One of the many misconceptions when creating a company is that the terms “startup” and “small business” are easily interchangeable. They are not. In the venture capital industry, a startup has many more requirements and expectations of being a hypergrowth endeavor that can generate at least 10x returns over the next seven years, whereas a small business is one that is your everyday run-of-the-mill company that grows over time and provides goods or services that cater to existing or historical needs.
Startups anticipate market needs based on existing trends and fill an unmet demand. The risk of success is much higher since there are a number of variables that need to play out in order for there to be venture returns.
THE PLAIN TRUTH
Let’s be clear—as much as venture capitalists want to see your vision succeed, there are still expectations of high financial returns, discipline, and control that underlie their support. Many entrepreneurs often feel that invested capital solves all the company’s problems. However, the reality is that it magnifies errors in the business and the responsibility to deliver goes through the roof.
Quite often, venture capitalists need to illustrate how your company fits into the investment thesis that they promised to their investors. This is partially why they vie for a position on your company’s board of directors, in addition to taking an equity stake in the company. They need to protect their investment as well as that of their limited partners (LPs).
Furthermore, they want to ensure that they cultivate a large return and can control the direction of the business to deliver the expected outcomes they are held accountable for. Though your company is just one of many in a portfolio, there is anticipation that your company’s success will cover the possible losses for a venture capitalist (VC) from their other investments.
A 3x return is not adequate. Investors are looking for exponentially more, which will vary based on the risk/return dynamic.
YOU ACTUALLY HAVE A CHOICE
You have to make a decision whether venture capital is right for your company. Many companies succeed without venture capital investment, so keep in mind that you actually have a choice. Bank loans, lines of credit, and simple organic growth are other options for financing. Some companies do not need the attachments associated with venture capital and other companies find the expectations to be too onerous. Other companies simply find a different route to finance their company needs that is more palatable to their company and management profile.
The purpose of this article is to briefly touch upon some of the main areas of consideration when determining whether venture capital money is right for you.
THE INVESTOR RELATIONSHIP
It is important to note that venture capital investment represents a long-term relationship between the investor and your company. You will likely be working with your investors at least until an exit occurs, which can take up to five to seven years in many cases. This is how they receive the exponential return on their investment that satisfies their needs and their investors’ needs. If you need a quick financial fix, a loan from a bank or other creditor may be more suitable for your needs.
When engaging venture capital, you will be giving up control in some fashion with each new round of investment. Each investor will be taking an equity stake in your company, with major investors generally asking for a seat on your board of directors and special voting rights in the case of major corporate transactions. Not only will you be in less control of the overall ownership of your company, but you may also be in less control of the day-to-day management and overall strategic direction of your business.
Investors generally bring along their paradigm of a how the company can reach success, and they may even bring along their own people to work within the company in executive or other high-ranking positions in order to achieve their vision. Though you may believe that you can and should be able to stop investor overreach, that is not always the case. While many investors at the venture stage write checks to capable management teams that they feel can scale the business, there may be junction points along the way that require new talent to execute the next phase of growth. It is quite rare that the founding team makes it all the way through “as is” to exit. Typically, the terms of your financing with the investor likely provide them with the power to act accordingly or, at the very least, the terms provide investors with power to make working with them very difficult until they get their way (e.g. financial reporting clauses, voting rights, board seats, the ability to show up and ask questions as they please, etc.).
Before you complain that VCs have too much control, keep in mind that they are providing capital and bear the risk of the company going belly-up. Generally, you are not personally liable for the company’s labilities and have the ability to walk away from the company at any point, leaving the investors with the aftermath. This is a huge risk, which is why venture capitalists usually have a set of requirements and assurances attached to their investments.
VC INVESTMENT CRITERIA
Commonly, venture capitalists have a set of parameters that guides them as to which companies to invest in and which to reject. Unsurprisingly, these criteria vary per investment, but are heavily reliant upon the potential of the company to grow quickly in a short period of time, the ability of management to scale with limited resources, and the diligence to achieve the required financial metrics. These attributes will shift over the life of the fund as it nears maturity. Overall, a VC fund needs to be returned to its investors typically by year seven, so it may be foolish to see an early stage fund invest in a seed round in year six unless there is a near-term exit on the horizon.
Keep in mind that returns are probably one of the most consistently heavily weighted factors with any venture capital investment. Put simply, investors look at the end result and think about the time and costs needed to get there.
Venture capital funds such as First Round Capital, Canaan Partners, and RRE have mentioned an emphasis on management, culture, high performance, transparency, and other factors used to analyze companies. Angel investors such as Mark Cuban have stated that they look for passionate founders, products/service timely for market demand, and strong management track records.
Again, the investment criteria varies by investment as well as by investor. Nevertheless, here is a quick snapshot of what venture capitalist commonly look for in an investment.
- Exit opportunities
- Proven business model
- Strong management team
- Scalability/growth trajectories
- Massive market potential
- Development stage of product/service
- Company costs/cash burn
QUESTIONS TO CONSIDER
As you are contemplating whether to seek venture capital investments, below are questions to help guide your thinking and decision-making:
- Why do I need the money?
- How long do I expect the money to last?
- Will I need to ask for money again?
- What role do I expect the investor to play in the narrative of my company’s development?
- Am I willing to give up control of my company? Why?
- How much control am I willing to give up? In which areas of the company am I willing? Why?
- How long am I willing to tolerate the control and influence from other parties?
- What are my requirements for investors?
Though venture capital comes with a great deal of attachments, there is still a great upside to knowing that the biggest and best investors want to work with your company to see it grow. The most important aspect of this article is to encourage critical thought about the implications of venture capital financing before determining that this is the direction you want to take your company. VCs are looking for a fit with their investment criteria, and you should also be looking for the same for your company. Alignment is critical as with any long-term arrangement.
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