Demystifying Venture Capital
There is a certain amount of mythology that surrounds venture capital. For many startups, getting VC backing can feel like a key objective, so in this week’s newsletter, Dragon Argent attempt to remove some of the mystery around this form of funding and provide some practical steps for startups looking to VCs to support their growth in 2021.
Intro
The aim of venture capital funds is to invest in early-stage companies that can demonstrate a potential to grow fast, become very big and have a real commercial advantage over competitors. Understanding these criteria is key to understanding whether VC money is right for your business. Typically, VCs raise a fund from investors, known as limited partners, and look to invest that fund into a portfolio of around 30 companies in total.
It can take up to 5 years to fully invest the fund (which is known as the investment period), with another 5 years for the fund to mature (known as the harvest period during which VCs are looking to exit investments), giving a total lifecycle of 10 years. Fund managers are looking to return around 2.5x the fund value back to investors. However, because a lot of startups fail, they are really looking for that one business that can achieve exponential growth and therefore returns to investors.
VC managers charge limited partners a management fee of 2% - 2.5% per annum, which is designed to cover the cost of administering the fund, and a "carry" or profit share, which is usually around 20% of the profits once the invested funds have been returned.
Realistically, venture capital is designed for a small number of business, meaning it's not for everyone. If it isn't right for your company or idea, getting backed by a VC could hurt rather than promote the development of your business. However, if your business does meet the criteria of what is suitable, then VCs need you as much as you may need them - so it should be a relationship of equals. It's a long-term commitment with a partner who will be focused on achieving extreme outcomes, such as an exit.
The Process of Getting Funded
Decisions to invest in a business are made by the Investment Committee, made up of general partners (those who manage the fund) and limited partners (those who invest in the fund), who will ordinarily meet once a week to review the pipeline of deals that originators have sourced.
This is where the ubiquitous pitch deck is so important. Alongside meetings, it is the main vehicle through which you demonstrate to VCs that your business or idea has potential. Typically, a business will be looking to raise enough to fund their development for 18 - 24 months. There are some key definitions to be aware of here that relate to the stage of the business and how much you'll be able to raise:
If you fall into one of these pigeon holes in terms of the stage of the business, the investment needed and the headcount, VCs will find it easier to understand and evaluate you as an investment opportunity. Preparing your business before you go to market is critical. Ensure that you have:
A robust business plan
A realistic but ambitious forecast for growth
A comprehensive set of management accounts
A clear and effective pitch deck
These materials are vital not least because they will help you to defend the valuation of your business, but also because they will demonstrate you are a credible investment target. Getting these in place can feel onerous for time-poor entrepreneurs, but without them, you’ll struggle to get off the start line.
An important note here - there are two types of company valuation that can be referenced in discussions with investors, pre-money, and post-money.
The pre-money valuation is the value of your business prior to investment
Post money is the value of your business as above + the money invested.
If you have a pre-money valuation of £1m and you raise £250k, your post-money valuation is £1.25m.
Nice-to-haves will include a strong presence online and across social media, a presence in trade publications and events and demonstrable knowledge of competitors and the market.
You'll then need to build a target list of VCs that are suitable as partners according to your sector and stage. Once you've done this, you need to get out and start engaging as waiting for the "perfect moment" will probably never arrive and delay you. When you have an interested party, you can expect to have 3 or 4 meetings before getting to a decision, at which point you will hope to receive heads of terms.
Remember, every interaction with a VC is an opportunity to pitch and sell your story but you can't say everything at once. So, think about how you can drip feed information throughout the process, obviously prioritising the most impactful statements at the beginning. As in any sales process, be assertive, be clear, ask questions and be prepared for knockbacks. After all, this is a relationship of equals and a long-term partnership that you are trying to establish – and it’s not easy.
Post Deal
All being well, you’ll have run a successful process over a period of 8-10 weeks, alongside maintaining performance levels in your business and you'll have worked with a great corporate solicitor who will have managed to negotiate favourable terms for you, so what happens after the deal is completed?
There should be a flurry of press activity, which can sometimes feel a little overwhelming, but understanding when and how your new partner can support you is vital. What is the right balance in terms of communication, input and dealing with inevitable rough patches? All this needs to be worked out by both parties to make sure the relationship works.
If you’re thinking about raising venture capital and would like more information or support on what to expect or how to manage the process, please don’t hesitate to reach out as Dragon Argent love nothing better than supporting entrepreneurs through complex engagements like this. In fact, we offer a range of corporate advisory services specifically tailored towards small businesses, SMEs and startups.