Fly the Aircraft First: The Potentially Paralyzing Effects of Fundraising

Startup CEOs can learn an important lesson from pilots.  Specifically, to always fly the aircraft first.  Sounds obvious, like maybe you shouldn’t need to remind pilots to do this, but here’s what they teach them and why:

From the earliest days of flight training, pilots are taught an important set of priorities that should follow them through their entire flying career: Aviate, Navigate, and Communicate.  The top priority — always — is to aviate. That means fly the airplane by using the flight controls and flight instruments to direct the airplane’s attitude, airspeed, and altitude …

A famous example of a failure to aviate is the December 1972 crash of Flight 401, an Eastern Airlines Lockheed L-1011. The entire crew was single-mindedly focused on the malfunction of a landing gear position indicator light. No one was left to keep the plane in the air, as it headed towards a shallow descent into the Florida Everglades. Four professional aviators … were so focused on a non-critical task that they failed to detect and arrest the descent.

In my work with startups, I periodically see CEOs surprisingly stop flying the aircraft first.  When does that happen?  When they are raising money, or think that they might be soon.  I know they’re not flying the aircraft first because they say things like:

• “I want to replace the CRO, but I can’t because I’ll be out fundraising next quarter.”
• “We need to reduce the burn rate because cash-out is about 9 months away, but I don’t want to cut expenses now because I’m trying to raise money.”
• “I’m no longer excited about the new product that we’re building, but I want to keep funding it because we’re out raising money and VCs like it as part of the pitch.”

Not flying the aircraft first means not making operational changes that you normally would because you are fundraising, or believe you soon will be.  It means running your business differently because you are trying to raise money.

This begs two questions:

• Are you actually fundraising or just talking to venture capitalists? There is a difference.
• Even if you actually are fundraising, is deferring such changes a good idea?

Are You Actually Out Raising Money?

Sometimes you want to keep the burn rate high while fundraising to stay on a hypergrowth trajectory and enable the big, next round.  Other times, you’re growing at 30%, and not particularly efficiently, and that next round is more fantasy than reality. Happy ears can help you avoid unpleasant-but-necessary decisions for another few weeks or months.

Are you out raising money or are you simply talking to VCs? How can you tell the difference?

• By receiving a term sheet.  VCs don’t need your permission to make you an offer, though such proactive term sheets are less common than they used to be.  Remember that if all that love is real, there’s an easy way for a VC to show it.
• By asking.  Remember the first rule of VC (and M&A):  the amount of time you invest, access you offer, and data you provide must always be proportional to the odds you see of actually closing a deal.  Ask if they’re thinking of making an offer, why or why not, and when.  Ask what additional information they need and provide it only if they are clearly doing their homework, signal an acceptable valuation range, and express valid concerns that you can resolve.

If you’re not getting term sheets and are starting to doubt some of the answers you’re hearing, then look for these clues that you’re more talking to VCs than raising money:

• You have been talking with an analyst or associate for 2+ meetings without talking to a principal or partner.
• Your meetings get rescheduled and responses to your communications come slowly. That likely means the VC doesn’t see your deal as urgent and probably thinks of your interactions more as a simple chat or check-in.
• The VC doesn’t appear to be doing their homework. They ask questions that are answered in the material you’ve already shared, they don’t communicate the due diligence agenda ahead of meetings, and they don’t follow-up on the data requests they’ve made. VCs do a lot of work preparing for their internal investment committee, and you can usually tell when they’re doing it.
• The VC focuses only on financial metrics, which could indicate that they’re just updating their database or, worse yet, are looking at another player in the space and using you as a data point. [1]

But even if an investor is genuinely working on an offer, if that offer is not qualified on valuation or, increasingly in these days, terms, then once again you’re not out raising money, you’re just talking to VCs. On valuation, it’s pretty clear — if an investor says they’re working on a term sheet at a valuation of 4x revenues when your absolute minimum is 6x, then you’re not out raising money; you’re just talking to VCs.

With terms (also known as structure), things are somewhat more subtle. You can receive a term sheet with an attractive headline valuation only to discover it’s dirty because it contains terms such as:

• A multiple liquidation preference, where the new investor gets not the usual 1x their money back before the common shareholders, but perhaps 1.5x or 2.0x.
• Participating preferred stock, where the new class of preferred stock gets both its liquidation preference and its pro rata, as opposed to one or the other.
• Redemption rights, where the company has the obligation to repurchase the shares from the new investor after some time period (e.g., five years). (Which begs the question of where it’s going to get the money to do so?)

For more information on dirty term sheets, see this excellent post by Janelle Teng. If you’re in receipt of one, I recommend doing these three things:

• Do the work to understand the terms. Ask your CFO, lawyer, or banker to create liquidation waterfalls to model the outcomes in numerous liquidation scenarios.
• Ask the investor if they would provide an equivalent offer on clean terms [2].  Understand and compare a possible down-round to a flat- or up-round on less desirable terms.
• Remember that terms only get worse.  No investor wants to invest on terms inferior to the prior investors.  This suggests that if you’re going to do a round with dirty terms that you make it big enough (and/or your path-to-profitability fast enough) to be pretty sure it’s your last [3].

But let’s zoom back up.  Why are we talking about dirty term sheets again? 

Just as spending time with VCs who will eventually make you an offer at an unacceptable valuation is not actually “out fundraising,” so is spending time with VCs who will eventually make you an offer on unacceptable terms. It’s more subtle, but it’s the same issue. And to defer necessary operational changes because of it is a big mistake.

Is Deferring Change a Good Idea?

Let’s say that you are actually out raising money — not just talking to VCs, but talking to VCs who are likely to make you an offer at an acceptable valuation and on acceptable terms.

In this case, is not flying the aircraft first a good idea? I think this is a hard question because of the risk of derailing a potentially transformational financing round. 

Even here, I think it’s wrong to defer the changes [4].  Why?  Because it’s:

• Dishonest.  You shouldn’t start your long-term relationship with a new investor by saying, “just kidding when I said the CRO was great, we need to replace them.” [5] You might be working together for the next 5-10 years.
• Ineffective.  It has spectacular backfire potential. Specifically, the investor is likely to detect the problem with the CRO and your vigorous (but disingenuous) defense of the CRO may cause them to question you and drop out the round as a result. [6]
• Bad for the company.  Failing to make a desired operational change is definitionally bad for the business.

As one VC said to me, “We don’t invest in perfect companies. We invest in companies where the upside is greater than the downside. I have invested in companies where the CRO, CTO, and CFO were all recently or in the midst of transition. The important thing is that we talk about the changes and understand them. We’re going to be investors for the next 5-10 years.”

What does that mean to me? If you, as CEO, think something needs to be done, then do it. Always fly the aircraft first.

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Notes

Thanks to Michael Lavner for his comments and review.

[1] This happened to me. If the VC had just told me they were doing diligence in the space on another potential investment (as opposed to seeming to express genuine interest in my company), then I wouldn’t have felt burned. Plus, a note to VCs: if you meet me, ask me all about the space, and then announce a deal with one of my competitors in about 2 weeks, I’m going to know what happened and feel used in the process.

[2] I love this one because they do the work for you and show you an offer that is mathematically equivalent (to them). Comparing the two sheets (and associated liquidation waterfalls) shows you the cost of maintaining the headline valuation and avoiding the consequences of a down-round.

[3] To be clear, some investors will be scared off by finding a lot of structure in previous rounds. So it’s not simply a question that you will have to raise subsequent rounds on equal or inferior terms. You may not be able to raise at all, or at least from the investors who you want to raise from.

[4] Though, perhaps sadly, it takes me longer to reach that conclusion. While I “get” the theory that I’m preaching, I’ve also raised money on the back of a CRO transition, and it wasn’t easy. Nevertheless, I still preach the theory.

[5] You easily could have said, “they’re nearing the end of their runway” during the process, instead.

[6] Or, more simply, they may just detect the deception.