments Involving Blockchain?

When it comes to investments involving blockchain, the best practice is to talk to as many familiar founders as possible and review their portfolio companies to understand their investment situations. For traditional venture capitalists who are afraid of blockchain and non-traditional blockchain investors who want to be more intimate, you need to tell a compelling story to explain what your company's unusual structure means to you.