EIGHT THINGS YOU NEED TO KNOW TO FUND YOUR STARTUP
VCs Are Not Bankers-Both investment bankers and merchant bank loan officers use a static financial template to make decisions. Investment bankers use raw data to reverse engineer into a static financial model that they scrutinize and use as their operative compass. Merchant bank loan officers simply pull out what amounts to a checklist of criteria a business must fulfill to qualify for funding. Unlike investment bankers, VCs can not make smart recommendations (and collect fees) without having to deal with issues of direct responsibility, execution, and sustainability. VCs are also dissimilar to merchant bankers, who’s loans are often insured and/or hedged, since they obviously can not just process your application, issue you a check, and leave you alone.
Venture capitalists are risk-defying bungee jumpers with much bravado and very thin cords. Seed stage and early stage VCs assess the intangibles of Startups who usually consists of little more than a small team of wide-eyed twenty and/or thirty-somethings and an idea. What this means is that VCs are directly responsible for their decisions due to the subjectivity of the investment selection process. Consequently, VCs have to manage and minimize the risks of their investments by being directly involved in the management of portfolio companies.
Average VC Fund Lasts Approximately Ten Years-VC investment vehicles are called Funds. These Funds provide financing to Startups, which are often referred to as portfolio companies. A grad student recently asked me Is there a time period when VCs are more motivated than usual in making investments? While she was referring to seasons in respect to Spring vs. Summer or Autumn vs. Winter, her question reminded me that the best time to approach a VC is when they have just raised a new Fund with an investment thesis that correlates in whole or in part with your Startup.
For example - If a leading VC Firm recently raised a Fund to make investments in Digital Media Startups, then unfunded Social Media Sites and Blog Networks with subscribers and ad revenue should convince someone familiar with the firm to refer them to the GP. To the contrary, the worst time to seek or even receive investment from a VC is within the last three years of a Fund because “technically” the Startup will not have much time to scale. The VCs’ implied investment expectation is that all Startups in a Fund should reach exit within the ten year lifespan of the Fund.
VCs Expect Startup Founders To Be Committed To Their Startup For At Least An 6-8 Year Period-Launching a Startup can be a seemingly unmanageable lifestyle adjustment. Despite the risks and uncertainties, there are lasting rewards for Startup Founders who persevere. Obviously, if Founders stay with the companies up until the point of exit then they are rewarded fiscally and professionally. Fiscally, they’ve received compensation in the form of vested equity for their hard work and assumption of risks. Professionally, they’ve demonstrated to the entire tech industry that they have the skill set and discipline to successfully manage the processes involved in developing a nascent idea into a viable enterprise.
The average successful Startup reaches exit within a 4-6 year period. The normal conditions within employment contracts and Founder agreements concerning IPOs and M&As usually require or entice Startup Founders to stay on with a firm an additional 2 or more years post-exit. Where the legal docs are mute on this subject, the industry norm is to expect Founders and Senior Execs to maintain their company affiliations for a reasonable time period post-exit. Any departure by a Founder or Senior Executive deemed early by the IPO market or an acquirer may adversely affect both the company’s valuation and investor relations credibility.
VCs ROI Target Is 6x-10x Investment-Before presenting to VCs Startup Founders must be certain that they are confident of the growth potential of their value proposition. Let’s do some oversimplified guess estimating. For the sake of simplicity, let’s say you received $1 million financing in exchange for 25% of your company at $4 million pre money. The VC has a 25% stake and expects a return of 1000% at exit. Well, How much does your company have to grow in value to allow the VC to walk away at exit with $10 million? The answer is growth of over 2500%. While this is a very rough guess estimate, the numbers are fundamentally realistic since we must take mental note of the affects of multiple rounds of financing and dilution. The principal questions that lingers in the mind of VCs while reading business plans and listening to pitches are - Does this Startup have a value proposition that can scale to allow a 10x return on investment post-dilution in a three to five year period? And How much funds and non-cash VC resources are necessary to viably accelerate the Startups’ growth processes?
VCs Customarily Limit Funding To One Year Of Operational Expenditures-Many seed stage or early stage Startups funded by a VC will have funding to pay for no more than one full year of operations. Startup founders must have clearly defined growth-oriented milestones that are attainable within one year. Subscriptions, User growth rates, Monthly Unique Visitors, and the like are appropriate indicators for measuring the feasibility of a Startup. Verifiable progress towards the attainment of these milestones will further substantiate the value of the company and generate interest among VCs who may participate in the next financing round.
Many VCs Distribute Funding To Startups In Tranches Based On Milestones Or Key Metrics Such As Subscriber Growth Rate or Cash Flow-VCs relationships with LPs have multiple impacts on VC-Startup interactions. VCs solicit investments from LPs, comprised of Institutional Investors (pension funds, insurers, government agencies) and adventuresome Billionaires. LPs rarely provide VCs with a check for the full amount of their “pledged” investments. LPs usually provide funds fractionally over a period of time. Only successful serial entrepreneurs can expect access to the total amount of financing from a VC . Inexperienced management teams receive funding in segments based on any key metric(s) that demonstrate a reasonable measure of traction and user adoption. Moreover, these funds are dispersed from VCs as per a mutually agreed upon line item budget with few , if any, contingencies. So, inexperienced Startup Founders can expect very little financial management flexibility after receiving funds from a VC.
Average Successful Startup In VC Portfolio Reaches Exit Within A 4-6 Year Period-This is the ballpark average touted by the National Venture Capital Association, many leading Academicians, and individual VCs. The implications of this fact are innumerable, for example, it debunks the quick IPO or even quicker M&A myths. It should bring Startups, Angel investors, and aspiring VCs to the conclusion that the path from launch to exit is incredibly arduous, long, and rarely results in billion dollar IPOs or M&As.
A VCs’ Decision To Fund Your Startup Has Very Little To Do With Money-The vast majority of affirmative financing decisions involving seed stage Startups are based on the perceived quality, authenticity, and believability of the Startup Founders and their Management Team. Most people, including VCs, become attracted to persons and groups that invoke curiosity. If you are sufficiently complex, personable, and intelligent possessing a diverse skill set and compelling ideas then you may be well suited for Founding and Managing a successful VC-backed Startup.