What is venture capital investment? What are the basic requirements that a startup must meet in order to be interesting in the eyes of these financiers?
This article gives many tips on how to set up the product, market and team presentation, but also on how the relationships between the board of directors and founders must be set up and managed until the happy ending.
The role of risk capital
Like Wall Street for bankers, like Hollywood Boulevard for actors. Sand Hill Road is the mythical place for entrepreneurs: here are the headquarters of venture capital companies that move the engine of the startup world in America and in the world. Innovative entrepreneurship is a great risk, but also an opportunity that the American economy cannot do without: according to a Kauffman Foundation study carried out in 2010, startups are responsible almost entirely for the 25 million jobs created between 1977 and 2010.
The management of the funds that feed this forge of ideas and well-being is obviously delicate, the relationship between entrepreneurs and financiers is not always simple, also due to the lack of knowledge. It is important to be clear about the process that guides the choice of investments in order to reach a fruitful agreement between the parties. As partners interested in starting a profitable business, entrepreneurs and investors must learn to know each other, to trust each other and to collaborate.
Signing a check is the starting phase, not the final one, for the VC: the work continues supporting the company in choosing the talents necessary for its growth, putting it in contact with other production companies, sharing experiences. As for the entrepreneur’s job, only he can do it: a VC is valid if he chooses good entrepreneurs to support. One thing above all: according to a 2015 study done by Ilya Strebulaev of Stanford University and Will Gornall of the University of British Columbia, 42% of all US companies that have been listed since 1974 had been financed with capital of risk.
The interaction between VC and entrepreneurs begins with the presentation session, the famous pitch , and goes all the way to the IPO ( Initial Public Offering ) or acquisition. It is a difficult path, and the asymmetry of information can create serious problems for a relationship that can be compared to a marriage. As for a wedding, success is tied to knowledge, to mutual understanding.
The first VC to open – in the true sense of the term – its doors to entrepreneurs was Y Combinator. Born in 2005, he gave birth to a model to make his startups grow, which he made school. YC, as it is known in the sector, selects a group of startups and welcomes them for a period of 3 months in a single large space, supporting their tutors, providing training, stimulating the passage of skills and experiences. YC has grown a generation of entrepreneurs, following them step by step in the process of launching their startups, and has created an ecosystem capable of supporting the development of over 1600 companies, including Airbnb, Coinbase, Instacart, Dropbox.
The financial characteristics of Venture Capital
Venture capital has replaced banks in the role of lender of innovative entrepreneurship after the serious crisis of 2007. The substantial change is that we no longer operate through the creation of debts: the financing is in equity, that is equity investments: the VC finances in exchange of the acquisition of a company property. It is in a way a bet on the future value of the company that finances itself.
From a technical point of view, the VC is an asset class , an investment category on which a part of the investment assets are allocated. For example, bonds are an asset class, as are public market shares; to build a balanced portfolio, investors often choose to invest a portion of their money in bonds or shares of listed companies.
The hedge funds , VC funds and buyout funds are asset classes that, to generate interest, take longer than necessary, for example, from the stock market. Traditional investment leads to small advantages from numerous (possibly all) shares in portfolios, while VC provides the opposite: of many companies, only a few will be exceptionally profitable, and it is by investing in many that you can “intercept” right subjects.
With a joke it is said that Isabella of Castiglia was the first VC. She provided Colombo with everything he needed for his project, to open a new route to the Indies, and he returned with the discovery of the Americas. Financing an impossible business is risky, but when you are successful, the return is very high, and is called “asymmetric return”.
Venture capital investment is a small business compared to other financial asset classes. In 2017, which was a great year, it reached 84 billion dollars, very little compared to the 450 billion invoiced by the acquisitions industry, as a whole, in that same year.
But the impact it is capable of causing is far more important than its weight, if we consider how the 5 largest American companies by capitalization (Apple, Facebook, Microsoft, Amazon and Google) were all financed through VC.
How VCs decide where to invest
The early stage offers little data to rely on, sometimes all that is available is a presentation with a future business model. The basis cannot be quantitative, but qualitative, and takes advantage of analyzes conducted on three elements: people, product and market.
- People: you invest in the team more than in the idea, if you start from the assumption that the idea has no bosses, it is the team that will best develop it to win the competition. How to be chosen? It is necessary to prevail the idea that you are a product-first company and not a company-first. The first is formed around the project: we are looking for the right people for that particular goal. The second, on the contrary, is made up of a team that has chosen what to focus its potential on.
- Product: the one defined in the project is not the one that will be presented to the market, much less the final version. For this reason it is essential that it is not static, that it shows an intrinsic ability to evolve. Another element of evaluation, its revolutionary nature. To change people’s habits, something must be 10 times better than what is already there, or 10 times cheaper. Ben Horowitz, co-founder of the VC Andreessen Horowitz, explains that, to interest him, the product must be like aspirin compared to the vitamin: vitamins are potentially useful for your health, but it takes time for them to do their job. If you have forgotten to take them and you are halfway between home and office you will not retrace your steps. Aspirin, on the other hand, is all you want when you have a headache: it solves your problem quickly.
- Market. Made popular by Steve Blank and Eric Ries, the product-market fit, that is the correspondence between product and market, describes the situation in which consumers recognize the problem that the product solves and are so satisfied that they no longer want to give up that specific solution. . Airbnb has achieved this ” fit “, such as Pinterest, Facebook and Instagram. As consumers, we can hardly imagine what we did before these products existed.
An important actor on the scene: the Limited Partners
The Limited Partners are the subjects who actually put the investment money. In the United States, when a private company wishes to raise funds to finance its operations, it must comply with securities laws and must therefore turn to entities that comply with the definition of accredited investor.
It is necessary to know them, because without them, the VC simply would not exist. The main ones are:
- Foundations. Thanks to the investments, the capitals are maintained and consolidated and the charitable works go on. To maintain free tax status, foundations must spend 5% per annum of their funds in support of their mission, therefore returns from capital must exceed this threshold to ensure the conservation of the Foundation in perpetuity.
- State or large company pension funds. IBM, but also the Californian pension system for teachers, invests to ensure the economic well-being of its underwriters.
- Large family investors. Their goals are set by individual families, often including charity for the conservation of wealth.
- Sovereign wealth funds. They serve to protect against financial dependence on a single asset. In the specific case of many Middle Eastern countries, sovereign wealth funds invest part of the oil profits in other activities.
- University funds: Stanford, Yale, Princeton, MIT, in general almost all universities raise funds from alumni and invest them for economic returns that can make them grow and progress. Let’s look at a specific case, that of Yale University. Its fund, until 1967, was mainly composed of Treasury bonds. A conservative position changed with incredible results: in 1985 the fund was around 1 billion, 30 years later we find it at 25 billion. Of course, this is also due to the growth in donations, but in fact the fund produced investment returns of 8% net, one of the highest among university funds. 16% of the portfolio relies on venture capital, 5% more than that of other universities, and produced returns of 77% per year. Translated, for 20 years,
Open a startup with venture capital financing
Let’s forget the romantic dream. It starts with the lawyer, or the notary. It is fundamental for the future to understand how to set up the business. This also includes figuring out if you should take money from a VC, and if so, how many.
The key rule of VC investment is that it all starts and ends with one factor: the size of the market. It does not matter how intellectually stimulating your idea is, if it cannot “scale” to the required size. What if your market isn’t huge? It is not a good thing to attract this type of capital. VC is not the right tool for your business.
Now, assuming you made the decision to raise venture capital, how much money should you collect? The right answer is: collect the amount that allows you to safely reach the fundamental stages to conquer before reaching the next fundraiser. In other words, think about the next funding round while you are working on the current one.
What will you have to show the next investor to convince him that you have done a good de-risk job and implemented enough to deserve his money? Don’t go too far: if you allow yourself or a VC to overestimate society today, you are raising the stakes tomorrow, which is not profitable.
The evaluation must reflect where you are, because your evaluation of the financing must be consistent with the success story you have told – and will tell – about the company.
How to conquer the opportunity to make your pitch
Angel business or seed investor , that is, subjects specialized in financing companies in their very first steps, are a good entry point. The environment is somewhat symbiotic, both sides have advantages: if an angel- funded startup manages to make a good funding cycle through VC, there will be gain for everyone. Another good entry point is lawyers. Alternatively, try to meet someone who can get you on a date.
There are hundreds of blogs, books, podcasts, conferences that teach the art of networking. Now you know what they are for! It can be challenging, but if you can’t find a creative way to reach a VC, how do you think you can reach a potential client’s senior executive?
Your job, once you get the appointment, is to convince the VC with a good presentation. The essential points to focus on are five.
The size of the market
Don’t assume that VC understands the market or its potential size. Remember that estimating market size is easier when a new product is positioned as a direct replacement for an existing product. You have to paint the image that will allow them to answer affirmatively to a question: “If I invest in this company, and the CEO (the administrator, generally the founder) and his team do everything they say they will do, this can a company be large enough to produce an exceptional return? “.
Proved that the market opportunity is large enough, you need to answer the potential question “Why you?”. Remember that at this level the analysis is qualitative, not quantitative. As uncomfortable as it is, you have to turn the spotlight on yourself as CEO and the rest of your team. In particular, what is it that makes you a uniquely qualified person to conquer the market? Once this is done, you must convince yourself that you are the person who can form the necessary team. Nobody, however brilliant, can do it alone. You must therefore show your natural leadership skills. An entrepreneur’s storyteller skills are considered by people like Ben Horowitz to be an excellent indicator of his potential success.
A great CEO finds a way to illustrate his vision and share it. Nobody expects you to be a fortune teller capable of predicting the precise needs of the market, but the process by which you arrived at your plan will be evaluated.
What data did you get from the market? How is this product ten times better or cheaper than existing alternatives?
The go-to-market (market strategy)
Don’t make the mistake of underestimating this point. How will you acquire customers? Does the business model support this acquisition mechanism profitably? Although at a high level, this is information that must be present in the presentation, because it is fundamental for the long-term performance of the business.
Plan the next fundraising round
You must clearly articulate the milestones you intend to achieve with the money you are collecting in this round. Remember that a VC evaluates the level of risk that it is taking even by “projecting” to the next round. Are you collecting enough money to reach the goals you have set, so that the next round brings new money and a substantially higher rating than the current one? “Substantially higher” is a value that depends very much on the market in which you operate, but in general you want to aim for an evaluation that is about double the previous round.
The work of the board
The CEO is responsible for day-to-day operations and long-term vision, but the board plays an important role in providing orientation and review of the strategy. This does not mean that the board dictates the strategy, in particular that of the product: its members do not have the necessary detailed knowledge and generally recognize it. Much of your work will be helping them do their job well.
What do you have to do when bad things happen
When things do not go as planned, it is difficult to start with a recapitalization proposal, rather one is oriented towards a “bridge loan”, an infusion of liquidity by the investors already present in the form of an extension of the last financing cycle.
Unfortunately, this solution is often the most wrong, because it does not solve the basic problem: we are where we are, and something must change. If for some reason the company has not developed the business according to the planned expectations, it is necessary to review the plan from all points of view, not simply adding money to the equation.
The happy ending: we arrived at the “exit”
We are using the term “exit” in a symbolic way, since both in the case of IPO ( Initial Public Offering ), and in that of an acquisition, the company passes to another phase of its life. The VCs leave their position as owners because they have made their journey and achieved their goal: investing early, helping to increase the value of the investment, seeing it get to the point of being able to return capital and margin to their Limited Partners.
VC vouchers help entrepreneurs to achieve their business goals by providing guidance, support and a network of relationships. They limit their interference with the board of directors and let the company be guided by those who live and breathe the air. They recognize that, in the end, it is the entrepreneur with his team who build companies destined to become icons.
Only by doing so will they remain important actors and will not become dinosaurs, destined to be supplanted by alternative forms of financing, such as crowdfunding (collective financing).