Even when the economy is growing, it's often difficult to raise equity capital for an early-stage company, with only a tiny number of entrepreneurs actually securing deals. The negotiation process itself is typically fraught: An angel or venture capital round can easily take six months from your initial pitch until you receive a term sheet, which requires its own complicated negotiation process. What's more, the money you raise may only last a year or so, which means you will have to start your next capital raise soon thereafter.
But as the economy continues to slide, such investments are getting even harder to raise. There was a major drop-off in VC funding in the fourth quarter of 2008 and angels are becoming pickier. As a result, leaders of early-stage companies need to be brutally honest with themselves about their prospects for outside investment.
While there are no standard rules on when to forgo a round of financing, there are certainly some red flags. Let's take a look:
Investor Doesn't Follow Up After the First Meeting It's not easy getting a meeting with a VC or angel investor, so it's an encouraging sign when it does happen. Yet you need to temper your enthusiasm. In some cases, an investor simply wants to learn more about your space. Or the meeting may be a favor for the person who made the introduction. Furthermore, an investor will likely have some positive words about your company—giving the impression that there is genuine interest. Again, be cautious. The true sign of interest is if you get a follow-up email or call—but for most companies this is a rare event.
Investor Continues to Postpone a Deal Keep in mind that investors rarely say no to a deal. Instead, they find creative ways of pushing back or making excuses. For example, an investor may say he or she is interested in a deal if you hit a certain milestone. But bear in mind, this milestone will often be something that is tough to accomplish, such as snagging a big customer or hitting a high level of traffic. A common excuse? An investor will say that things are hectic and it will take some time. Alas, this is really a nice way of saying no.
Multiple Investors Make Objections How many rejections from individual investors before you should give up entirely? This is a tough one. But after meeting with 10 or so investors and hearing similar objections, you should know that it will be extremely difficult to get financing. You'll likely need to make some big changes to your company.
Your "Burn-Rate" Is High; Value Proposition Unclear Simply put, investors have greatly toughened their criteria when making new investments. In addition, funds are starting to close down lagging investments and focus on the stronger ones in the portfolio. To get interest from investors, you need to show that your venture's growth potential is substantial and has fairly low downside (meaning investors want to see that even if the company fails on certain milestones, it will still be valuable enough to sell and get the money invested back). For the most part, investors want a low monthly "burn-rate," below $100,000 (depending on your type of business, of course). Also, the product or service must hold value for customers, such as improving revenues or cutting costs—quickly. At the same time, there should be a small up-front cost for the product or service you're selling.
Investor Wants You to Find a "Lead Investor." An investor may say, "We like your deal and we'd be interested in investing in the round if you can bring in a lead investor." Somehow, founders think this is really positive news. But it isn't. It can be extremely difficult to find a lead investor—the investor that will commit to the round and take the initiative in terms of negotiating the term sheet and performing due diligence. Know that many investors do not lead deals.
Despite the poor odds and red flags described above, it's easy for entrepreneurs to be overly optimistic and cling to the hope that somehow a deal will get done. But the capital-raising process can be a huge, time-consuming distraction, so it's better to be realistic and devote your efforts elsewhere. If you experience a combination of the danger signs described above, then you should probably seek alternatives. One strategy is to sell the company. Another approach is to put your company into hibernation mode. This means drastically reducing costs and making minimal improvements to the company's offerings with the hope that as times improve, the company will be in a position to reap the benefits.
Yes, this is bleak stuff. But it's the current state of the early-stage investing marketplace. For many early-stage entrepreneurs, it means forgoing this type of financing—at least for now.
Tom Taulli is a noted finance author and blogger.