Financing Your Business through Venture Capital
In this article, we will start with 1) an introduction to venture capital and 2) venture capital terms you should know, continuing then with 3) people behind venture capital funds, 4) how to choose the right VC fund for a business, 5) the process of getting venture capital funding, and 6) a conclusion.
INTRODUCTION TO VENTURE CAPITAL
When a new business is started, money is required to launch it, to pay employees, and to rent space, furniture, equipment, supplies etc. Often, ventures are financed through means other than banks and financial institutions, which may refuse financing due to a number of reasons including high risk or innovative business ideas. In such cases, venture capital is a good way to finance your venture. Funds lent by investors to startups and small businesses with expected longer term growth potential, is venture capital. It is investing in an enterprise where there is a substantial element of risk for the investor, yet it has the potential for greater than average returns.
Venture capital funding is most often in the form of cash for a share in the equity of the startup. Most VC comes from an investor group, investment banks or other funding enterprises. These investors are not merely funding your venture, they also are experts of their field and will want to have a say in the administration and running of your business.
There are some differences between venture capital and traditional funding. The most important ones are:
- VC focuses on startup business and young companies that are expected to grow exponentially.
- VC invests cash in exchange of equity, which means that the VC’s have a more active role as compared to traditional funding sources where there is no investment but a cash loan is provided.
- VC invests in companies that are high risk, but expected to yield higher returns.
- The investment provided by VC is for a longer term than traditional finance.
- VC has an active directorial governance of the enterprise, as also in strategic marketing, and technical guardianship, etc.
VC funding is conditional to the enterprise going public at the end of a period of 3 – 7 years in the hope that by then the company will have become profitable and the equity can be cashed and profit booked. The cash thus realized for VC firm is put back into the fund. A successful cycle for the VC fund portfolio is to profit manifold over the original investments. The profits are disbursed to the investors according to their contribution percentage of the fund.
For example, a fund invests $100 million in 10 companies ($10 million each). Some of these will fail, some stand still, and some may do well enough to go public. Those that eventually go public, may be worth a hundred million dollars. From a $100 million total bet, a fund may yield $200 million over a 3 -7 year period. The law of averages works here with the successful ventures covering up for the not so successful investments for the VC. The skill of the art is, Knowledge.
VENTURE CAPITAL TERMS YOU SHOULD KNOW
Equity capital or funding, means cash raised by an enterprise in return for a share of ownership in the company. It is represented by outright ownership of shares and stock, or a legal agreement and status to convert other financial instruments into stock. Key sources of equity are angel investors and VC firms. VC is long term or “patient capital”, which gives startup firms time to mature as profitable entities before encashing the investment.
A classic approach for VC firm is to open a fund; i.e. a pool of money, attracted from wealthy individuals, companies, and pension funds, etc., for the VC firm to invest. The firm raises a fixed amount for the fund.
When a private individual or investor finances a startup in its initial stages, it is known as seed funding. The amount invested as seed capital or seed money is dependent entirely upon the investor’s whim. The money is invested in exchange for an equity share in the startup. This is very early stage funding, to support a venture until it can sustain itself, or is ready for more investment. Seed options include family, friends, angels, and crowdfunding.
Series A Finance
The initial phase of finance for a young firm venture after seed investment is called Series A Finance. Generally, it is the first opportunity offered to external investors to make an investment in a startup. Series A may be in the form of preferred stock and include non-dilution exceptions, in the event that a further financing round occurs in the future. Known also as ‘A round’ financing, it tends to occur when a company is generating some revenue, but rarely will a business generate net profits at this stage.
It is the financing of working capital for early stage companies that are selling products, but not quite yielding a profit. This is also known as a ‘Series B’ round.
When a startup requires extra funding between full VC rounds it called Bridge Financing. This is typically to raise small amounts rather than a full funding. Generally the existing investors will fund the bridge finance too, but it is not essential that they do so.
Capital call or Draw down
This is a legal call by a company that has been promised funding to demand it of its investors. Sometimes, the VC also face a cash crunch due to slow financial market or other related reasons, under such circumstances, they are unable to find the money required to invest in a company that they had promised to fund. Under such conditions, the company can legally demand the funds it has been promised by the VC.
PEOPLE BEHIND VENTURE CAPITAL FUNDS
Who runs a VC fund, and their powers?
Former entrepreneurs, financial professionals, and similarly experienced individuals set up VC funds. These individuals are called the GP’s or the general partners. They are the people who decide the size, investment options, and offers of a VC fund. Based upon these recommendations, suggestions and offering memorandum, investors who wish to become the limited partners or LP’s invest their money in the fund.
- GPs – They are the people who manage the VC fund and make investment decisions on its behalf. GP’s typically place personal capital up to 1 – 2% of the fund’s total amount to show their commitment to the LP’s.
- Venture Partners – They are the deal brokers for the fund. These are the partners who find the investment options for the fund and its partners. They get a percentage of the deals they introduce as compensation.
- Principals – They are mid-level players in the fund and are often working their way up to the position of becoming a partner in a fund. They are generally people who have risen up the ranks from associates to senior associates. They often have commensurate expertise in an allied field, such as management consulting, or a sector that’s of keen interest to the VC fund’s strategy.
- Associates – This is an entry level position in the VC. They may rise through the ranks if they are good enough. Normally, to become an associate in a VC, the person has to have a few years’ experience in an allied field such as investment banking and management consultancy.
- Entrepreneur in Residence – EIR’s are the resident evaluators of the VC funds. They are generally experts of their field and are entrusted to study any potential investment opportunity, sound it out and approve it before the VC makes an offer for investment. EIR’s are temporarily commissioned by VC firms, typically for periods of six to eighteen months.
HOW TO CHOOSE THE RIGHT VC FUND FOR A BUSINESS
Choosing the right fund for your business very important. You need to know which funds are interested in your line of business before you approach them. Do your research about a fund by defining your needs and asking questions such as:
- Do I need funding?
- What type of funding do I need?
- What is the stage of my firm’s development, and what level of VC investment is sought?
- What is the quantum of funding the firm requires?
Once you have determined your own requirements then you can begin your research on the VC funds that might be interested in your firm. Research the VC firms by:
- Finding out as much as they can about a fund: Internet has provided you a powerful tool to discover more about the VC you are interested in. look up the internet to learn about the firm and what is being said about it on the social media. This will provide you with a clear enough picture to determine whether the VC is for you or not.
- Asking Questions about the funding and viability of the fund: Study the investment pattern of the fund. If it hasn’t made an investment in the past few months, it could mean that the fund might be facing finance crunch. Also look into the average size of the funding to know how much funding you can expect.
- Discovering the fund cycle and pace: Most funds have a fund cycle and pace at which they fund new ventures. They may be funding only so many ventures in a quarter. If their quota is over, it is useless expecting them to invest with you.
- Whether the partners in the fund work well together: A fund where the partners all work together well is the one you should associate yourself with. Cohesiveness is important since these people are going to be sitting on your management board and directing your business to an extent. If there is no harmony it is bound to affect your enterprise too.
- Look for the perfect angel investor: Pick out your angel investors wisely. Look for people who are well connected in the VC world and will help you later in finding a VC to invest in your idea.
- Choose wisely: Above all, choose your VC wisely. Do not hurry into the contract look at all the pros and cons before accepting an offer.
If you are looking for a venture capital fund here is a good resource of the top 100 Funds that invest in early stage startups.
THE PROCESS OF GETTING VENTURE CAPITAL FUNDING
Overall, the process of VC funding usually involves several phases in a company’s development, which generally follow these steps:
Step 1: Preparing a Business Plan.
This is perhaps the most important part of the process of VC funding. You need to have a detailed business plan with all the various stages of your venture described in detail including the financial outlay for each stage. It should systematically assess all factors critical to the business and its goals. It should be accompanied with a Mission Statement which is a concise outline of your business and summarizes the intended business purpose, goals and exactly how they will be executed. Focus on the specialty market intending to be served and the USP of your venture. More often, specialists fare better with VCs.
Step 2: Contacting VCs and pitching business idea.
The next step is to find a VC and to present your business plan to them in order to interest them in your project and get a promise for investment. Ensure that you include the resumes of all the major people involved in your enterprise and their previous experience in similar projects. It helps if you concentrate on the following:
- People behind the firm: VC’s are more interested in the potential of the people who are behind the idea being pitched to them. They are more likely to be interested in projects where the associated people have a track record of some sort and have experience in their field. Also passion and enthusiasm for the project also affects the decisions of VC’s.
- Try to get referrals : VC’s place a much higher priority on companies and entrepreneurs that are referred or endorsed by people they know and trust. This is why it is important to have angel investors or consultants who are well known or connected in the VC world. They can then get you a warm introduction which can go a long way in settling the decision in your favor.
- Gain traction, follow up: Before the VC’s loosen their pockets for you they need to be sure that you have the wherewithal to deliver what you promise and that your project has market potential. This may necessitate a pilot project or beta testing to demonstrate the market traction. Follow up the market test with reports that can be displayed to the VCs to convince them off the viability of your project.
Step 3: First Contact with VC (a call with an associate).
You start at the bottom with an associate of the VC looking over your Mission statement or business plan to determine whether the VC would be interested in your project or not. This is the person who determines the future of your venture at a VC. If the associate is convinced of the idea, he then schedules a call to speak to you about the project and where you wish to take it. If this goes well then the your file moves along to the next level to a partner meeting where you plan may be discussed.
Step 4: First Meeting.
If your plan is good enough to interest a partner, you may be invited to a meeting. This initial meeting could be scheduled at their office or your office, whichever is more convenient for both parties. You can expect to be asked the following during this meeting:
- What is your experience and your educational background and other such questions that may give them insight about you and your abilities.
- Details of your team members and their qualifications and experience to gauge the overall expertise of the entire team.
- Who or what you perceive as your competitors and how your project will match up to the competition.
- About Product Differentiation.
- Whether you are aware of your market and its size.
- What exactly your funding requirements are.
If you arrive at a general valuation range that suits both parties, the partner may require a presentation in person, or via videoconferencing to their associates.
Step 5: Initial Due Diligence.
Once the partners are satisfied with their interaction with you and your presentation of your project. They may ask for your financial records to go through them to ascertain the health and viability of your company. They may also ask to speak to your team members and customers to gauge your worth.
Step 6: Term Sheet.
If all is proceeding positively, the VC firm may furnish you with a term sheet. This document contains the details of all the terms and conditions under which you are being offered the money. This is generally about three to ten pages and is indicative of an investment interest. The VC, with the term sheet, is attempting to forge agreement around the general terms of a deal before lawyers create a thorough investment agreement proposal.
Step 7: Negotiations (about valuation and other terms).
Go over the term sheet with your lawyer and if there are any areas you feel need to be negotiated, mark them out to be discussed with a partner or an associate. Bear in mind that a term sheet contains comprehensive protection clauses for the VC, these can significantly reduce any valuation to an entrepreneur. It’s vital to engage an experienced lawyer with you, to negotiate a term sheet. This process may take several months. Your negotiating power is limited by certain factor such as your need for money, you and your firm’s reputation, the need for the finance, experience, market conditions, etc.
Step 8: Complete due diligence.
This may require a full disclosure of all your financial records, documents, contracts, etc. The VCs have to know all about your project before they hand over their money to you. You need not be scared, just provide the information asked for. Remember, they are going to be part owners in your venture as well as co-administrators and decision makers, so there is nothing to hide here really.
This due diligence will cover many aspects including:
- Full business plan
- Detailed sales pipeline by customer type
- Detailed operational plan and budget
- Hiring plan
- Detailed revenue assumptions
- Audited financial statements
- Bank reconciliation detail
- Product Pricing list
- Detailed product roadmap
- Customer, Employee, Insurance, and Lease contracts
- Relevant whitepapers and analyst coverage
- Details on IT infrastructure
- Current partner list
- Lead generation processes
- Customer satisfaction survey
- Customer reference list
- Details on intellectual property
- Current capitalization chart with options detail
- Organizational chart
- Salary and bonus structure for company
- Employee turnover
- Management background checks
- Competitive analysis
- Expected acquirers
- Past board meeting minute
Step 9: Investment documents and signing them.
Signing terms prematurely, before completing due diligence is construed as a desperate act. However, assuming progress, you will receive a final investment document from the VC’s lawyer. Review it closely with your legal team and negotiate required alterations. Pay attention to any representations or warranties you are confirming as an officer of the company, and also personally. A final investment document usually states:
- Share Purchase Agreement;
- Investor Rights Agreement;
- Right of First Refusal and Co-Sale Agreement;
- Voting Agreement.
VCs don’t generally want the common shares that exist when a company is founded; they want preferred shares as they have a number of protections, like liquidation preferences and voting rights. These provide VC’s with downside protection and control.
Step 10: Execution with VC support.
Once the documents are signed, the VCs start taking active interest in the enterprise. Typically the funds are not invested in one go. They are released over a period of time and are most often linked with milestones completed.
Step 11: Exit.
Though VCs are investing in you for a longer term than traditional financer would, they are in it only to nurture you and take you so far, book a profit and then take their leave of your venture. This process may take about 4-7 years. The exits are planned through merger, or acquisitions, or through going public and launching an IPO.
Of the thousands companies with business plans that apply a vast majority never get anywhere near a VC. Hundreds of applications are examined each day and may be just one or two of those may make it anywhere beyond an associate’s desk. So the question rises, how likely is it to get venture capital funding?
If you are in a severe cash crunch and have a winning business plan, you may try the VCs for funding. Overwhelmingly, VCs prefer to invest in any enterprise after its potential has been exampled and an investor’s risk diminished. VC’s are choosy! In a free capitalist market place there is always more hope than actual success.
By building a venture to a level where its potential is self-evident, one is more assured of attracting several VC funds. This enables one to choose the better VC fit for an enterprise, to negotiate preferable terms, while retaining more of the business and its control. But if you already have a proven business plan, then do you really need a VC in the long run? You would be handing over a large piece of your pie and administrative rights to a VC in exchange for finance.
There are no simple remedies here. VC’s could be the greatest thing to happen to a company or the worst scenario. The choice is to finance a startup oneself, and for the time being stay small, or take a risk and seek venture capital. However, be aware that in the marriage, there is no divorce.
Just because one reads about venture capital, the venture capitalists, and their publicized winners, does not automatically translate to one receiving a slice of that VC fund. So think before you waste your precious time chasing the VC dream.