When should you take a pre-emptive term sheet?
Recently, I was asked to advise a few CEOs who received pre-emptive offers to fund their companies. For all three, the decision to take money sooner than they had planned was not a slam dunk decision - it was one with upsides and downsides that they intended to carefully deliberate.
These discussions sparked my own thinking around whether there is a framework or set of guiding principles for how CEOs might think about taking more capital, sooner than expected.
First, any CEO debating this question must realize this is a great problem to have because it not only means the business is doing well but the market sees and values the progress you’ve made. Very few companies have a line of investors waiting to give them money so that alone is great validation that you’re on a great path.
In my view, the decision to consummate a pre-emptive offer comes down to quality of the partner/offer, time, and use of proceeds.
Obviously, if you receive an offer at an incredible price with a high-quality firm / partner, why wait? This rarely happens though - often the investor expects to pay a discount to what the next round price might have looked like if you decided to wait. Additionally, the quality of the firm / partner is highly subjective - how well do you know someone that you’ve met on Zoom for a few hours? My guidance is to weigh the dilution and quality of a partner against what an average outcome might look like if you wait (if taking an average sounds unambitious, weigh it against what outcome you might reasonably expect). Use publicly available benchmarking data to see what the typical Series A/B/C round implies about size of round, valuation, etc. If the offer in hand is materially better than that and the partner is clearly someone who understands the business and can help - it may make sense. If you’re getting a below-market offer, at the very least, you have an argument to negotiate it up to more appropriate terms.
The person you choose to partner with, more than the firm or the terms of the offer, is the biggest point to contemplate. This decision is a one-way door and one that you should weigh heavily. What will this partner bring to the table? How will he/she react when shit inevitably hits the fan? When thinking about fit with a specific investor, I consider: the value they bring to the company, the understanding they have of the business / business model, their influence / standing within their firm, and the chemistry / compatibility with the CEO. Whatever framework you use to determine the fit, leverage references to validate and qualify your judgment.
Every CEO will have a nagging feeling that they should do some price (valuation) discovery and not just settle for a pre-emptive offer even if it is a good one. While this might be logically true, this is where the value of time comes into play. The time to run a process and all the preparation before that is nontrivial. As a CEO, you must determine what the cost of your bandwidth will be and whether the trade-off of time and certainty are worth making in exchange for price discovery. In some cases, it will be worth it but in many cases, getting a fair offer and moving quickly may outweigh the benefits of feeling out the market.
Lastly and possibly the most important is how you will use the capital taken today vs. later. The main question to think through is: what does money today buy you? If that capital is simply sitting on your balance sheet and doesn’t allow the company to grow faster, hire more, build a management team sooner, then it may be a waste. Not only will the capital be underutilized but you may have issues down the road with your new investors who may have been hoping for acceleration in the business.
In addition to these three considerations (quality of the offer, time, use of proceeds), there are a few additional watch-outs that are highly dependent on your specific situation but are worth noting here:
Commitment of your investor - depending on the structure and size of the round or whether a board seat is part of the negotiation, you may have some questions about how your new investor views the investment (are they buying an option? Is the fund big enough to support the company in the future?). These are fair questions and even though the process may have unfolded quickly, CEOs should feel very comfortable engaging with the potential investor on these questions.
Avoid doing things that create friction for the next round - examples of this might include raising the valuation bar for the next round beyond the company’s ability to scale or creating a non-traditional board structure. Sometimes these things are hard to avoid given the dynamics of the round but when raising any round of capital, you should consider what the narrative will look like at the next round.
Secondary for founders - Part of the use of proceeds could be founder secondary which should be given careful thought. All your eggs are in one basket so it’s not unreasonable to consider some liquidity as part of the round.
I hope this helps give some structure for how to think about a pre-emptive financing offer. If you’re still on the fence and need someone to chat through it, please drop me a line (gautam at m13.co).