When to raise VC money (and when not to)

Startup Funding Masterclass: Part Three

raise VC money with venture capitalists
Is liking Patagonia vests a good reason? – Source

 

Now that we have a good idea of the most common available startup funding sources, let’s go ahead and take a more in-depth view at when to raise VC money.

Partly due to the success of recent unicorns (e.g. Slack, Uber, Airbnb, …) and partly due to the massive amounts of available capital, venture capital has taken a prominent place inside the startup ecosystem. But is this also the right route for your startup? Is your startup right for raising venture capital? 🤔

In this article, we aim to give you a better understanding of when to raise VC money… and when not to. We’ll do this by investigating the venture capital industry and how they look at the world when making investment decisions.

This post is Part Three in a new Masterclass series on Startup Funding. Funding is the fuel that every business runs on. Knowing the ins and outs of funding is therefore essential if you want your startup to be successful. We searched for a compact-yet-comprehensive guide on startup funding and found it nowhere, so we decided to build one ourselves. This is that essential guide.

We bring it to you in partnership with Belgium’s largest startup and scale-up accelerator Start it @KBC, supporting and promoting more than 1.000 entrepreneurs with innovative ideas and scalable business models.

– Jeroen Corthout, Co-Founder Salesflare, an easy-to-use sales CRM for small B2B companies


Who does a venture capital firm work for?

Like all businesses, venture capital firms have a client, who is willing to pay for their services. And just like most businesses, venture capital firms compete based on the quality of the products that they provide. Understanding these two key components is the key to understanding the industry.

The investors of the investors

A venture capital firm sells an investment fund to (usually) bigger investors. 💸

Just like other investment funds in the financial industry, the funds have an investment period (2 – 4 years) during which the money is invested and a final closing date (10 years after opening). After this, the fund is closed, all assets are sold, and the money is returned to the clients.

It is mainly the mandate, to invest in early-stage private companies, that sets VC funds apart from other investments funds.

The quality of the fund is determined by how much money is returned to the clients at the end of the fund. Next to that, it’s also defined by the specific way they achieved this return (through one investment vs many).

the big investors with the big money
Photographer: Etienne Martin | Source: Unsplash

Limited Partners

The clients are the so-called “Limited Partners”, who provide the capital for the investment fund. They of course expect to make a significant return at the end of the fund.

Not unlike regular shareholders, Limited Partners have no decision-making authority and no liabilities to the fund when things go bad. They only provide the money.

Limited Partners are typically large investment institutions. These can be university endowment funds, pension funds, insurance companies, sovereign wealth funds, wealthy individuals, or large financial institutions.

For those large professional investors, venture capital is an asset class just like stocks, corporate and sovereign bonds, or private equity. It is important for them to be invested across all asset classes. They actively look for diversification and create a return in excess of their benchmark.

Beating the benchmark

The key thing to understand about those benchmarks is that all these professional investors have access to all kinds of investment opportunities. This includes the easiest investment of them all: the stock market (a.k.a. the benchmark). If they go through all this trouble of investing in a VC firm, and are willing to take this additional risk of investing in early-stage companies instead of simply investing in the S&P 500, they do expect some benefits for this additional risk and work.

Starting from the S&P, which is commonly understood to return 7%, many LPs will look to generate excess returns of 5% – 8% from their VC portfolio, hence 12% – 15% per year. 📈

Applying this expected return of 12% per year to a 10-year period shows that the LP is looking for the venture fund to return > 3.0x the size of their fund at the end of the fund.

1.12^10 = 3.1 or 1.15^10 = 4.0

Management fees

In return, the venture fund management is paid a fee structure.

A commonly referenced structure is 2% and 20%. It refers to a base fee of 2% per year on the size of the investment vehicle (i.e. $100m fund results in $2m p.a.) and 20% of all money returned in excess of the invested amount (i.e. $200m return for a $100m fund results in a $20m fee).

In summary, a venture capital firm sells an investment fund to professional investors who expect a return of 12% – 15% per year or 3 – 4x their money back at the end of the fund.

If you are looking for more details on the economics of the VC industry we recommend this article from Andreessen Horowitz.

 

How do venture capital firms deliver their returns?

Now that we know the goal, the question is how venture funds work to achieve it.

A good indicator to understand how VCs are currently looking to deliver to their clients is by looking at what they did in the past.

This means looking back at the distribution of previous VC returns. And as Peter Thiel noted, these returns are incredibly skewed. They do not follow a normal distribution, in fact, they follow a power law distribution.

What does a Power Law distribution mean?

Have you ever heard of “the winner takes all”, “the long tail”, or the “80 – 20 rule”? They are all manifestations of the Power Law where a small number of companies or initiatives drive the entirety of the result.

Coming back to our VC funds, this effectively means that the performance of the fund is dictated by a small number of investments with amazing returns. Or in other words: it is all about the big home run winners and not about a portfolio of decent performers.

This is further illustrated in the following graph shared by Andreessen Horowitz, which shows that 6% of the deals produce 60% of the returns, while 50% of the deals even lose money.

VC power law curve
Source

A fictitious example

Let’s take what we just learned and imagine that we have a $100m fund, Hermans Ventures 😇. Yup, I got my own fund now!

Assuming that we take a 10% ownership in all the companies we invest in, this means that at the end of the period the aggregated value of all our portfolio companies needs to be $3bn in order for us to be able to return $300m to our LPs. If we fail at doing so, chances are that we won’t be able to raise another fund.

Following the above Power Law, our return will be driven by 10% of our companies. As we are a small team, we only managed to invest in 20 startups during our investment period; each worth $50m pre-money at the time of investment.

This means that, in order to be successful, 2 companies of ours will need to grow from being worth $50m to at least $1.5bn. 😲 For the rest of our portfolio we can assume that they will return nothing or even result in a loss.

Focus on huge returns

Our example showed that in order to be successful VCs have to look for companies capable of delivering those magical 30x returns. Additionally, there are the following complicating factors:

  • Check size: The ideas and companies need to become big enough, so that our fund can invest enough money to get a $300m return.
  • Timing: The return needs to be created within a 10 year period.
  • Ownership: In order to maintain ownership and not dilute throughout the life cycle of the company, we need to ensure that we can invest pro-rata in any subsequent rounds.

In summary, venture capital firms are highly dependent on big winners and big ideas. They need to be able to get a major return (30x or more) on a large enough bet to be able to return enough money to their clients at the end of the fund period. 💪

 

What does this mean for startups?

Now that we understand who venture capital firms work for and how they deliver on their promises, we can take a look at some of the common behaviors in the industry and the impact these have on your startup. This will ultimately define when to raise VC money for your startup and when to stay away from it.

VCs expect you to become a unicorn so you can return them enough money
Photographer: Marco Secchi | Source: Unsplash

Big ideas in big markets

As VCs are looking for the next big thing or unicorn, they are looking for companies with large revenue potential (> $100m – $300m). 🚀

In order to have the comfort that your startup will deliver this revenue within the desired time frame, it is important that there is also a huge addressable market (+$10bn). That way, you can get to the desired result even with a low market penetration.

Go big or go home

Venture firms are highly selective. It is not uncommon for partners to only invest in a few companies each year. They need to get the absolute maximum out of these investments.

This also means that they need to be willing to risk a good offer or deal in the present in return for the potential of an even bigger win in the future.

While understandable from the perspective of a VC portfolio this, of course, can be in stark contrast with the ideal situation for the founder, as she is fully invested in just one company.

Ain’t no time for losers

VCs know that a majority of their bets are bad investments. They also know that it is all about super fueling those winners to the top. Obviously, they can’t predict this at the time of investment, but as the investment shows signs of weakness a VC can quite abruptly decide that it is no longer worth her time.

This is certainly not the case for all venture firms, as there is also a point to be made that the founders of a bad performing firm might be the founders of the next big thing. Still, there certainly is a clear tendency to grant more attention to the winners.

Peter Thiel has criticised the VC industry in the past by making the observation that most VCs spend 80% of their time on “the losers” instead of on the winners.

It is not uncommon for the boards of successful companies to grow rapidly as more and more senior partners are attending, while at less successful companies junior staff is being employed to attend the board meetings.

Grow, grow, grow!

Returns need to happen and they need to happen fast. Getting to unicorn valuations within a 10 year period requires a lot of growth. 🦄

This can lead investors to sacrifice everything for top-line growth, pushing companies too hard or too early. It can also lead to nasty side effects:

  • High burn rates without any focus on profitability
  • No time to resolve small issues, resulting in big issues down the line
  • Acquiring growth at a loss, without any indication that the startup will be able to make back the difference

High growth firms have recently been very successful at raising large amounts of capital, as the investment world was hungry for growth. 🤑

As many of these fast-growing companies mature however, questions start arising on their future potential in terms of profitability. Not everyone can be Amazon and continue focussing on growth for more than a decade. At some point, a company needs to turn a profit and this requires a completely different mindset and focus.

Just look at the investor community’s reaction to the recent IPOs of Uber and Lyft to see how public market investors can react sceptically to the VC ethos of putting growth above everything.

raise and burn the VC money
Photographer: Jp Valery | Source: Unsplash

Take more money

Finding new deals is hard, so once a deal seems to start becoming a success, it is in the best interest of the VC to allocate as much capital as possible in the company. 💰

Of course, for every additionally invested dollar, the expected value at the time of exit needs to raise as well.

This can lead to founders getting overly diluted, or to companies being pushed too hard to get an outsized valuation in order to provide enough return. 😔

 

What to ask yourself to know when to raise VC money?

Raising venture capital is certainly not all bad and there are a lot of great cases for VC investments. More importantly, there are a lot of companies which would not exist if not for the ability to raise vast amounts of capital, as it is a key to the success of their business.

So in order to understand when to raise VC money and if venture capital is at all right for your business, we have created a list of questions you can ask yourself. 🤔

looking for a sign? here's questions you can ask yourself to know when to raise VC money
Photographer: Austin Chan | Source: Unsplash

Don’t worry if raising venture capital does not seem right for your business. There are a lot of great companies with very wealthy founders that did not raise any venture funding with their companies.

Besides, let’s not forget that we just listed 9 great sources of startup funding, of which venture capital was only one. 👈

Does your startup classify as a “potential big win”?

Do you have a $10bn potentially addressable market?

Could your business reach +$100m in annual revenue within a 7-8 year time frame?

And if so, what would it take to get there (geographies, verticals, markets)?

Is your business insanely scalable?

Does adding new clients hardly increase the complexity of your business?

Do you have a relatively low additional cost to deliver to additional clients?

Do you have a product that is pretty much “plug and play” across markets?

Do you have a product that is ready, and is money the main blocker from getting market share?

Does your business require scale to be successful?

Are you running a marketplace, a micro-mobility provider or any other business that benefits greatly from scale?

Are your unit economics highly reliant on getting the right scale?

Or do you need a big investment up front with promise of great scalability in the future?

Do you mind giving away control?

Do you believe that having 10% of the business with VC money is better than having 80% of the business without?

Do you not mind dealing with and reporting to professional investors?

going public on wall street and returning the VC money you raised
Photographer: Rick Tap | Source: Unsplash

Are you ready to sell or go public in the next 5-10 years?

Are you ready to start the clock and prepare your business for an exit within the VC timeframe?

Would you mind running a public company with all the public scrutiny it entails?

Or are you willing to sell to another industry player or a financial sponsor at some point?

Do you mind having limited leverage in the exit decision?

 

What should I do if my startup is not right for venture capital?

Now that you understand when to raise VC money, you might find out that venture capital is not right for your business.

First of all, don’t worry, you are in great company! 😃 There are many great firms, with founders that are doing very well, without taking on any venture capital investment.

Your first option is to not take funding at all and let the business finance your growth.

bootstrapping instead of raising VC money
Photographer: Nathan Dumlao | Source: Unsplash

This is often referred to as bootstrapping or running a capital efficient business and it has a number of clear advantages. 👇

  • It requires an immediate focus on generating revenue and thus on figuring out what a customer will pay for.
  • It’s more resilient to economic downturns.
  • You get to keep ownership and control over your business.

In fact, for a lot of niche businesses being capital efficient also makes you a more attractive take-over target as, in contrast to venture backed companies, there is a higher chance to find a deal that is beneficial to all stakeholders.

Great resources on bootstrapping

Just take a look at the following “bootstrapping to exit” list from Sramana Mitra.

There are many great sources on how to bootstrap your way to success, but we couldn’t resist to list a few tips:

  • Focus on profitable growth right from the start
  • Evaluate every expense carefully
  • Become a star in generating low cost publicity
  • Become very good at recruiting and only recruit when you have to

For more inspiration take a look at some excellent case studies aggregated by Basecamp.

And if you do need additional capital to grow your business, perhaps another funding source is right for you. Just go back to our previous episode and take a look at the 9 common types of funding. 👈


Will you raise VC money or not? 🤔 We hope we helped you to answer this question with a bit more background and confidence.

May you find the right path and build an awesome company! 👊

Let us know if you have any questions left; we’ll be happy to elaborate! Also, don’t forget to tune in next week for Part Four in our Startup Funding Masterclass: Startup Funding Rounds!

We hope you liked this post. If you did, spread the word!

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Frederik Hermans

Tech & Finance Enthusiast. From banking to startups, looking to combine a passion for business and innovation.