Over the last 10 years, we have seen a massive increase in venture capital deals from all over the world.
In ‘How the geography of startups and innovation is changing’, Richard Florida and Ian Hathaway showed that the ‘annual number of venture capital deals expanded from 8,500 in 2010 to 14,800 in 2017 with an increase of 73% in just seven years. The amount of capital invested in those deals surged from USD $52 billion in 2010 to USD $171 billion in 2017, a gain of 231%.’
Inspired by the successes of unicorn companies (valued at more than USD $1 billion) such as Facebook, Alibaba, Google, Tencent, Airbnb, DJI, DiDi, and so on, the end goals of most modern day startups are either to get acquired by large corporations or go IPO (Initial Public Offering).
This explained the increased hype around venture capital financing and the common misconception that shaped today’s startup landscape globally. That is, you have to raise capital to successfully launch a new business.
Now, there is nothing wrong for early-stage startups to raise capital in order to grow and scale their businesses. However, it becomes a problem when first-time and inexperienced founders perceive capital funding as the need to launch and grow a business without truly understanding the funding mechanisms, especially venture capital.
Why? Simply because capital funding is essentially designed to reward investors.
“Big problems occurred when you have founders who have unwillingly or unknowingly signed on for an outcome they didn’t know they were signing on for,” said Josh Kopelman, a venture investor at First Round Capital, an early backer of Uber, Warby Parker and Ring.
Moreover, a lot of first-time and inexperienced founders are disillusioned by the fundraising fantasy enabled by pitch decks. By doing so, they end up forgetting what their real objectives are, that is not funding but the focus of progressing their startup development.
Alternatively, it is not impossible to bootstrap a business to success. In fact, many of today’s biggest companies bootstrapped before becoming a global success, such as Microsoft, Dell, Oracle, GoPro, Mailchimp, SurveyMonkey, GitHub, and so on.
Therefore, I am recommending Clement Vouillon's article, 'An early stage founders guide to working with VCs - Before working with VCs', so that every founders can ponder this question, "should we raise money or bootstrap"?
(Two cents’ worth from Paul at Flipidea)
For many early stage founders it’s unclear what working with VCs means and how they should prepare for it. It’s perfectly fine, after all, it’s better for a founder to be an expert in its field rather than in Venture Capital.
This guide is intended for founders who plan to raise their first round with “institutional” VCs (a.k.a VC firms and not business angels) which is, most of the times, a Seed or Series A round. I’ll try to answer the question “What does it mean to work with VCs?” by describing the different interactions you’ll have with investors throughout the whole process:
- Part 1: Before working with VCs.
- Part 2: Preparing your fundraising.
- Part 3: Assessment phase, hot or not?
- Part 4: From term sheet to signed deal.
- Part 5: Post investment.
This guide is not a “technical” guide that will teach you how to create a pitch deck or how to read a term sheet. Plenty of great posts already cover in details these aspects — some of which are linked in this guide. I’ll focus more on describing the interactions that you’ll have with the VCs during this journey.
I also insist on the fact that what follows is just a “framework.” Your own particular experience with VCs will depend on a myriad of factors such as who you are interacting with, the structure of the deal, the industry you’re operating in, your location, how “hot” your company is and many other factors.
Part 1: Before Working with VCs
Before starting your fundraising process, it’s important to:
- Understand how the VC model works.
- Define the most important values that you expect from VCs: money, mentorship, branding, network.
- Think whether the VC model is aligned with your aspirations as an entrepreneur or not.
#1 How does the VC model work?
Why do VC firms invest money in startups?
To get a return on investment.
Most VCs you probably know are middlemen. They raise money from various sources (sovereign funds, foundations, family offices, large corporations, etc.), which are called LPs for Limited Partners, to invest in startups they believe can grow enough to provide a healthy return on investment. They invest X$ to acquire Y% of a startup and if the startup grows its value increases, and as a consequence, the X$ initially invested become XX$ dollars. The VC firm gets its cash once an “exit” happens meaning that the startup is either acquired by another company or goes public. Then the VC firm splits the result between their LPs and themselves.
Some firms invest their own money. It’s the case of family offices or corporate funds (Ex: Google Venture).
It’s an important aspect to keep in mind because it’s what drives their incentive.
The primary goal of “middlemen VCs” is to invest in companies which have the potential to provide a significant return on investment. That way they make their LPs happy from which they can raise more money to invest in more startups. If they don’t provide a good enough return on investment to their LPs, these VC firms won’t be able to raise more money and will eventually die or become zombies.
For firms which invest their “own money,” such as corporate funds, the incentives are a bit different. For instance, SalesForce Ventures or Google Ventures have other goals such as making “strategic” investments to get access to new markets, explore tech trends, help startup grow their ecosystem or to acquire them later.
When you start fundraising it’s important to understand what are the aims/incentive of the funds you want to work with because it will impact your relationship with them in the long term. Always be aware that they don’t give away money just for the sake of it but because they have their own goals too.
If you want to dig deeper on this topic here are some great posts:
- The maths behind a VC fund.
- Power law in venture.
- Micro-VC — Smaller is better, but the math is still really hard.
- The European venture capital landscape: an EIF perspective.
The second aspect which is useful to understand before fundraising is how a fund structures his org chart.
Job titles in VC firms are something very complicated (and quite funny). There are so many variations that it’s impossible to list them all and the same job title might cover different responsibilities from one firm to the other. To be honest after two years working on the VC side I gave up trying to understand it.
The simplest way to picture it is to distinguish two hierarchy levels — for the investment team at least:
- People who have the power to make an investment decision: generally the “partner” level (Partner, Senior Partner, Managing Partner, Founding Partner, etc…)
- People who don’t have this power and need to convince the ones who have it: Analysts, Associates, Principals, etc.
It’s an important aspect to understand especially during the “first contact” phase that we’ll cover in more details in Part 3.
#2 What value add should I expect from VCs?
Another important question that you should ask yourself before raising your first round with an institutional VC is: what values do you expect beyond money?
Obviously, the main aim of fundraising is to get money to grow your business, but what makes a great VC is not only the money it brings but also the value it can add:
- Expertise/knowledge: whether it’s because they have invested in many great companies and could build unique insights or because they are a “specialized” fund with industry specific knowledge.
- Network/mentorship: VCs can grant you access to a network of founders, big corporations or other investors that might be critical to your success.
- Operational support: more and more VC firms offer operational support through HR, marketing or design in residence teams or through a network of advisors.
- Branding: being backed by a firm with a great brand can open a lot of doors.
These four aspects are crucial because it’s what differentiates top VCs from the rest.
Defining what’s important depends on your particular situation and is worth thinking about. Depending on the business category or vertical you operate in the choice of your investor, beyond money, is a strategic one.
Nowadays every single VC firm advertises itself as “value-added.” By setting up your expectations before raising money it’ll be easier to assess whether a VC is bullshitting or not when you’ll “due diligence” them.
If you want to dig deeper on this topic here are some great posts:
- The truth about VC value-add.
- Investor VCs and Operator VCs.
- Should you take small checks from deep pockets?
#3 Is the VC model aligned with my aspirations as an entrepreneur?
Once you’ve understood the two aspects above, it’s important to check whether the VC model is aligned with your aspirations as an entrepreneur. When you commit to the VC way, it’s almost impossible to go backward. This is why beyond money and support you should think whether the VC model fits you or not.
Quoting Steve Blank here: “The minute you take money from someone their business model now becomes yours.”
The VC model is not an “evil model”, but if it’s not aligned with your personal beliefs and if you haven’t made an effort to understand it, things can go horribly wrong. It’s essential to come prepared and to avoid going the “VC backed” way if you don’t believe in it (don’t do it just for the money).
I’ve written a post covering this topic in more details: “The rise of non VC compatible SaaS companies.” If you value control over speed, then you should consider other financing options. If you want to grow as fast as possible, the VC option is probably the best one.
- Try to understand how the VC model works and what could be the implications when growing your business.
- Set your expectations regarding VC “value-add” before you raise.
- Thoroughly think whether building a VC backed company fits your aspirations as an entrepreneur. If not, do not follow that path.
Clement Vouillon is an alumni from Point Nine Capital. Point Nine Capital is a VC firm focused on SaaS and marketplaces. If you want to be kept informed of their new posts you can subscribe to their content newsletters or follow their Medium channel.
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Last edited on 21 October 2022.