Start-up Guide to Raising Venture Capital
Date: 1 September 2016 Share on Twitter Share on Facebook
The paradox of venture capital
The main obstacle between a simple idea and a profitable business is almost invariably cash. The modern venture capital industry attempts to overcome this obstacle.
Those involved, venture capitalists, invest in high risk start-ups with the aim of generating capital gains through the sale of their shares at a later point in time. But unlike other forms of private equity, venture capital funds (VC) come with an extreme risk profile, adopting the motto ‘buy very low, sell very high’.
There is no shortage of cash in the VC industry: Andreessen Horowitz, currently the number one investor in early-stage businesses, reportedly placed in excess of $1 billion in start-ups in 2015.
As a result of the number of willing investors, raising venture capital has become an attractive option for many start-ups as they search for the investment required to boost their entrepreneurial ambitions.
Yet for several reasons raising VC needs to be treated with caution. This article will hopefully explain how, if at all, to go about raising venture capital.
Is venture capital the right option?
Venture capital has two main advantages over other forms of equity investment: more cash and less debt.
Venture capitalist dollars are almost always superior to what you can obtain through debt capital or other financing venues. As already mentioned, the portfolios of VC firms can run into the billions: since 1972, Sequoia Capital has invested in over 250 companies with a combined public market value of over $1.4 trillion. Such an affluence of capital flowing into a fast-growing business can be crucial in its development.
Unlike other sources of investment, VC is not a loan. This means that there is no repayment schedule, buying the business more time to evolve into an efficient profit-making enterprise. Only as the company begins to make profits, VC dollars have to be repaid, eliminating the repayment of debt.
Aware of these perks, investment-hungry companies often jump straight into a venture capital fund. Yet raising VC investment brings a different set of risks which should be considered before pursuing it.
Firstly, if the company is not yet ready to grow, venture capital funds can be harmful to profits. If businesses accept outside funding before the business is profitable and self-sufficient, it can end up spending unnecessary money on hires and expenses that won’t benefit the company in the long run. Whilst tempting, scaling too early and obtaining investment prematurely should be avoided.
Secondly, raising VC funds can itself be a waste of time and resources, as companies spend considerable hours rehearsing pitches and meeting potential investors. Searching for venture funding can shift the focus away from profit-making and impact negatively the growth of the business.
Finally, even though companies are not required to repay VC funds, the money comes with strings attached, mainly through the loss of control to investors, who gain an equity share in the company. Businesses should be wary not to give away too large a stake, otherwise the power and control lies in the hands of the investors, restricting the autonomy of the management team.
What type of fund are you looking for?
There are two main ways to obtain venture capital financing: common stock and preferred stock. Both options have advantages and disadvantages for the company and venture capitalist.
Common stock, as its name suggests, is the more widespread option. They provide income, both through appreciation as the company grows and through dividends paid out to investors. Yet the VC fund’s profits are completely dependent on the success of the company, leaving the door open to considerable gains or substantial losses for the investor.
On the other hand, the value and returns of preferred stock are less rigidly determined, since venture capitalists purchase a stake in the company under certain conditions. These conditions bring additional rights to the preferred stock which helps protect the VC and increase the value of the VC’s investment.
The decision often comes down to a risk and reward relationship. Common stock is usually a safer bet from the company’s point of view, with the stock’s value in line with the company’s performance. Preferred stock will demand a set dividend and repayment terms: dangerous if the company is struggling for profit, great news if it exceeds its growth targets.
How are VC partnerships structured?
Having considered the benefits and setbacks of venture funding, enterprises should be careful to follow the correct process in order to understand the demands of the VC firm, the timescale, and the management of the investment process.
The process begins from the moment an entrepreneur engages with a VC firm. From this point, before any transactions are confirmed, relations need to be developed between both parties, with the enterprise assessing the size and timing of the fund, and the investor evaluating the compatibility of the investment with their own interests and goals.
Once an informal deal has been established, there is a phase of due diligence, whereby the venture capital firm will carry out external research, internal discussions and collaborate with existing portfolio companies and advisers.
Should the investors be satisfied with their findings, they will proceed to negotiate terms. This will lead to a final due diligence, with a more detailed investigation of the company, before the deal becomes legally binding.
How to select a VC company
Entering into a partnership with a venture capital firm marks an exciting landmark for many companies. However it is important that the right investment firm is selected, and hence it is important for the enterprise to do their homework and ensure the right VC firm is chosen.
Selecting an established firm is always a way to guarantee experience and knowledge in the specific market of the company. Even if they are not experts in the relevant industry, it is crucial that the venture capitalist understands the business model and has contacts in the company’s sector.
Especially noteworthy for start-ups is the potential for venture capital firms to act as a gateway for future investors. Sourcing venture capital to reputable firms improves the status of the start-up, as other investors feel encouraged to throw good money.
An interesting emerging trend in recent years is that of in-house investor firms. This is common among major technology companies – Google, for instance, has the in-house investor Google Ventures – and, although only prominent among larger corporations, are beneficial because they prioritize reinvestment back into their sectors, allowing them to gain a firmer hold on the market.
Raising VC funds requires a great deal of deliberation and forward planning. It is not always the answer for start-ups, nor should businesses rush into partnerships with the first VC firm they come across. If, however, it is considered the right decision for the business, it can prove to be a hugely advantageous venture that kick-starts unprecedented growth.