A venture capitalist generally invests in companies and startups which are still in a stage where their business model needs to be proved viable, or they need resources to scale up. Thus, those companies present high risks, but the potential for exponential growth. Therefore, venture capitalists look for startups that can bring a high ROI and high valuation multiples.
A Glance at venture capital investing
The set of investments venture capitalists make; only a few will succeed. Therefore, they have to place more bets to make the system work in their favor.
In the end, the venture capitalist makes money (the so-called exit) by either reselling the stake in the company at a much larger valuation or with the IPO of the company they invested in.
When that happens, venture capitalists make substantial returns for their partners. Indeed, the venture capital firm is usually comprised by a group of partners which raised capital from another group of limited partners to invest for them.
The limited partners (or LPs) can be either large institutions or wealthy individuals looking for high returns.
Usually, venture capital firms invest in growth potential. Therefore, when a startup receives venture capital money, the venture capital firm – usually – expects aggressive growth.
Before we get to the advantage and disadvantages of taking venture capital money, let’s first understand the explicit and hidden incentives that drive venture capital firms. Indeed, at the end, taking venture capital money is mostly about interests alignment.
And if those interests do not converge, that is when probably it might be not a good idea to take that money.
Understand the venture capital incentives
To understand how venture capital works, we need to look at the two resources that they allocate:
capital;
and money
Time, because VCs funds, compared to other models, where financial resources are endowed, do contribute to the growth of the firm they invest in. This contribution can come in several ways, from assistance in hiring to providing guidance, or also having a VC on the board.
On the other hand, VCs provide capital for funding the scale of those startups.
Why is it important to understand the two essential resources? Well, while capital might be a relatively scalable resource, assuming VCs can bring in continuously limited partners.
Time is not. Indeed, VCs usually run out of capacity in managing a certain number of investments as those investments need to be also managed and supported.
And in general, VCs look for a return anywhere between 3-10 years, depending on the market condition, startup growth and more.
Which means they also look for 10-30x ROI in a 5-10 year timeframe.
Therefore, a few aspects we can highlight so far:
venture capital have limited time resources to allocate due to the fact they can only manage a certain number of investments (as they provide several forms of support to startups);
they look for extremely high returns (10-30x in the lifespan of the investment);
those returns can happen anywhere between 3-10 years depending on several conditions (this means in this period VCs will ask for aggressive growth)
Let’s look now at the advantages and disadvantages of getting VCs’ money.
Advantages of VC money
Some of the key advantages can be summarized in a few key points:
Guidance and expertise: usually VCs don’t bring just cash on the table but also the expertise of the team and partners part of the fund, which is one of the primary advantages of getting VCs’ money.
Rapid Growth: if you’re looking for rapid growth, VCs will look for the same thing. Thus, you’ll both be aligned in terms of objective, which makes it easier to make this sort of agreement work.
Connections: VCs will introduce you to the right people to unlock growth potential, which is another undeniable advantage.
Hiring: the VC investing in your company can also help you find the right people to form your team and scale.
Additional support: in some cases, VCs support can also come in other areas that are important to grow smoothly, which include legal, tax, and accounting matters.
For all these reasons, VC money makes sense. Let’s see when it doesn’t.
Disadvantages of VC money
There are two significant disadvantages in taking VC money:
Loss of control and ownership: this is by far the most significant disadvantage as if you let VC in it means you need to be ready to give up some or a good part of the control. Therefore, you won’t be the only one in charge of the company’s vision and mission, but you’ll need to share that with the VC.
While it is legitimate for VC to ask a high ROI for a risky startup which business model still needs to be proved viable. A very High ROI and an excessive push on growth might break things up. Remember that, companies, like products, might have a lifecycle and forcing too much on growth might well make the company implode.
When does it make sense to take venture capital money?
The only thing that matters is getting to product/market fit.
Product/market fit means being in a good market with a product that can satisfy that market.
How do you assess whether you passed through this product/market fit stage?
Marc Andreessen explained:
You can always feel when product/market fit isn’t happening.The customers aren’t quite getting value out of the product, word of mouth isn’t spreading, usage isn’t growing that fast, press reviews are kind of “blah”, the sales cycle takes too long, and lots of deals never close.
Therefore, there is no single way to measure that, but as Andreessen emphasized:
And you can always feel product/market fit when it’s happening.The customers are buying the product just as fast as you can make it — or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling because they’ve heard about your hot new thing and they want to talk to you about it. You start getting entrepreneur of the year awards from Harvard Business School. Investment bankers are staking out your house. You could eat free for a year at Buck’s.
And he highlighted something that would stick as a paradigm in the startup world for years to come:
Lots of startups fail before product/market fit ever happens.
This is (when to take VC money), of course, going to be a function of the kind of business model and product that you have. If you can bootstrap, if you can go all the way to product market fit and then raise money, you maintain the most control in your company. You have a lot of say in where the company goes from that point on.
And he continued:
In an ideal world, and it’s not just me, even the venture capitals and other angel investors will give you the same advice. The best ideal time to raise your big round of funding would be as you cross product-market fit.
Once you have product-market fit, some success is guaranteed. The question is how big can it get?
The other thing that’s also going in your favor then is that your goal, you being the entrepreneur or innovator, your goal and the investor’s goals are completely aligned. It’s all about growth.
You have figured out the product, you have figured out the customer, now it’s really engines of growth.
Source: blog.leanstack.com
Thus, if you were in the condition to bootstrap – grow with your resources, or with a profitable business model – your company is in a perfect place to be.
You can decide whether to move to the next stage (scale), thus take VC money. Or keep growing organically.
And he also highlighted:
If you were doing something that required capital investment upfront, this is where VC makes sense, but there is now, increasingly so, a very mature market of other investors that play in that space.
Those would be super angels or angel investors that understand that you still haven’t reached product-market fit and you are going to be learning and pivoting and course correcting, and they tend to be more patient for those types of things.
What questions to ask before taking venture capital money?
Therefore before taking VC money, I would ask the following questions:
can I validate the idea without external resources?
Is the product technically complex that it requires additional resources to develop?
Do I need money to scale?
Am I ready to give up part of the control of my business?
In short, if you are a control freak, and you want to keep your vision of the company intact, VC money might not be the best option. If you’re willing to give up some control in exchange for money and expertise that might make sense.
In other cases, if you managed to bootstrap your way to product/market fit you might be in a good position as VC will want you. Thus, you will be able to negotiate better deals.
In the case in which you need a long term perspective to grow your business and still be in charge of angel investing or “super angels” might be a better option.
In all the other cases, bootstrapping is the way to go!
Alternatives to Venture Capital
Revenue-based funding: This alternative is effective for start-ups that generate recurring revenue, such as through subscriptions or service-based systems. Business development companies, private equity firms, and banks consider annual or monthly recurring revenue when providing funds.
Venture debt: Venture debt is suitable for entrepreneurs who have already given up equity in a venture capital deal and want to avoid further dilution. It can also be used for specific projects. Venture debt is provided by BDCs, private equity firms, and other companies, but the start-up must ensure it can repay the loan.
Grants: Grants are non-dilutive capital that does not need to be repaid. They can help reduce business costs early on and may be offered by governments, community organizations, foundations, and private entities. However, securing grants can be challenging and time-consuming.
Angel investors: Angel investors provide early-stage capital to start-ups in exchange for equity or sales royalties. They often bring expertise and industry connections. Angel investments typically range from $50,000 to $500,000, but securing angel funding can be difficult.
Crowdfunding: Crowdfunding allows individuals to back a start-up through a platform in exchange for rewards or equity. Platforms like Kickstarter and Indiegogo offer rewards, while equity platforms like Republic.co and Netcapital.com provide equity in return. Crowdfunding can be challenging for start-ups without an established following.
Key takeaways
While undoubtedly effective and potentially lucrative, venture capital is not perfect. Nor is it the only way a company can raise funds. Revenue-based funding, for example, can be effective for start-ups that rely on subscriptions, service-based systems, or any other mechanism that involves scheduled or recurrent revenue.
Venture debt is an ideal solution for entrepreneurs who, for whatever reason, have already relinquished equity in a venture capital deal. Grants are a non-dilutive form of capital that does not have to be repaid, but these can be harder to secure.
Angel investors provide critical early capital to a start-up to help it manufacture products or get off the ground, while crowdfunding is a way to raise funds from a group of individuals who may also be the start-up’s biggest fans.
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
