Six things startups need to know about venture capitalists

Every startup needs capital – money it can use to either get off the ground or ramp up growth.

The most important and the most valuable way to fund the business is to sell your product or service. And for the vast majority of companies, this might be the best way to grow. But if you want to grow quickly, funding your business through sales may take too much time.

There are different ways to raise money, and each method usually comes into play at different stages of a company’s growth. First you use your own money (yours and your partners’). Next, it’s usual to call on friends and family to invest. Then you look for outside investors – angels or VCs – and after that, private equity. And once you really take off, you sell shares through an IPO (initial public offering of shares).

At each stage, the pot of money available is bigger.

For startups, the big hurdle – the one you need to overcome if you are to get on the path to serious growth – is convincing people who don’t know you personally to invest in your firm. This means venturing into angel investor/VC territory.

Unfortunately, too many startups don’t know enough about how the VC investor system works. Here’s what I’ve learned – and what I think every startup entrepreneur should know.

1. Understand what a VC is, and how a VC is different from an angel investor

In its early days, if a startup raises any money, it’s from people who know the entrepreneurs personally. These people - friends and family - will be happy to get a return on their investment eventually. But chances are, they are not investing solely to make a profit. The money they provide is what I call “love money.”

Moving up a notch, angels and VCs want a return on their investment.

However, each comes at it from a slightly different angle.

Angel investors - most often past entrepreneurs themselves - have an interest in a particular city or industry, and because of that are driven to take a chance on companies “closer to home”.

An angel can be an individual or a syndicate (a group of angels, coordinating as one group).

Individual angels will generally invest from $10,000 to $250,000, while angel syndicates have a bigger pot of money available – usually between $250,000 and $1 million.

Venture capitalists are in it to make money, period. And they want that money over a certain time period – usually about seven years.

Venture capital funds are larger pots of money, raised from various sources – wealthy individuals, corporations or pension funds, for example. VC funds are generally bigger than angel funds. A small VC fund might contain $50 million, a big one $1 billion.

Nobody, angel or VC, is going to put a significant amount of money into your firm and walk away. In exchange for investment money, the early-stage entrepreneurs have to agree to let the new investors have a say in how the company operates. That means giving up a portion of your control and ownership.

If you are dealing with an individual angel investor, realize also that you will be dealing with an individual – a person who has a stake in your company.

While angels are generally more founder-friendly, there’s a downside to having an individual on your capitalization table. It’s their money, and if things go bad, psychologically, they will act differently than angel syndicates or VCs, who are managing an investment - and are therefore are one step further removed.

That remove can sometimes make VCs more attractive than individual angels.

2. Know how VCs make their money

VCs make their money by helping a young company grow and gain in value, and then cashing in a few years later when the company is sold or goes public.

They expect a huge return on their investment – two to 10 times or more of what they put in.

Why so big a return?

Because not every firm with VC money succeeds. As a matter fact, of the companies that fail, more are VC-funded than not. The investors need impressive returns from some firms to offset the inevitable losses elsewhere.

It’s estimated that of all the firms VCs invest in:

• 65 percent fail and return less than the capital invested
• 25 percent barely give a return on the investment (i.e. a 1-5X)
• 6 percent give a good return (i.e. a 5-10X)
• 4 percent give a spectacular return (i.e. a 10X or higher)

It’s also important to remember that VCs don’t make their money as they go. They make it in one lump sum, years after the initial investment. This mindset affects how they view their investments.

There are two basic ‘exits’ that allow VCs to make their money: either the company gets bought out (the acquisition exit) or it goes public (the IPO exit).

As I wrote earlier, VC investors expect the ‘exit’ to happen in about seven years – give or take a year or two. Most companies on their own expect it will take 10 years to get to the point where they can be bought. So that means companies with VC money will face extra pressure to come to an exit sooner.

3. Know how VC funds work

A VC fund is a pot of money that is raised from wealthy individuals or institutions, locked in place, and then placed into “fundable” companies.

Each fund contains a set amount of money, so that the investors can calculate the IRR (investment rate of return) on that amount. No new money is added to an individual pot. As a result, a venture capitalist will often have several active funds in its portfolio.

The money in a fund is not doled out all at once; the fund’s managers decide where and when. There is constant pressure to make investments in new and promising companies, because with each passing day the IRR is more difficult to achieve.

Suppose a $100 million fund is raised and the money is ready to be placed. Part of this fund will be allocated to initial investments, and the balance will be reserved for follow-on investments. Remember that for the IRR to be properly calculated, if your company receives an initial investment out of this fund, then the VC will want to continue to invest out of this fund for all subsequent follow-on investments.

So, your company might get an initial $2 million investment, followed by two or three subsequent follow-on investments as your company grows.

But keep in mind that when the time comes for the next round of investment, the fund’s managers can decide to cut off poorly performing companies – no point in throwing good money after bad.

And so on through the next rounds of investment. With every round, they will focus more and more on the companies that are succeeding, while abandoning the poor performers.

You also need to know the stage the fund is at when it invests in your company. How “fresh” is the fund? Are you part of its first round of investments? If so, good – you have a lot of lead time before you and the fund need to show returns. But if you’re being brought in at a later stage – as a new investment three years after the fund first started placing investments – realize that the investors may be looking for a return in five years instead of eight. And there is a lot less money left in the pot for further investments. In these cases, where the fund is a few years in, investors generally look for later-stage deals, where your company is closer to an exit.

You also need to have an appreciation for whether you can move a particular fund’s needle. If you get $5 million from a $50 million VC fund, you will be more important to that fund than if you get the same amount from a VC fund worth $1 billion. In the first case, you will bring a huge benefit (proportionately) to the fund if you do well; in the second case, you’re more like a drop in the bucket. In the first scenario, there will be more pressure on you to perform.

4. Understand that you are giving up some control

When the VC signs the first cheque, the investor is given shares in the company in return – usually preferred shares, which among other things will help the investor reduce their investment risk.

If there are several investors, the one who wrote the biggest cheque is the generally the lead. The lead’s lawyer negotiates the terms, and the secondary investors follow along. The terms are often overlooked by entrepreneurs, who commonly focus more on getting the highest valuation possible. I would consider friendly terms to be far more important than a huge valuation. The more you push valuation, the more the terms will be written to protect any downside. More on this topic in a future post.

The lead investor usually gets a seat on your board.

The lead may negotiate that board seat for him or herself, but the secondary investors may want observer status. Don’t worry too much about having an odd number of board members - if there is discourse on your board, you have bigger issues to worry about.

5. Understand that the VC investor will be your partner

Having a VC partner on your board offers a wonderful opportunity to tap into the skills and network of an individual who moves in business circles outside your own. Use your partner well, and you’ll be on the road to growth.

Because so much is at stake, it is critically important to pay attention to who that person is. Choosing a VC partner is kind of like hiring an employee - except that you can’t fire them! Whether it works depends to some extent on whether you click. So it’s important that you choose someone with whom you get along and with whom you can build a good, trusting relationship. That partner is going to sit across from you at the board table for five to eight years.

There are advantages to different kinds of partners.

We have one of each on our board – a past operator who is very supportive, and an accountant who is good about introducing me to people who can help.

If you get a good partner, hope that person stays.

If a partner who is your champion leaves the VC fund he or she is with, that fund will send in a replacement – someone who may not know you as well, someone who may have less of a stake in your success.

So it’s good to discreetly check out partners before they come in. Do they have a history of fund-hopping?

And while you’re checking, see if you can find out how a potential partner reacts when the company hits a rough patch. Look for someone who is patient and even-keeled.

One other thing: Ask how your VC partner gets compensated. Are they getting paid as you go? On what basis? Do they get a bonus if you achieve certain metrics? Will they get paid once you make it to the next round of financing? Or do they only get compensated once you get bought out? This will influence how they behave with you – and help you understand what motivates them.

6. Understand the current VC environment

Despite fears earlier this year that the VC market would dry up, it hasn’t. I know that because in the last few months I have fielded phone calls from several dozen of them. There is a tremendous amount of money in the system, and I think this is a very good time to be looking for VC money.

If you compare this year’s Q2 activity to the same period a year ago, VCs closed roughly 100 new funds (the same as 2015). However, they raised more money, with the average fund size now at $103 million, up from $78 million last year.

The bigger story is in the number of deals being done - and it’s noticeably down from last year. According to Pitchbook, there were 2,800 deals in Q2, 2016, compared to a staggering 4,400 in Q2, 2015. But, each deal this year is receiving a bigger cheque.

For the top tier companies, this is good news. This combination, where there is heaps of fresh capital but a more cautious investor, means bets are being placed on only the best. Quality over quantity.

Next time, I’ll be taking a look at VC math – the calculations venture capitalists make as they decide whether you’re worth investing in.

Allan Wille is a co-founder of Klipfolio, and its president and CEO. He’s also a designer, a cyclist, a father and a resolute optimist.