This article is the fourth in an ongoing series on Deal Leadership. To learn more about leading a deal efficiently, download this free eBook today: Lead, Follow Or Get Out Of the Way -The Art and Science of Deal Leadership or purchase our books at Amazon.com.
Since I am part of a team that runs a very active angel network, most of the time, I am juggling a bunch of deals in different stages of completion. It can be hard to keep track of where everything stands. Obviously, regularly updated lists and status reviews are helpful, but even more helpful is an overall sense of each of the stages in the process. In particular it helps to know which stages are critical junctures and key turning points in the life of a deal. That way as deals make progress and are approaching those points, you can jump in proactively and help guide them along.
So what are these stages and how should a deal lead think about the overall process? As we have pointed out in our articles on diligence, we like to progress diligence in logical, sequential stages in order to conserve time and effort - that of the entrepreneur as well as the investors. It doesn’t make sense to put a ton of work into an effort if you have no likelihood of investing. So a process designed with checkpoints along the way is the best approach.
A good basic process will include the following stages:
Initial Pitch Meeting
Deep Dive Meeting
Due Diligence Phase & Goal Alignment
Negotiation of Terms
Solicitation of Soft-Circles
Let’s have Christopher take us through a closer look at each of these stages at an overview level.
Christopher, how do initial meetings work? Are you talking about screening, or a formal pitch?
Pitching companies typically are introduced to the investors by a trusted source and then selected and invited to pitch as a result of making it through some form of screening process. Active early stage investors will look at anywhere from 50-100 companies for each company they actually invest in. Angels invest in a lot of companies, but say no to the significant majority of companies they speak with.
Screening is typically done by a committee or subset of the investors in a network. The companies which make it through screening will typically progress to a pitch in front of the full group or network. These pitches are almost always relatively short in duration - somewhere between 10 and 30 minutes, with a 15-20 slide deck as a guide, and some time for questions and answers after the presentation.
Well-crafted pitches will typically cover a pretty wide gamut of topics, including:
Description of the Customer Problem
Overview of the Product/Solution
Go To Market Strategy
Stage of Development & Key Milestones
Critical Risks and Challenges
Financial Model & Projections
Funding Requirements & Use of Funds
If the pitch and Q&A goes well, a presenting company will typically progress to a more lengthy session. Many groups including Launchpad refer to this next lengthy meeting as a “deep dive meeting.”
What do you mean by a “Deep Dive?” How do those meetings work? Who attends? Is there a formal agenda?
The deep dive meeting is pretty much exactly what it sounds like. A longer format meeting, typically two or more hours, to unpack the story in a little bit greater detail than can be done in a pitch. If a pitch is a quick check of investor interest, a deep dive is a chance to qualify that interest and see if there is enough substance to merit forming a due diligence team. Deep dive meetings typically involve the investors most interested in the company based on the initial pitch meeting. And, not surprisingly, the diligence team is recruited from these deep dive volunteers.
In most cases, there will be 2-5 themes or clusters of key questions that arise during the pitch. The deep dive is focused on these questions; the questions should be organized into an informal agenda with time allocations. To make the meeting most effective, the company should receive in advance an overview of the key topics to be covered and the key questions which were brought up at their presentation. And the meeting should be actively monitored to keep it on schedule and ensure that all the key topics are touched on.
As noted in an earlier question, a good diligence process progresses through a series of checkpoints.
Screening is one,
A successful pitch is another,
And a deep dive is a big one.
Forming a team and undertaking a diligence process is a lot of work for investors, and a lot of time and distraction for founders. It should not be undertaken on a whim. Therefore many companies progress no further.
At Launchpad, slightly over 50% of the time, interest in the company diminishes after the deep dive and we halt discussions with the company. The decision need not be unanimous, but it must be crisp and clear. If the majority lacks interest, it is important to be definitive and not waste investor or company time.
Diligence causes some attrition and fatigue; it is a disaster to go in with too few volunteers and too little conviction. It is better for all involved to make a clean break and step out of the lead role. If the company finds another lead and gets the round going, investors can always peel off and circle back and join the round under another group’s leadership. But a group with insufficient enthusiasm should not undertake the deal lead role. It is bad for everybody involved.
If interest remains after the deep dive meeting, we select a deal lead and launch into the next phase of due diligence.
When noting the section of diligence, you called the main phase “due diligence & goal alignment.” Why do you give “goal alignment” the same billing as due diligence?
They get equal billing because diligence is really a combination of micro and macro. You need the team to delve into the details of the business and build and test an investment hypothesis. But the deal lead’s job is to simultaneously keep an eye on the big picture:
Are the investors and founders on the same page?
Is this a deal that is going to work?
Goal alignment is about making sure everyone wants and expects the same things out of the company. Goal alignment is typically used to establish common ground around the long range plans of the company. It’s crucial to make sure the investors and the founders are in sync and want and expect the same things. Goal alignment needs to cover a variety of areas, including:
Long term company objectives
One of the key conversations the deal lead should have with the CEO revolves around where and how fast the company is planning to spend the cash investors are supplying. This “Use of Funds” discussion presents an interesting test for the early working relationship because it involves some tricky questions. Key hot button topics that frequently come up include compensation for the management team, key initial hires and marketing spend.
It is also important to figure out if there is agreement on what we need to learn about product / market fit before we pour on the gas. Is there a consensus about how many new markets we will enter simultaneously?
Another set of alignment-oriented questions might be along the lines of:
What are the growth milestones that allow the company to raise a future round of financing at a favorable valuation to the early investors?
Will there be enough funding from this early round to allow the company to achieve these important growth milestones?
As the diligence team is unearthing key details of the plan, the deal lead’s role is to fit that information into the overall big picture puzzle and make sure there is alignment on goals.
Another very important by-product of the goal alignment process is laying a foundation for the long term relationship between the deal lead and the CEO. It is fairly typical for a deal lead to end up being a board member or at least a close advisor to the company or liaison to investors. Over a period of 6 to 8 weeks, the deal lead will spend a fair amount of time interacting with the CEO. This is an important time to establish the basis for a longer term working relationship. If possible, it helps to spend time getting to know the CEO on a more personal basis. The goal is to make sure you are comfortable working together for the next several years.
Goal alignment sounds awfully close to a negotiation. When does the negotiation stage formally start? How do you know it is time? Who is in charge of it? How do the issues from diligence play into it?
It has been observed that everything is a negotiation, and that is probably true in this context. Every interaction tells you something about the management team and informs your approach to deal formation. Many of the issues uncovered by the diligence team will have implications for terms like valuation and size of round. And, you often discuss with the CEO, at least preliminarily, big issues like valuation range, size of round and board representation as a sanity check and condition of inviting a company in to pitch.
But all that said, the formal negotiation really should not start in earnest until it is virtually certain that the diligence team will reach a positive recommendation. It is true that you could shave a little time off if you started a bit earlier, but that can prove to be a disastrous mistake for a couple of reasons:
If the team suddenly uncovers a “deal breaker” issue and decides the deal is uninvestable, you will have a mess on your hands trying to explain that to founders with whom you already started negotiating deal terms.
If the team finds an issue, that is not important enough to kill the deal, but has big implications in terms of valuation, you are going to find it extremely hard to re-trade the price of the deal if you have already floated a higher number. It does not matter that you found a new issue - the entrepreneurs will always experience it like you are reneging on the deal.
So it is generally best to wait until the team has reached a positive consensus and begun drafting their diligence report. At that point you can begin to flesh out a termsheet. There are two ways to go about forming a termsheet: you can walk the CEO through the concepts and your thoughts before showing it to them, or you can just send them a proposed draft termsheet. I generally base my approach on the sophistication level of the founding team. If they are very experienced and familiar with early stage investing terms, I will generally just prepare a draft termsheet and send it to them.
But, if they are new to the whole investment process and some context and education and perspective might help them better understand the termsheet and react to it more constructively, then I will generally have a conversation and explain the various issues and where I am coming from on each point before sending it over. That way they know roughly what to expect and are not surprised by the harsh black and white of the terms on paper.
What do you mean by soft-circle? What is going on and how does that process work? What is the role of the deal lead? Are there better and worse ways to do it?
A soft-circle is an indication of interest by an investor in a deal. It typically involves the investor specifying an actual dollar amount they are willing to invest in this round with this company. It is called “soft” because it is conditioned on the final terms being acceptable and as described in the termsheet.
Soft-circles are an essential tool for two reasons. First they allow a deal lead and entrepreneur to run around and line everyone up and rally support for the deal. The mounting cumulative total of the soft-circles is really the yardstick of the deal’s progress and momentum. If they accumulate quickly, or at least steadily, it is an indication that the terms of the deal are going to be acceptable to the market.
Secondly, soft-circles are a way of holding investors and money in suspension while you line up one or two orchestrated closings. People are mentally committed to the deal, but they have not yet written a check. So they are on-board but held in suspension while you get the minimum money needed for the first close.
This ability to hold committed investors in suspension is invaluable because closings are a fair amount of work and involve coordination and transactional expense working with outside counsel. This is because the key terms of the deal are effectuated by means of a new class of preferred shares and these are memorialized by the filing of a revised certificate of incorporation in Delaware or another state of incorporation. (For more on deal terms, see A Guide To Angel Investing Documents: Preferred Stock Deals and Fine Print: Understanding Key Deal Terms and How They Can Affect Your Returns). Closings also involve the collection of a lot of signatures on a lot of documents as well as the transmission of a lot of checks. It is much more efficient to do all that work at once in one big organized orchestrated way than to have money trickling in over weeks and months.
Soft-circles can be solicited any number of ways; via email, telephone or a webform. At Launchpad we use a simple webform which results in a cloud spreadsheet (for example, Google Forms and Google Docs). This way, all the information is in one organized place and the resulting cloud spreadsheet can be shared with the entrepreneur and their attorney. In fact, we often let the entrepreneur use the webform for other investors who are not in our group. And, they can embellish the cloud spreadsheet with other notes and annotations that everyone involved in the deal administration can see. Since we are consistent in using Google Forms, the investors in Launchpad are familiar and comfortable with the process. We can easily post and circulate new investments to our investors. Very effective, yet fast, light and efficient.
You’ve referred to a “first close.” Are there others? Is this syndication? What is a syndication and how does it work? For that matter, why is it called syndication?
Yes, yes, it is all related. In finance, the term syndication refers to bringing groups or entities together into a transaction. In early stage investing it is about showing the deal to different investors, groups, networks, or funds to have them join the collection of investors funding the deal.
Often this kind of collaboration is necessary to fill the deal since each individual investor is only contributing a small amount relative to the overall round size. But regardless of whether it is necessary, it is often desirable since it builds a stronger, broader and more diversified financial base for the company to rely on in future rounds. And it gives the company a broader network of investors who can advise, help and make introductions.
The way syndication typically works is the lead investor and their network or closest associates will be in the first close. (Once the closing minimum is met, the company has a close and can start putting the money to work.) Then, the deal lead will accelerate the process of presenting the deal to other investors. Not only will they have a termsheet and diligence report, they will have two other key advantages:
They now have some momentum to show - they can show that a good chunk of money has already closed, and additional soft circles are piling up.
They have scarcity - the round is starting to fill up - a consensus is emerging and it is time to move or you will be left behind.
Momentum and scarcity are absolutely key ingredients for deal leads looking to get investors to move. For more on that topic see Angel Syndication for Deal Leads: Strategies To Engage Other Investors Quickly and Should I Jump On That Bandwagon?
What is a closing? Why are they necessary? How should a deal lead be involved with a closing?
As noted above, a closing is an orchestrated transaction involving the company and all the investors signing and exchanging deal documents, sending in money and making filings with the state and federal regulators. Because closings are a fair amount of work and involve coordination and transactional expense working with outside lawyers, you want to have as few closings as possible and have each one be as big as possible. This is because the key terms of the deal are effectuated by means of a new class of preferred shares and these are memorialized by the filing of a revised certificate of incorporation in Delaware or another state of incorporation.
Closings, in conjunction with closing minimums, allow for a very important protection for investors, who fear being the first person to invest and having their money stuck in an under-funded company. A closing with a defined minimum needed to close gives investors the certainty that their money will not be released to the company until a certain minimum viable dollar threshold has been met.
A deal lead’s role in a closing is to keep the lines of communication open with investors on timing and expectations, and to advise the company on how not to screw it up. The way most companies screw it up is by sending the closing package from hell – the biggest “unforced error” in all of early stage investing.
Every investor has experienced it. A giant mess of documents arrives via email late on a Friday night from some person you never heard of. Some documents are in PDF, some Excel, the rest in MS Word. They are all dumped into the bottom of an unclear email demanding immediate attention and response. The documents are inscrutably named, with long strings of digits from internal file system numbers.
When investors start to wade in, nowhere is it made clear what documents they are supposed to sign and what documents are for information only. Nowhere does it indicate where in the document they are supposed to sign. Nor is it ever made clear that several documents need to be signed in two places and one in three. And of course some documents are only for existing investors whereas others need to be signed by everyone.
A deal lead can and should make sure everyone is clear on the closing process and it gets done on time as expected. They should keep on top of the company to communicate with investors to make sure the follow-ups happen:
Counter-signed documents go out,
Stock certificates (or receipts or electronic certificates) go out,
A summary of the final close and company financing status goes out.
Want to learn more about leading a deal efficiently? Download this free eBook today Lead, Follow Or Get Out Of the Way -The Art and Science of Deal Leadership or purchase our books at Amazon.com.