Funding rounds happen in one of two ways. Either a founder asks for money and gets it, or an investor offers money and the founder accepts it. This may seem simple, but the dynamics are complicated.
I’ve written about how founders should fundraise. However, in running YC’s Series A Program, I’ve noticed how many companies raise money without any process at all. This normally happens when an investor offers a founder money before that founder is ready to run a process. This is usually a good signal. However, unprepared founders can get trapped by the dynamics of a preemptive offer and forced into suboptimal outcomes.
There are two types of preemptive offer. In the first type, an investor delivers a term sheet to a founder without making that founder jump through the usual hoops.[^1] In these situations, the founder doesn’t have to build a deck or pitch a full partnership. In the second type, the investor convinces the founder that an offer exists without actually stating the offer. This kicks off a one to one fundraising process on the investor’s timeline.
Most founders don’t realize that investors can write offers without a full pitch. Since founders don’t know this can happen, they often get fooled into believing that enthusiastic assertions of interest are the same as offers. This is in investors’ best interest because it reduces the expectations that they’ll make this kind of offer. To be clear, an offer is only an offer if it is a term sheet.[^2]
Groundwork for preemption
Preemptive offers do not appear out of thin air. Founders generally lay groundwork for them, sometimes unintentionally. Each time a founder meets with an investor, the investor is evaluating whether or not to make an offer. Founders who realize this know that no cup of coffee is entirely between friends.
I’ve noticed that founders who regularly – though infrequently – meet with a small but highly motivated set of investors are generally presented with the most options during fundraising, and are mostly likely to get preemptive term sheets. This contradicts what I used to believe: that founders should only meet with investors when they are actively fundraising. In today’s over-capitalized world, founders always need to be thinking about fundraising because investors are always thinking about deploying capital.
This has changed the advice I give to founders after their seed rounds. I’ve started to tell founders to work through a list of investors who they think might be good in order to arrive at a set that the founder believes are good and would be a good fit. At this point, the founder needs to keep this set of investors interested in the company and convinced it is doing well without being able to piece together enough information to make a full decision. It is important, at each of these more casual meetings, for the founder to clearly communicate whether or not she is actively raising.[^3]
This balance is tricky. When a founder meets with too many investors in this way, he gets distracted and risks being seen as a socializer rather than company builder. When a founder shares too much information or pitches too hard, investors believe that the founder is actively fundraising and act accordingly.
There is no perfect science to this balance. When an investor does issue a preemptive offer, it is usually because she thinks the founder is about to start fundraising, and the investor wants to get ahead of the entire process.
Deciding whether or not to take a preemptive offer
If you find yourself in a situation where you think you are getting preempted, here’s what to do.
- Ask whether or not you’ve been given a term sheet. If not, you haven’t been preempted.
- If you have gotten a term sheet, ask whether or not, in a vacuum, you’d want the investor to own more of your company. If the answer is no, then politely decline.
- If you do want the investor to own more of your company, ask whether or not the amount of money you are being offered makes sense for what you need to get done before your next round.
- If the money seems right, ask whether or not the amount of equity the investor is asking for is something with which you are comfortable.
- If the answers to all of these questions are “yes,” then take the offer without doing more work.
If the answer to any of these are “no”, then you have to decide whether or not you want to start a fundraising process. This is where the groundwork laid during those coffee meetings becomes valuable. The relationships you’ve formed during those coffee meetings become the set of investors who can quickly be pulled into an actual fundraising process. At this point, refer back to this: https://blog.ycombinator.com/process-and-leverage-in-fundraising/.
[^1]: I’ve seen investors deliver signed term sheets to companies that were not even thinking about raising.
[^2]: I’m mainly referring to priced equity rounds here. This logic holds for safes and converts as well, though in that case, there is no actual term sheet.
[^3]: The specific cadence and tactics of these early coffee meetings is the subject of a significant amount of discussion during YCA.