How To Pitch Successfully to Investors for Follow-on Funding (Part 3)

This is part 3 of this series of articles: “How To Pitch Successfully to Investors for Follow-on Funding.”

Step 3: Align all stakeholders around follow-on round economics and – critically – around a future capital raising plan.

The follow-on investment you’re considering is likely going to be the first time in the history of your company when founders and friends are not the only stakeholders influencing the decisions, and when the interests of your many stakeholders are starting to diverge. Have you perhaps got an early angel who wants to cash out already? A loan or a repayable grant from an implacable government agency that has way more lawyers than you do? A couple of potential investors that would join the round if someone were to lead and if the terms were structured just so? Perhaps a respected and influential advisor who knows exactly how your round should be organized?

Whatever the combinatorics of any particular situation are, it is always a good practice to align all these disparate voices before you go out to raise funds, so that everyone internally knows what the objectives and acceptable parameters of the investment round are and there’s no internal dissent once you’re locked in complex negotiations with investors.

In Southeast Asia, this step is particularly tricky for a number of reasons. First of all, valuation disparities between Southeast Asian start-ups and companies in the US or China are massive and signals from other markets tend to wreak havoc in valuation discussions in SEA (a typical symptom of such confusion would be a voice at the table saying “but a company so-and-so in the US got a multiple on (accounting parameter du jour) of x 10 – we should not accept anything less!”).

Secondly, there are a lot of disparities between local investors focused on SEA and each particular country – some are family groups and governments with multi-decade investment horizons, some are corporates with HQ agendas to follow, some are venture investment teams determined to kill it in their very first fund, and some are angels with altruistic investment economics – so depending on who you talk to and which growth story you propose, the very same company could be valued at US$5 million and US$15 million (real example) – and that’s before we introduce financial engineering and complex term sheets.

Finally and perhaps most importantly, it is still an open question as to what Southeast Asia would look like in a few years – will it be a single digital media market with multi-100 million revenue companies in each vertical? Will we see Southeast Asia’s first US$ 1B IPO in 2 years or in 4 years? Or will the growth be relatively slow and steady, like in a number of other emerging markets that haven’t yet followed the glittering trajectory of China?

In practice, what happens as the follow-on round is being planned is that the founders have to face multiple contradictory signals internally and from the market and are under enormous pressure to promise a very high next round valuation to all of their stakeholders. This sets the company up for a number of disappointments and even dangers – be it an extended fundraising period to find the investor willing to value the company sufficiently highly, loss of confidence in founders by their erstwhile investors if such an investor is not found, stakeholders interfering with fundraising process, conflicts between stakeholders, loss of team morale and such.

This is easily one of the most controversial topics in the ecosystem to date, we don’t have much of a silver bullet to recommend – but from experience, one exercise that tends to help founders caught in such situations is to bring all the internal stakeholders together to come up with a long-range capital raising plan that describes not just the pending follow-on round but, critically, future one or two rounds of funding and perhaps even an approximate parameters of an exit event.

Here’s an imaginary scenario. Let’s say we have a company with $5 million annual turnover (“external revenue” in e-commerce parlance, “sales” in the case of a game publisher, sometimes a “throughput” in case of an ad tech company) and $1 million gross annual margin (“internal revenue” for ecommerce folks, “commission” in the case of a game publisher or ad tech company). Leaving profitability out of the scope of this exercise for the moment, let’s further assume that the company is looking for $3 million in fresh funding and a chorus of internal stakeholder voices demands from the founders the following valuation points: at least $5 million (says the angel who aims for x10 their initial investment), at least $10 million (says the co-founder, because similar companies in the US are valued x10 on gross margin), and at least $15 million (says the latest investor on board who aims for x5 their initial investment).

In our example, the founders would find themselves under pressure to raise funds at $15 million pre-money valuation. It is at this stage, before fundraising has kicked off, that we’d recommend to sit down with all the stakeholders and to jointly work out exactly how much this combination of team, product, geography, and model would need to raise in the next round of funding, after the current follow-on raise is done. While it’s not something very obvious to worry about at this stage, it will be of immense use for internal alignment if the stakeholders agreed that (for the purposes of our example) this company will require $5 million in its next round in two years and the market-appropriate valuation point at that time would be $20 million (based on conversations with Series C investors or a corporate would-be acquirer perhaps).

Based on such insight, it will become obvious that raising $3 million+ today on a pre-money valuation of $15 million would leave a very small gap between $18 million post-money of this round and ideal $20 million pre-money of next round that the company will be stuck in for two years – and that this proposition most likely will cause a range of issues with the existing fundraising (as the incoming follow-on investor is looking at company appreciation from $18 million to $20 million over the course of two years, which is not something most venture investors would look for).

This example, of course, is yet another major simplification for the sake of relatively quick overview of risks of misalignment at the time of follow-on investment – but hopefully it goes to show how important it is to manage such risk in advance. To provide a necessary disclaimer, this example is entirely fictitious and all resemblances with real-life situations would be purely coincidental. For an all-time classic write-up on the use of investment terms to align stakeholders, we’d highly recommend this article .

To be continued. Stay tuned for Part 4 of this series, “How To Pitch Successfully to Investors for Follow-on Funding.”