In this follow-on to the interview with Chuck Donnelly of Rockstep Solutions, I talk about the funding chasm between Seed and Series A funding. But first, I dive a bit deeper into some of the issues surrounding grant funding, specifically the US federal and state grants designed to encourage technology development by young and small companies. And I also touch upon the importance of regular communications to potential investors during the extended fundraising period. The funding chasm is not unusual. I talk about some of the operational challenges of evolving the business from early seed stage to Series A stage. And I also talk about the specific funding vehicle: do you use a seed funding mechanism like convertible notes or Series Seed equity? Or do you lean towards more complex Series A preferred shares? The conclusion, for companies in the Funding Chasm, is that leaning towards Series A is going to be a preferred solution for investors, even if it’s more expensive for the company in terms of legal expenses.
Links and Resources
Small Business Innovation Research – federal agency set-asides to fund technology research and development. $Billions a year.
State Science and Technology Institute – a central organization (kind of a trade organization) for US state organizations involved in TBED (yeah, another acronym): Technology Based Economic Development. In other words, growing a state economy by funding and encouraging technology development. The list of members isn’t organized by state, so you’ll have to do a bit of digging to find relevant resources for you (note to self: project for the future!).
SAFE from Y Combinator
In this episode I’m following on to the interview that I did with Chuck Donnelly, who is both founder and CEO of Rockstep Solutions. Rockstep Solutions, you may recall, is providing software as a service to biomedical labs that are doing research, especially on mice.
I want to talk about just three things. I could talk about a lot of different topics after talking with Chuck. But the three issues I want to focus on here are going to be: first, what is it like to have grants as a funding source. And I want to dig in just a little bit deeper into some of the things that Chuck pointed out about his own experience. Second, I want to just touch on the importance of having regular communications with potential investors. And then finally, talk a bit about what you might think of as the funding chasm between seed funding – seed equity funding – and Series A equity funding.
But first let’s talk about grants now. It’s easy to say oh yeah it’s free money but of course it isn’t. And here I’m going to be focusing especially on here in the U.S. the federal and state grants that are used primarily for technology research and development.
If you want to learn more about those kinds of grants here’s two web sites you go to, and of course I’ll include these links in our show notes. First of all, SBIR.gov. That is for the SBIR federal program. And then there is a trade association of state organizations that provide similar kinds of funding. And that is at SSTI.org.
So here are a couple things to think about if you’re considering these types of grants for funding the early stages of technology development at your company.
First of all, grant providers think about projects as opposed to companies. And you’re of course thinking about the long term funding of your company, and the long term technology and product development for your company. But most of these organizations think of the world in terms of projects. So a project has a beginning, middle, and an end. And the goal is going to be technology development – often product development, yes, but sometimes that’s secondary to fundamental technology development and proving a technology as opposed to the acceptance of a product. And there may also be other goals that these typically government organizations have. And those other goals could be creation of jobs, or otherwise having impact on the community, or the industry as a whole.
One of the implications of these projects being funded as opposed to companies is that typically sales and marketing expenses are not going to be funded by the grants. And there may be some other things that are specifically excluded. The devil is always in the details in these things, so it’s best to read them several times over. There are usually plenty of documents, but you have to read them a couple of times to make sure you really understand what all the jargon is talking about.
And that kind of leads into another important point. That the skills of grant writing and after-the-fact reporting on grants can become quite specialized, especially for very large grants. It is possible to go hire a grant writer. Unfortunately though it’s usually a fixed fee. It’s going to be payment upfront or along the way. It’s not going to be contingency, which is to say, oh yeah you only get your $10,000 for writing this grant if I actually get my half a million dollar grant. Unfortunately it doesn’t work that way usually. It’s important to check references of potential grant writers because it’s very easy for somebody just kind of raise their hand and say, Oh yeah I’m in the grant writing business. You want to talk with at least three references hopefully of similar projects that the grant writer has worked with, to find out how much the grant writer has actually done the work themselves versus the company having to supply lots of information. Different balance depending on the grant writer.
And one other important point is that for very large grants the reporting on a regular basis to the grant providing agency can in fact become a full time job. I’m an investor in a company that has received tens of millions of dollars in these kind of grants – which are technically contracts as opposed to just free grants – and that reporting … they have somebody on board who that’s her full time job.
So again, this is not free money. There are always strings attached. There are costs associated with them. So if you’re thinking about grants you have to think of it as part of a multi coloured strategy, if you will, on the funding side. It’s going to be grants plus something else to cover the other expenses not covered by the grant. So that may be friends and family, as Rockstep Solutions has done so far. It may also be grants plus angel investors. And angel investors are comfortable typically at that early stage. And they often like the fact that a company can get grant funding because it is non-dilutive.
Just to remind you if you don’t know what that term means… Dilution is the process of your ownership of a stock in a company – the percentage ownership – goes down as more money comes into the company if it’s raised as additional shares of equity. More people are getting shares, the percentage you own goes down. It is diluted. But grant money is money coming into a company that is non-dilutive. So again, equity investors often like that.
So to conclude then grants can be a great source of funding if you’re in the right kind of business that is developing a technology that either the federal or the state organizations want to encourage, and overall your development as a company will be supporting the goals that those organizations want to support.
So let’s move on to the issue of communications with potential equity investors as you’re going through the process of fundraising. So why is this important? Well there are two interconnected reasons.
First of all, fundraising can be a very extended process. I usually tell companies to expect that it’s going to take at least six months from the time they send out their first pitch deck to that first investor, to the time that money is actually in the bank. And it can be longer.
And during that period the investors that you’re talking to are going to continually see a flood of new deals coming across the transom. And so you don’t want them to succumb to shiny new ball syndrome and run after all the new deals, and instead pay attention to you as the single most exciting deal that they are looking at during that extended time period.
So regular communications with potential investors is critical. And I always recommend a monthly newsletter that goes out that informs them about the progress of your company. I have written a blog post that shares for templates that other professional investors have developed for Investor Communications, and I’ll include a link to that blog post in the show notes for this episode.
So there are just a couple challenges to keep in mind when you are communicating to potential investors during a fundraising. First of all, keep it short. Investors want to see concise communications, they don’t want an entire restatement of a bunch of things that you’ve already told them. Secondly do make sure that you are using investor language when you are communicating with them. This is something that in fact I worked on with Chuck Donnelly. He comes from the world of writing grants and kind of an academia type of language, and you need to translate from what you might write on a grant to what investors are expecting to see in terms the language and the emphasis on the topics.
And make sure you include both specific asks… For example, if you need to hire a director of sales, include that because potential investors may know someone, and they want to see how they might be able to be engaged in your company long term. But also – and this is a hard one – include the challenges that your company is facing and a little bit about what your plan is, and maybe even some asks to help overcome those challenges. That again is something that investors want to see. They want to understand that you can be honest about the progress of your company. And if they know what they’re doing, they’re not going to be scared away that you’ve had a little hiccup, ’cause that kind of stuff happens. Instead they want to understand that if they’re an investor in your company, they’ll hear about it soon and they’ll know that you will be open to help on those kind of things.
So the goal overall is not only to keep investors.. rather, potential investors… engaged in your company as you’re making progress on the fundraising – you know, herding the cats if you will, to put together a full round – but also to show them that you’re going to be great at communications after they’ve made their investment. And that will make you stand out from the crowd.
I’d like to finish with an extended discussion about the issue of the Funding Chasm, if you will, between seed funding and Series A funding. If you’re not familiar with those terms I have written a post about what is seed funding. Generally speaking Series A is a larger professional venture capital type of funding. Larger being at least $2 million maybe $5 million or more maybe even $10 million. And that’s as opposed to a seed funding where you’re a pretty young company and you may be getting under a million dollars.
But there is this chasm between seed and Series A for a couple of reasons. First of all there are far fewer companies that end up raising a Series A funding than successfully raise a seed funding. I don’t know what the exact statistics are but I think it’s only about 10 percent to maybe 20 percent of companies that get a seed size financing actually end up successfully raising a Series A. So that’s a pretty big difference between the two rounds, a big chasm if you will.
And of course in startups everything takes longer and more money than you expect.
So it’s not at all unusual for companies to find themselves in this kind of middle ground that feels very uncomfortable. Rockstep Solutions is clearly there. I’ve seen a bunch of companies in this space where they’re beyond seed stage but they’re not quite at Series A.
So let me first talk about some of the operational challenges that are going on that characterize this this middle ground. You’re trying to show Series A investors that you have “traction.” Traction is this magical world word in funding. And it means different things to different people unfortunately.
First off investors are talking about marketing and sales traction. Specifically in terms of the number of customers you have, but also the type of customers that you have. In the case of Rockstep Solutions they need to prove to later stage investors that they are able to get corporate biopharma kinds of customers who have the potential to spend up to millions of dollars a year on the software as a service contracts, versus the academia customers that they’ve already been able to land which are more in the thousands to tens of thousands of dollars per year type of customers. But you may be in a different kind of business where perhaps you have some people who are getting a free version and investors want to know, to be able to see that you can attract people who are actually paying for your solution. And again there may be other kinds of customers depending on your business. Maybe it is larger distributors that the later stage Series A investors want you to be able to show.
In any case getting those customers often requires money and you get in this chicken and egg situation of, well, I need the money to get the customers and the investors say, oh you have to get the customers before you can get the money. It’s a tough situation. Not at all unusual.
Unfortunately there are also other kinds of traction or validation that investors may want to see. For example, validation that your pricing strategy is going to be accepted in the market. Validation that your go to market strategy – the very specific steps that you’re taking to combine marketing and sales and targeting of customers and geographies – that that is working. And that you understand better than a seed stage company what exactly your cost of customer acquisition is going to be. That is to say you’ve got lots of experience, or at least, you know, measurable and measured experience, that says it looks like today, you know, it costs twenty five dollars to acquire a customer that is going to be worth 250 dollars over the lifetime value. And we can see that those costs are coming down. Those are the kinds of things that Series A investors want to be able to see.
But in addition to marketing and sales traction, often Series A investors wants to understand that your business is scalable, which has to do with operational kinds of issues. So for example as you become more mature, you understand better the product development processes that you need to be successful. Things like your long term development plan is much more clear over the next, say, three years as opposed to what you’re doing in the next six months. You have a process to develop your product and you are actually meeting that schedule. Imagine that! If you’re in manufacturing you understand in a lot of detail what your supply chain looks like, and what the costs are from that supply chain. And in many businesses there’s an issue of how do you onboard customers. That is to say a company has signed on, but there is some process to get people trained, get people set up, get people to, you know, migrate what they’ve done in the past to what they’re going to be doing with you in the future, and providing customer service to all of them. So those are all kind of product related traction issues that Series A investors are going to be looking at.
And there are also things related to operational maturity, things like: Is your company at the point where you are setting and meeting budgets? Imagine that! Do you have customer contracts and what do those contracts actually look like? And is the process of signing on new customers and their contracts smooth, or is it still requiring a bunch of heroics and last minute back and forth? Is your hiring process well-developed? If you’re going to be scaling your company, you’re going to be needing a lot more people. Where are you in terms of the maturity of that process? And then things like your bookkeeping and your accounting and your financial reporting, all of that matures as you become more and more of a Series A kind of company as opposed to a seed stage company. I’ll include a link in the show notes for this episode on the video I did on scaling your business processes, and it’s very helpful to understanding at a high level what it is you need to do.
But again, it’s a little vague in terms of just how far along in this maturing of your company as a real functioning business you need to be before you’re actually ready for a Series A.
So with that, I want to now turn to the differences in the actual funding vehicles that are used for seed financing versus Series A because they can be quite different.
With less baggage, potentially, from a long past and with lower expectations about how mature the company’s operations are today, it’s possible for investors who are putting in smaller amounts of money to have documents along with their investment that are simpler than the much more extensive Series A documents. So over the last decade or 15 years or so there have been several different variations for seed funding documentation. So there are convertible notes, which are loans with the expectation that they will turn into equity in the future. Typically in a Series A or some other larger equity funding. There are also a couple of variations called Series Seed kinds of equity, which are priced equity but they are much simpler than typical Series A funding. And then Y Combinator, one of the leading accelerators out of Silicon Valley, has developed something called SAFE – Simple Agreement for Future Equity – which is basically an option to buy, or a warrant to buy stock at the terms of a future equity investor.
So with less worry about the past, they basically kick a bunch of issues down the road into this Series A funding.
But if you’re in this chasm between seed funding and Series A, the investors that are considering putting money into your company are going to have some of the same concerns that a Series A investor would have. So if your business has been around for two to five years there can be issues such as… There are former employees – did they have contracts? Do they have claims against you? What’s the status of their stock? Do they have any back salary that’s owed from when times were tough? And are there customer issues. What are the contracts look like? Do your legal foundational documents like articles of incorporation reflect the kind of issues that are going to be needed for a Series A funding? Do you have intellectual property assigned from your employees to the company? Are there employee contracts? And on and on and on.
So the longer that you are around as a business, the more potential stuff can accumulate. And of course a funding that is much bigger than that earliest of seed funding often comes with a desire by the investors to have more influence on your future decisions as a business.
And then there are a couple other important issues for a funding at this stage. There’s something I call “term inheritance,” which is to say that the earliest of equity rounds that have certain kinds of preferences and terms that go along with the equity, set the expectations of what kind of terms will be included in later rounds of funding. And so it’s something that early investors should be paying attention to, but they may not be necessarily having the experience to understand some of these subtle issues. So in any case you have to be careful when you’re crafting these documents that this is going to set the stage for a better Series A funding.
And there’s one other issue that early stage investors somewhere between seed and Series A will be concerned with. If your numbers show that you need to raise significant amounts in the future beyond what typical angel or small venture capital fund could provide, those early investors are going to want to try to protect themselves from the actions of those future investors. Because unfortunately there are plenty of stories of venture capitalists who are driving a deal and they come up with terms that put those earlier investors in a very unfavorable position. That’s just something to be aware of.
So as you’re going through this process of trying to get an equity funding in this chasm between the seed and the Series A, it’s likely that you’re going to need to include a bunch of the terms that are included in a Series A, setting it up the right way so that the later investors aren’t taking advantage unnecessarily of the early stage investors, but also they’re not adding egregious terms that are bad for you as the founder of the company.
And all of that unfortunately does translate into higher legal bills associated with this kind of funding. And I know it’s hard to rationalize if you’re raising less than a million dollars to be spending $30,000 or $40,000 on the legal bills. But you should probably think of it as an investment in cleaning up the legal act of your company. So it opens the door to a Series A to happen much more easily because that investment in part of the infrastructure of your business has already been made.