Venture Capital Tutorial
Posted by Pierre de la Fortune on May 13, 2015 @ 12:01 a.m.
Written by Patrick Vernon
Know what VCs are looking for
A lot of people have the misconception that venture capitalists are a mysterious bunch who invest in all kinds of startups. And that is a little bit true, but a more accurate truth is that they invest in a very specific kind of start-up: one that is poised for hyper-fast growth. You see, VCs “swing for the fence.” Your venture must have a very large potential for VCs to be able to fulfill their fiduciary duty to their limited partners (explained below). Gone are the days, if they ever existed, of maverick VCs who give a couple of guys in a garage a few hundred thousand dollars to develop a prototype. Nowadays, the venture capital industry is well-defined and very sophisticated and everyone is wondering what happened to those good ole days. VCs have a short list of must-haves in the ventures in which they’ll invest. and if you don’t satisfy these criteria, you either need to change your strategy or don’t waste your time chasing VCs. Here’s the list: 1. $1B market potential. If yours is not that big, then you need to broaden your horizons and think bigger. What if you had a $10M investment? How big could you get then? That’s the thinking VCs want to hear because they’ve got the millions you’ll need to get there.
2. Experienced management team. This is a catch-22 for many entrepreneurs. The good news is that VCs have great networks that can help you round out your team. But you need to work very hard getting it close. You need to have experts on your side, at least as advisors if not on the payroll.
3. Sustainable competitive advantage. This is a really tough one that most start-ups don’t have, and you can’t just change strategies to get one. If your venture is not built off of some protectable and scalable technology, VCs won’t usually be interested. It is conceivable that in the right type of business you could build barriers to entry if you are a well-funded first-mover, but it is quite rare that that will suffice.
4. Proven business model. I mentioned scalable in the last point. You have to be able to grow fast. And I mean crazy fast. Again, think unlimited resources. VCs want to invest millions of dollars for hyper-fast growth (see below about asking for the right amount), which means you need to build something that can get to lots of customers fast. You need to be a product business, not a service business.
5. Verifiable customer pain. You must demonstrate that you are in touch with your customers. This is not the area in which to hypothesize. Get customers early, even if they don’t pay. Work with customers before you seek funding. Their participation will prove to the VCs that you have a solution that people care about.
6. Clear exit strategy within 3-7 years. If you are planning to run your business forever, don’t bother VCs. They must exit to provide a return to their limited partners. They are capitalists, and the only way they can cash in their investment in your venture is for your venture to be sold or to go public.
Know the difference between VCs and “Angels”
VCs are explained above. They are professional investors with very specific criteria and a fiduciary duty to their limited partners (explained below). An “angel” could be anybody who writes you a check. Since the tech bubble, a lot of newly wealthy people dabble in angel investing, and angel groups sprouted up, too. Most of these act as VC-light, that is, they want the same criteria as VCs. But they often will do earlier and smaller deals.
Ask for the right amount
VCs these days generally have much more money that they need to “put to work.” Because of today’s fund sizes, most firms are not looking for any deal for under $1M (that means they want to invest at least $1M in your venture) and would prefer a first investment to be in the $3-5M range. Then they will expect to put in another $3-15M in future rounds so that your company can grow into a $500M company in five years. That is hyper-speed growth. That’s the VC business. It is “hit-driven.” Their “core business” is not helping aspiring entrepreneurs learn the ropes to eventually have a profitable business. They need the next big hit to pay for all the ventures that won’t make it. Do not come to VCIC asking for $300,000 as the only funding you will ever need. That is not enough capital to “move the needle” for a VC firm.
Plan on future rounds of investments
Most entrepreneurs think they can “get there” with only one round of funding. You’ve been trained to bootstrap. That’s unfortunate when you start looking into venture capital. You need to start thinking of how you could grow the fastest, with almost unlimited resources. VCs are experts at growing new ventures. They say things like, “To get a new semi-conductor business to $500M takes about $30-50M.” It is what they do. You will have to get comfortable with that dynamic. If you accept one round of VC funding, that means you are on board for several. It might look like this: * $1M early stage round to get to prototype or perhaps get first customers; * a year later, another round of $3-5M to test the business model and whether it can scale, milestones of $1M in sales or some # of customers; * then maybe 18 months later, $5-10M to go BIG and try to position yourself for an “exit” (sale of company or IPO). * (Note: some smaller firms with fund sizes below $40M have the strategy to exit before bullet #3 rather than take a 3rd round. But this is an exception, not the rule these days.)
Understand pre-money, post-money and % ownership
When you accept an investment, you are selling a piece of your company. Just how much you are selling is determined by the investment amount and the “pre-money valuation,” which is the amount you and your investors agree your company is worth the moment before you receive an investment (hence the “pre” in pre-money). Quick example: if you receive a $1M investment and you negotiated a $1M pre-money valuation, you just sold half your company. The value of your company after the investment is $2M (= pre + cash), and that is called “post-money” valuation.
Pre-money valuation is a negotiated value, negotiated between you and your investors, and this negotiation process has the potential to create acrimony, partly because VCs are experts in this process, and you usually are not. VCIC is a great place to get a glimpse of what it is like in your investors’ shoes and to practice negotiating with student VCs.
VCs know the valuation of other start-ups and will compare you to them (you’ll often hear the term “comparables”). Comps are the biggest driving factor when it comes to determining pre-money valuation. You are well-served to find your own comps that support your cause for a higher valuation. However, it is not all about the money. The expertise a VC brings to your company is a significant part of their overall contribution. It is a mistake to take money from the VC firm that offers the highest pre-money valuation if it is not the firm that can help you grow the most. At VCIC, you will meet multiple (mock) VC firms. They are competing for your business as much as you and the other entrepreneurs are competing for theirs.
Another important issue to consider in pre-money valuation is percent ownership in the long haul. Remember above we stated you’d need several rounds to become a hundred million dollar company. At the end of that process, it is not likely that you’ll own much of the company (maybe 25% in a good case). The cliché is that you’d rather have a slice of a giant watermelon than the whole raisin. If you own 25% of a $200M company, you’re doing OK, so start getting comfortable now with the reality that you’ll have to give up more and more of your company to your investors through all the rounds of funding.
Do not get stuck on 50%! The number 50 is meaningless. Real control of your company is going to change dramatically the moment you take on investors regardless of percentages. Your company cannot afford infighting on your board of directors regardless of who has the majority vote. It is not conducive to fast growth, and a minority stake can ruin a company just as fast as a majority can. It is far more important to begin thinking of how well you will work together because you know what drives VCs and they know what drives you.
Exit strategy The last major factor that impacts a VCs negotiation for pre-money valuation is potential exit valuation. That is, how big can it get? They look at the exit values of comparables and then back into a pre-money valuation that could give them a desired return. This is probably best explained in an example. Let’s say your company needs $1M right now, but will probably need a total of $10M to grow. Looking at other companies who were recently acquired, your VC believes that there is a good chance you could be acquired for somewhere between $80-100M in 3-5 years. Let’s be generous and go with $100M. Quick math: that’s $100M return on $10M, or “10x.” But your investor doesn’t own 100%. Let’s say they own 75%. That gives them a 7.5x return, and as you’ll see below in the “understand how a VC fund works,” 7.5x is not a very good return for a portfolio company, even though it is probably a great return for you, an individual.
Example Here’s how a VC might think through this scenario: “We could exit for around $100M. If I believe we can get there with only a $8M investment total and that for that $8M I could own 80% of the company, that would give my firm a 10x return. To get to 80% ownership, we should probably buy about 50% of the company in the first round, 20% more in the second round and the last 10% in the third round. Hence, I’ll try to negotiate a $1M pre-money valuation for an investment of $1M in the first round.”
The example in the previous section may look something like this: * $1M investment on a $1M pre-money = $2M post-money valuation the moment you get the cash. Management retains 50% (one divided by two) of the company. Management’s portion is worth $1M. * Next round, $4M investment on a $6M pre. That implies that the venture tripled in value as you hit some milestones. Why? Because it was worth $2M at the last post-money, and now you’ve negotiated a $6M pre. 6/2=3x increase. Something good must have happened. Your widget worked! With this new $4M cash investment, the company is worth $10M post-money. New investors bought 40% of the company with that $4M (of $10M total). Management still has half of the remaining 60%, or 30% of post-money valuation. In dollar terms, management’s portion now is worth $3M. (See table below.) * Final round, just before going public: $10M investment on a $20M pre. You just sold a third of the company again, so you are down to 20%, but it is 20% of a $30M company, worth $6M. Not bad for spending other people’s money. And that is going to grow quickly because you have $10M in cash that you’re going to use to create tons of value and then sell your company to Rupert Murdoch for $200M, which will be $40M for you. Of course, your investors didn’t do too shabby either. For their total investment of $1M+$4M+$10M=$15M they get a return of $160M. They look like greedy bastards until you take into account all the other companies they invested in with this fund that failed. Let’s take a look at that. IF YOU DO NOT UNDERSTAND THE SECTION ABOVE, YOU NEED TO STUDY IT BEFORE YOU SIT DOWN WITH A VC. You do not want to be naïve about how much of your company you are selling to your investors. More examples at the bottom of this paper.
Understand how a VC fund works You are in the business of your business. VCs are in the business of investing in high growth companies, and then returning the capital to their limited partners (folks like state pension funds, university endowments, insurance companies, banks and anyone else with large pools of money to invest). Here’s how a simple fund might work. Let’s start one called VCIC Ventures. We hit the road looking for investors (LPs) with a target fund size of $160M. To the LPs, venture capital is a high risk asset class they call “alternative assets,” and while they’ll put 90% of their money into safer things like mutual funds, stocks and bonds, they’ll also put a few percent into alternative. That few percent adds up (at CalPERs, the biggest by far, for example, a few percent is a few billion dollars). These days if we’re trying to raise $160, we’ll probably raise $200. That’s the way it’s been going lately. That’s both good news and bad news for entrepreneur. The good news is that there is money out there. The bad news is that it is a LOT of money. That’s why you need to be asking for a lot. It takes a VC just as much time to manage an investment of $500,000 as $15M. And if the $500,000 gets a 10x return, that’s only $5M. But we’re getting ahead of ourselves. We raise $200M, and with that we will probably invest in a dozen or so companies (our “portfolio”), averaging around $10-15M in each “portfolio company.” Almost all venture funds last 10 years. That means we have to return all the money to the LPs in 10 years. Because we are in a high risk class, our LPs expect to get a higher return than, say, the S&P index. So they want us to be returning upwards of 20% on an annual basis (a crude estimate of the stock market by comparison is an average of about 10% a year in stocks, bonds are safer and even lower). To give our LPs a 20% annual return, we’d need to cough up a check in the year 2018 for $1.2B.
This is a crude and inaccurate example because the money doesn’t move around so simply. In reality, VCIC Ventures wouldn’t get all the money on the first day, nor do we distribute all the proceeds on the last day. It is more accurate to guestimate that we’d have to return somewhere around $700M to our LPs over the course of that 10 years.
So now go back and take a look at the greedy VCs who got $160M from your venture. Yes, that is a lot of money, but in the context of needing a portfolio return of around $700M to their LPs, your company’s “success” barely makes a dent. And you thought you were a rock star! Now you start to see why VCs swing for the fence. All it takes is one eBay or Google or MySpace to get that return for your LPs. What if your company sold for $1.5B!?! Then CalPERS might event notice. Well, no, not really, because to mitigated their risk they invest in a lot of VC funds.
If you keep an eye on this bigger picture you see two things clearly. 1) VCs are not at the top of this food chain, though it often feels to entrepreneurs as if they are because VCs do control the spigot. And 2) VCs have a lot of pressure from the capital markets to return a sufficient amount. Another important point is that all of this is “market driven,” by which I mean the day that CalPERS decides this business is too risky, everything could dry up.
VC math examples 1.You negotiate a $500,000 pre-money and the VC is going to invest $1M. What percentage ownership will you have? How much is the post-money 2. Two different firms are investing in your venture. One is putting in $1M, the other $2M. Your pre-money valuation is $3M. What percentage ownership do you retain? 3. We are looking back on a couple of rounds of investing that you got. One was a year ago when you received $2.5M from a VC firm on a pre-money of $5M. Then this year you got another $5M on a pre-money of $15M. What percentage do you own? How about the VC? If you sell the company next year for $50 million, will you be happy? Will the VCs be happy?
Yes, you are happy, you are a millionaire many times over. But no, your VC is not! He barely got a 3x return, which won’t be much help towards that 20% return on 10 years on the entire portfolio. His LPs might sue him for the early exit. You can see how entrepreneurs and VCs do not always have the smoothest relationship – they’re incentives are not always aligned.
The Fallacy of Taking Other People’s Money
It is tempting, isn’t it? These crazy VCs and “angels” out there will give you money to help you start your business. How could you resist? Well, having read this article to this point, you probably have a reasonable idea as to whether you even have an idea they’d be interested in ($1B market, experienced team, sustainable advantage…). If you do not meet those criteria, then you are wasting a valuable resource, your time, in chasing money you will not get. If you do meet those criteria, then why do you want to sell part of your company? Remember, it ain’t free money. To get venture capital, you have to sell a piece of your company. That’s not always a good deal for you.
There is an unfortunate catch-22 when it comes to getting funded. Money seems only to be available to the companies that need it the least. Why is this? Because most entrepreneurs are not truly offering an opportunity to investors. Rather, they are trying to mitigate their own risk by spending someone else’s money. If you do not think the opportunity is worth every dime you can muster up from your savings, your family and every friend you can find, then do you really believe it is a great investment opportunity? Why wouldn’t you give family and friends first crack at it if it is such a great deal? If you can’t convince your uncle, investors won’t be compelled either. VCs are just as risk averse as your family. That is why only companies that seem to be “sure things” get funded. Often they could be profitable businesses without the extra funding. They need extra capital for growth.
So the rule is, you should never go looking for other people’s money because you need cash to minimize your personal risk. You should only take other people’s money to maximize opportunity. If taking $1M can get you to $1B market, go get it! But if you are hoping to find $50,000 before you quit your day job, you’ll have to take that risk on yourself. For more info please visit: http://www.vcic.unc.edu/entrepreneur-tutorial.html
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