What’s actually required to start or close a funding round?

David S. Rose
David S. Rose , Founder and CEO , GUST INC.
7 Aug 2014

Technically, a “funding round” simply means a company accepting one or more investments from one or more investors on similar terms within a certain period of time. As such, this could cover many different things, such as:

  • Your parents loaning you money to cover your expenses while you code your product
  • 25 individual angel investors funding a startup on a convertible note
  • two angel groups investing money in Series Seed Preferred stock purchase
  • a single venture capital fund putting in the full amount as Series A Convertible Preferred investment

In all cases, the one fundamental requirement is that the company and the investor agree on how much is being invested, and on what terms. These items are included in what is known as a term sheet. What the terms end up being, and how a company and the investor(s) arrive at that term sheet, can differ widely.

The simple fact of the market is that there are many, many more entrepreneurs seeking capital than there are investors seeking to fund them. Indeed, the odds are 40:1 against getting money from angels and 400:1 against a company receiving an investment from a VC fund. This means that it is a “buyer’s market”, and it is infinitely more common for an investor to decline to make an investment offer than it is for a company to decline to accept an investment offer.

In an absolutely ideal world, an entrepreneur bootstraps a startup, gets traction in the marketplace and gets noticed, a smart investor calls up the company and says “Hey, I think you’re doing great things, I’d like to invest a million dollars in exchange for 10% of your common stock”, the entrepreneur agrees, the lawyers quickly draw up the documents, the investor sends over a check, and the deal is done.

To say this is an extremely rare occurrence would be to wildly overstate the likelihood of it happening.

So what does usually happen? A company gets started and gets some traction [these days it is difficult to nearly-impossible to get funded without having an operating company and a product that is pretty near completion], and then starts talking to as many investors as it can find, ideally getting introduced to them by mutual acquaintances. This is known as “starting a round”.

With luck, at least one of the investors will make a funding offer by presenting a term sheet. If they offer the full amount the company thinks it needs, and the terms they offer are acceptable to the company (perhaps after some negotiation), then the paperwork is signed, the money wired, and the round is closed.

However, if the investor is willing to put in some—but not all—of the money needed, and both sides agree on the term sheet, the company then has a “round in progress”, with a “lead investor”. At that point the company (assisted in some cases by the lead investor) goes out to other investors with the term sheet from the lead to try to “fill out” the round and get the full amount. Other investors will be invited to put in money on the same terms as the lead investor (and thus, as part of the same round.)

In some cases the term sheet will provide that the round will be closed (that is, stop taking in new investments and have the investors transfer in their money) by a certain date, regardless of whether any other investors join in.  Typically, however, the term sheet will provide for a minimum amount to be raised before anyone, including the lead investor, will actually transfer the money, and may provide for a maximum amount, beyond which no additional investors will be allowed to join in. In either case, since the terms of the round have already been negotiated and agreed upon by the company and the lead investor, the decision for all the following investors is a much simpler, ‘take it or leave it’ choice based on the signed term sheet (and therefore much easier to get.)

The challenge is that getting that lead investor is just about the single toughest thing in the startup world, because it means that someone needs to take the first step, similar to getting the first pickle out of a tightly packed pickle jar. A good lead investor will likely have the following characteristics:

  • “Smart money” which means they know the startup business and the particular domain of the company, and can be helpful in many ways going forward.
  • A strong commitment to the company, so they will devote time and effort to the company both during and after the fundraising round.
  • A significant amount of money that they are willing to invest themselves (typically at least 25%-50% of the target raise).
  • Deep pockets (that is, plenty of more cash reserved for follow on rounds)
  • A network of other investors to whom they can introduce the company
  • Good personal chemistry with the entrepreneur

However, because it is so damn difficult to get that lead investor, companies will often be desperate enough to try shortcuts. One of those is to draw up a term sheet themselves, setting a valuation, terms and target amount . They then try to function as their own ‘lead investor’ by presenting ‘their’ term sheet to potential investors, getting quickly to the easy “take it or leave it” decision and entirely skipping the really tough “step up and lead” decision.

The problem is that this rarely works, because it is just about 100% guaranteed that an entrepreneur ‘negotiating’ that self-proposed term sheet with him- or herself will simply not end up with the same kind of term sheet that a smart, tough, lead investor would have negotiated. And because (a) the ‘pseudo term sheet’ will be less investor-friendly than a real one, and because (b) there will be no smart-committed-deep-pocketed-well-networked investor providing validation, support, and a good chunk of the funding for the round, the resulting easy ‘take it or leave it’ choice invariably gets turned into an even easier ‘leave it’.

So, the TL;DR answer to the original questions are:

  • What’s actually involved in order to start or close a funding round? A term sheet.
  • Should there already be people interested in investing first before starting a round? Not before you start asking, but yes before a term sheet is presented (by the investor).
  • Does a target have to be set before starting a round? Typically yes, because you need to know what you’re looking for, although the target can be negotiated.
  • If so, does it have to be met before closing a round? It depends on the term sheet, but most typically yes, at least an agreed-upon minimum must be reached.

Gust Launch can set your startup right so its investment ready.

This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.