There’s essentially three different phases in a startup’s life when it comes to raising money: (i) before product/market fit (PMF), (ii) right after PMF, and (iii) scaling.
For each phase, distinct categories of investors come into play. Generally speaking, venture capitalists are the ones fueling growth, covering the investment spectrum from market validation and initial traction to late stage expansion; depending on who you talk to that means from Seed Round to Series A, B, C and beyond.
The Venture Capitalist game is based on a few simple but important rules that entrepreneurs need to understand before jumping head first into cold emailing and warm intros. The question one should be able to answer as a prerequisite is: Should I raise VC funding?
As trivial as it may sound, a vast majority of first time founders view VC rounds as a mandatory step to scale a successful company, especially with the Series-F-fueled-unicorn hype.
So here’s a breakdown of the different factors that should influence the decision of whether or not to look for VC funding. If you’re a first time founder, you’ll know where you stand after reading this piece.
> You should seek VC funding if and only if: you’re in (or on the edge of) a hyper-growth phase, looking for a big exit at some point, and can’t really do without.
> VC is a service industry – not only do they bring $$, but also invaluable advices, introductions and resources. Choose your investors wisely.
> Don’t expect it to be an overnight process; expect to get rid of a big equity chunk.
The demand side in the VC business is the startup. Whether bootstrapped, or angel-backed, it has a precise market to address and the product is already launched (with a few exceptions to the rule). As a founder seeking investment, you should at least be able to show an early traction which can take different forms depending upon your business (e.g. BtoC: 50-100% user growth MoM, BtoB: a growing base of recurring paying users). More often than not, the most effective marketing channels are already identified, and a growth plan (whatever growth means to the business) has already been laid out to reach an exponential number of users/customers.
Now that we’ve set the scene, the founding team must figure out if their startup is intended for an aggressive, fast-paced growth or a regular and steady maturation. It’s crucial not to confuse rapid growth with success in this game, as the former is a strategy while the latter is an objective.
Furthermore, if founders choose the hockey stick path, the question that needs to be answered is: Is there a real need to raise lots of capital in order to achieve this growth? Or is it possible to obtain the same results using organic channels, or by re-investing margins into user acquisition?
Although growth money represents a large part of a Venture Capitalist’s offering, a whole set of world-class services come alongside the written check. Wise founders know the value of bringing in VCs in the form of mentors and advisors. As industry veterans, growth experts and seasoned managers able to turn struggles into successes, VCs are here to help you take crucial decisions, open up closed doors, close that previously unreachable lead, attract & recruit top talents, sort legal battles and the list goes on. On a side note, current board members will also have new individual(s) to seat with.
When multi-million dollar minds are investing in a startup, it’s important for founders to remind themselves that for the VC business model to actually benefit investors, a big chunk of equity has to be given away, there’s no way around it. Moreover, remember that success from a founder’s standpoint isn’t necessarily defined as success from a VC standpoint.
“[…] Where venture money plays an important role is in the next stage of the innovation life cycle—the period in a company’s life when it begins to commercialize its innovation.”
B. Zider, Harvard Business Review, Nov.-Dec. 98
As Bob Zider presents it in great length in his dedicated HBS article, venture capital stepped in when the investment supply shortage appeared over the life cycle of many companies. When neither banks nor public markets could legally or realistically fund highly demanding company growth, VCs took on the bet.
As you may know, VC partners report to their own investors, and both are looking to make a comfortable return on their investment (i.e. big ROI for investors = big upside for partners). Consequently the objective of those firms is to select startups where both the team and the product have an unfair odd to win in a market with immense potential. Unfair odd of what? An interesting exit.
But investing remains a bet, and like all bets, there’s a mix of analysis, expertise and intuition when it comes down to decision making. Depending on the investment size and the firm’s track record in a given vertical, investors will evaluate the percentage of chances that the team will succeed with an IPO or an acquisition.
It’s no secret; investors’ return comes from a very small number of their portfolio companies. This return is usually expected within 2 to 10 years following the initial investment.
Now you get the whole picture: with a strong hold of the board and precise exit objectives, very little room is left for founders to make experiments. As soon as they raise VC funding, they are under pressure to attain specific milestones (standard market metrics) in a short time frame, and aim at new ones every time the previous benchmarks are reached. Founders need to be aware that attaining critical growth can sometimes go against their grain, like appointing a new CEO, or focusing on sales rather than R&D.
When raising funds, out of all existing resource, time may be the most important factor in this complex equation. Although there’s a notion that raising funds can be time consuming (which is often true), when a startup has the potential to disrupt a billion dollar-industry, quick investment decisions and large sums of money can trail your entrepreneurial path.
But one needs to consider all the necessary ingredients to get to that point which includes a small and agile team constantly focused on growth, time to prospect investors, argumentation, negotiations, due diligences, and closing – although this process is tough, it isn’t the hardest part of building a successful company, far from it.
It’s a full time job for at least one of the founders; and this process can take up from 2 to 6 months. The CEO normally bears this responsibility as he holds all the cards in hand – vision, strategy, metrics, and legitimacy.
As you may have guessed, the negotiation power usually lies on the VC side, mainly because partners can afford the luxury of waiting for a more compelling traction or more struggles on the startup’s end. Therefore, VCs have more control over the deal’s terms as they possess the two most precious resources: time & money.
Although this power relationship is usually true (especially in 2016), a company can create a so called FOMO in the investor’s mind, as the VC landscape is particularly competitive.
The Final Equation
With all those elements in mind, we can craft the final equation including the parameters above:
Startup(has an absolute Need + accepts Offer terms + able to go through Process without jeopardizing the company) = TRUE; Raise VC Money; Wait)
A founding team shouldn’t look for/take VC money if it can’t solve that!