5 tips to secure a term sheet on your terms
When it comes to pitching investors, it’s no secret that success rates in securing term sheets are paltry. After spending five years working as a San Francisco-based venture capitalist, I can say with conviction that this all comes back to asymmetric information. Historically, there have been limited resources available to entrepreneurs that uncover the ways in which investors view a business’ potential.
Given the plethora of writing available on this subject today, you may wonder how this disconnect could exist. The answer? Most existing literature on securing a term sheet is either too specific or too general to be useful. The key is to focus on five main actions to bridge this knowledge gap, so you can understand what investors are actually evaluating when they look at your business.
1. Know whether you are creating or destroying value.
This is a fundamental piece of information for every company to know—but few actually take the time to calculate it. At Hum Capital, we provide the mathematics to understand it here and have built an algorithm that helps companies calculate their cost of capital in a few simple steps.
The takeaway is that all companies are financeable at the right price. That said, the more aggressively you are creating value, the more investors will be willing to pay for a piece of your company. Having a clear picture of historical value creation will put you in the driver’s seat to find the right investors.
While an entrepreneur who cay say he or she is an alumnus of a certain school or grew up in the same town might get a second look, what an investor can’t deny is the cold, hard facts of value creation math. In the past, companies haven’t had the tools to present these calculations to investors in a straightforward way, so the fact that you do will set you apart—and eliminate room for bias to creep into the term sheet.
2. Benchmark yourself against other companies.
Investors look at as many companies as possible and pick the ones that create the most value at the lowest price in order to “maximize their risk-adjusted returns.” In public markets, this is calculated using the Sharpe Ratio. However, public markets have a few legs up on private ones: 1) a richer history of quantification and 2) standardized benchmark data from companies like Bloomberg and Yahoo! Finance. No similar outlet for comparison has existed for private markets (until now).
If you know how much value you are creating relative to other investment opportunities investors have access to, this gives you a strong foundation to drive favorable terms in the term sheet. If someone’s not interested, you can always pick up and go talk to another investor that hasn’t yet had access to opportunities like yours.
3. Understand how macroeconomics affect your business.
There is only one thing an investor cannot infer from a company’s data, and that is how a different future than the company has lived through will affect the company’s performance.
In investor-speak, this is called understanding “macro-stress,” which is all about knowing how a recession would decrease revenues, raise costs and lower value creation. This is the part of investing that deserves to be artistic, because macro events notoriously do not repeat (even though they rhyme).
Some effects of macro-stress might surprise you. For example, during recessions, luxury watch sales actually increase, due to a known phenomenon called the “Lipstick Effect.” Thus, it is imperative that you help investors understand how macro-stress applies to your business.
4. Make a killer investor list, and remember that investors are human.
Hopefully now it’s clearer why investors have a hard time explaining what they look for; the best investors invest in the highest risk-adjusted returns. But knowing that doesn’t make the process of creating an investor list any easier for you. How do you know whom to pitch? Whom should you talk to first? Should you re-engage after somebody passes?
These are impossibly hard questions to answer, which is why successful fundraisers work totally differently: they choreograph their fundraise.
Successful fundraisers don’t care about which investors are interested in their “space.” Why? Because if an investor already has an active investment, he or she often does not want more exposure. This also explains how Peter Thiel can be the best consumer internet investor and enterprise analytics investor of all time—and how Peter Fenton can have a big data infrastructure company and a computer security company go public on the same day.
5. Choreograph your fundraise.
Use these three buckets to inform your approach to securing a term sheet (or two or three) that you want to accept:
Ready to choreograph? The first step of this “dance” is to start with the “easy yesses,” your friends and family. They are people who will often say yes to you just because you are you. This group is necessary to unlock groups #2 and #3 and is, unfortunately, the reason why there is so much bias in capital access. Rich friends and family lead to more immediate “easy yesses.” The more data-driven the investment process, the more this issue will go away but today’s market is unfortunately fraught with bias in this department.
“Independent thinkers” are the next bucket. These are investors who will assess the merits of your business by understanding value creation, benchmarking and macroeconomics. They take comfort in the fact that there is demand for what you are doing (because the “easy yesses” are in), but that makes up only ~25% of their calculus.
Once the easy yesses and independent thinkers are in, your round is done. You have enough capital available to make your plan, and you can credibly say to investors, “This is done, but I took the meeting with you because I have heard great things about you.” This has a powerful effect with its roots in evolutionary social proof, so you can use it as you see fit to raise your valuation and/or check size.
Entrepreneurs love to tell stories about the last bucket, “followers,” because the sad fact is that too many investors fall into this category. Avoiding bias is hard, and some investors do hilarious things like attempting to access closed rounds. Nonetheless, followers can materially affect your likelihood of success by delivering more capital at higher valuations, which lowers your cost of capital. Many can even provide real value post-investment. It’s hard to give advice on how much to optimize, so be sure to use your discretion.
These five tips may seem straightforward, but putting them into practice with discipline is more difficult. Learn how Hum Capital can help you access the private capital markets and secure a preferable term sheet here.
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