The Hardest Thing for Early Stage NC Startups: Finding the Elusive 'Lead' Investor.
In this article, we dig into THE most common challenge fundraising, dig into why and provide strategies for finding your lead.
In the last 90 days, I’ve talked to at least 10 founders who have the exact problem illustrated above. They could raise their 1X-2X their pre-seed or seed round amount based on “I’d put in $X if you had a lead” - add those together and you’re there! But sadly it doesn’t work that way. You have to find that lead.
BUT FIRST!
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What Does a Lead Do? And Why Does Everyone Want One?
In VC-land the word ‘lead’ has a lot of meaning embedded in it. It includes some or all of these assumptions in the one term:
Term setting - At it’s core, ‘lead implies’ that someone is setting the price and terms of the round. Most institutional VCs as leads implies a priced round, but in pre-seed/seed and angels lead can apply to SAFE and convertible notes as well.
Large investment - the typical rule of thumb is that a lead will invest 33-50% of the round
Governance - for priced rounds, wrapped in the ‘lead’ branding is the firm taking a board seat.
Due Diligence - the lead is committing to performing due diligence on the company. For syndicated deals, this can introduce a perceived liability. e.g. if the company is up to something shady and the lead misses it, but another 2-6 investors come into the deal, what happens to the lead when this surfaces?
Water carrying - finally implied in ‘lead’ for the institutional investor is that they are going to use the reserves to help bridge the company between rounds, support future rounds, and stay at pro-rata (if they are pleased with the progress).
Understanding Venture Capital Structure
Before we dig into why there’s a shortage of leads and how to support it. Let’s cover a couple of basic structural elements of institutional VC that drive the upstream trends causing a lack of Leads.
What’s an LP?
In VC-land you’ll hear the two-letter acronym - LP - Limited Partner. Here’s a graphic that describes it:
in other-words, the VC has investors and those investors are called LPs. Some of these are individuals, some are Family Offices, most, from a $ perspective are huge pools of capital in pension funds, insurance capital, endowments, and foundations.
How Does Venture Fund-Size Impact Founders?
As a fellow founder, I have to admit, this took me a long time to understand and even realize I had to really understand a couple metrics of the firm I was pitching or it was a waste of time. At the end of the day the math starts at ‘fund-size’.
I this table, we take the fund size and:
Set aside 50% of the fund for reserves
That leaves 50% for fresh investments, what I call First Round Capital
Note: this used to be 25-30% but over the last 5yrs VCs have been increasing it due to the lack of reserves.
Then we have a range of 10-15 companies per fund that VCs invest over the investment phase of the fund.
Looking at a range of fund-sizes, you can see that the average check size for 10-15 yields a range of $650k-$1m up to larger numbers. This is handy because if you’re raising a $5m seed - a $20m fund is too small and a $250m fund is out of your range.
Therefore, the most data points as you’re looking to find a lead is ‘what’s your fund size’. Crunchbase and online research can help you narrow this down quickly.
The other thing first-time founders don’t think about is ‘target ownership’. When a VC leads a round, they are typically trying to get to at least 20% in earlier rounds and in later rounds they will consider 15%.
Here if you are doing a $2m seed and you want a lead to invest $2m, that’s implying a $8-11.3m valuation.
You can’t for example, raise $1m on a $10m pre-money - that math doesn’t math with institutional VCs.
For a tactical example, here’s the progressio of the three local Triangle funds:
Bull City Venture Partners (Durham)
Fund I — ~2010–2011, $15M
Fund III — June 2014, $26M
Fund IV — May 2022, $53M
Cofounders Capital (Cary)
Fund I — June 2015, $12M
Fund II — April 2018, $31M
Fund III — March 2023, $50M
IDEA Fund Partners (Durham/Chapel Hill)
Fund I — 2007–2008, ~$20M (targeted $25M)
Fund II — January 2015 close
Fund III — May 2019 close, ~$25M
Using this math on the BCVP and Cofounders $50m fund:
$25m first rounds
$1.7m-$2.5m checksize
That’s leading $3-5m rounds
$3m implies $12-$17 pre-money
$5m implies $20-$28m pre-money
At $25m IFP:
$12.5m first rounds
$830k-$1.25m check range.
$830k implies $3.3m pre-money
$1.25k implies $5m pre-money
There are always exception to the rule, but hopefully this helps you think through how to best identify a target lead and how to craft your round to improve your chances of landing a lead.
Where Did All the Leads Go?
With that backgrounder, first for most pre-seed and many seed rounds, the local institutional firms got larger which, using the math above has priced them out of many early rounds.
Looking at the broader market, one outcome of companies staying private longer and M+A being somewhat frozen, has caused a liquidity crunch:
Here you see that LPs have been investing in firms and not getting distributions from exits since 2001. That’s a 5yr severe deficit in capital expected by LPs.
The good news is with the IPO filings of SpaceX, OpenAI and Anthropic each of those firms are going to raise $50-100b each at > $1T valuations. After the lock-ups that’s $3T in liquidity flooding back to LPs. Hopefully this will work it’s way back into new funds and fresh capital looking to deploy it into early stage NC companies!
Found More Leads - in secondaries!
Another downstream challenge with companies staying private longer:
The chart above shows that venture funds are increasingly buying their ways into unicorns by buying secondary offers. Every time this happens, a fresh round isn’t done, instead the big unicorn/decacorn companies (stripe, databricks, etc.)
What can I do TODAY?
That gives us some of the reasons, what about the remedies, what can you do to increase your changes of getting a round done.
Flush out a lead as fast as possible
For institutional investors, when someone says they want to invest a largish amount (25-50% of the round size you’ve articulated), but after you get a lead, what they are saying one of two things:
They like the deal, but don’t have conviction to commit to lead and use one of their ‘10-15’ shots on goal.
They don’t want to tell you ‘no’ and if you get a lead they can always reconsider.
Your job as founder is to get to the bottom of this. One strategy, especially if you have a solid ‘plan B’ is to press a bit and ask some qualifying questions. It’s best to have these ready should they give you the “We’d like to invest, let us know when you have a lead…” Here’s some questions you can use that fit the situation. The goal is to get any more information out of them you can:
“Any feedback you can share as you and the other partners evaluated the opportunity?”
“When we get a lead, what were you thinking as far as range of investment to help us put the round together?”
“From a lead perspective, would guidance on valuation help get you over the hump on leading?”
“Great, can you give me some of the reasons you wouldn’t lead so I can work on getting you through those?”
If that doesn’t work, you can just say something like: “What would it take for your to lead. If all that falls through, time to move on to B1.
Execute Plan B1 - Get an Angel to Lead
Angels have a lot more flexibility to lead rounds and at the pre-seed/seed level, angels tend to be open to SAFEs which reduces the long list of ‘lead responsibilities’ to ‘setting terms’ - SAFEs strip away the governance, Due Diligence and water carrying. Friendly angels have kick-started many a round by setting prices, committing a first check and getting the ball rolling.
If that doesn’t work, time for Plan C→
Execute Plan C - Company Sets Terms
In the absence of a lead - institutional or angel there’s no rule that the company can’t set your own terms. I recommend putting your price on the low side of your range to entice investors (note we published data on these ranges back in this piece, this has not changed materially since the 12/25 publication date). In addition to lowering the price, you should also start as low as gives you 12-18months of runway - both to manage dilution and these ‘community rounds’ have a way of getting rolling. I’ve seen many start at $500, then grow to $750 and finally the founder cuts it off at $1m. It’s easier to raise the amount you’re raising (no savvy investor ever got mad that an early stage company raised more capital than initially discussed!) than it is to raise less. Starting small and raising creates momentum, buzz and excitement and hopefully a little FOMO. A large round sitting around not getting nibbled on has the opposite impact.
Summary
Let’s face it, fundraising in NC is hard. It’s been especially tough in the last 2yrs as the lack of leads has caused many startups to never close a round, even when they had the round committed but couldn’t land a lead. Hopefully, understanding where the leads have gone and providing some tips on how to find your lead, and get the round done. Good luck out there!