Founders Guide: Eight Recommendations For Raising Venture Capital
Start-ups and scale-ups that require significant financing in order to sustain or accelerate growth often turn to venture capital, which offers a blend of cash, business support and, often, the promise of further capital down the line.
Unlike angel investors, who typically fund deals up to a value of around £100,000, venture capitalists can write multimillion-pound cheques. Apple, Amazon, Facebook, and Google all started life as venture-backed start-ups.
In 2020, UK businesses raised a total of £11.7bn in VC funding– a new record, despite the impact of the global COVID crisis. The UK market for venture capital is more robust than anywhere else in Europe. It represents 25% of all venture investing across the bloc; the venture capital spends here is double that of Germany ( Pitchbook analysis 2020).
Here is the ultimate guide to everything you need to know about how to choose and use VC:
1 - The Money
A typical VC will manage a fund worth between £100m and £500m – less for early stage funds. This money comes from a range of sources, including institutional funds, sovereign wealth funds, high net worths and family offices.
VCs charge a variety of fees in return for their capital. They will take a management fee – usually around 2% - which covers salaries and expenses at the VC. They also charge carried interest, or carry. This is typically 20% of the profit made on investments. This ‘2 and 20’ model is fairly standard but top VCs have been known to charge as much as 3 and 30. This may sound expensive, especially as the average interest rate on a bank loan is around 5%, but early-stage companies often struggle to secure traditional finance – especially large loans. Plus, VCs usually bring more than money. They can help break new markets, launch new products, attract top talent and more. VCs tend to make a small play in the first round of finance (the seed round) and then commit more in the second (series A) and third rounds (series B), upping their share of equity each time.
2 - VC Versus its Cousin, Private Equity
VC funds tend to invest in early-stage, cash-hungry companies with limited track record and, often, low profitability. Private equity funds invest in more mature companies with the aim of reducing operational inefficiencies and driving business growth, often by cutting costs or finding new sources of revenue.
Private equity will often accept lower rates of growth as long as it’s steady, profitable growth whereas a VC will expect exponential growth. To put this into perspective, it’s helpful to understand how VCs make their money. A typical VC fund that makes 10 investments will expect three or four to go pop, three or four will just about cover expenses or manage a small return, and there will be one or two star performers that deliver a 10x to 20x return. Index Ventures, MMC Ventures, Accel and Octopus Venture, which are among the most active investors in the UK right now, are looking for a 10x return on investment within five years. Private equity typically looks for a 2x-4x return over the same period.
3 - Preparing your business to take on VC
Be clear on what you want from an investor, as this will determine which VC you choose to work with. Do you just need cash or do you need a specialist to help you crack the US or get a new technology to market? If you don’t have a management team in place, build one around you before you start fundraising. Raising finance can turn into a full-time pursuit so you’ll need support running the company. Most VCs will also expect a chairperson on the board to act as the intermediary between the founder and investor. The chairperson also adds structure and accountability to board meetings, making them more impactful and keeping everyone focused on decision-making rather than general reporting. Before you go out to raise VC, prepare yourself psychologically for the change in power structure. After the deal, you will be focused on delivering on your promises for the next five years; you will be effectively ‘employed’ by the board. Be clear on how your key metrics are calculated and make sure all your records are in order before going out to pitch. This includes financials, employment contracts, supplier/customer agreements, and intellectual property arrangements – every single document that is relevant to how your business trades.
4 - Choosing The Right VC For You
Do your homework and only approach the VCs that are focused on your sector/business size and will understand your proposition. You want an investor with access to a great network that can support you beyond investment. Members always advise talking to other founders from investee companies and getting the inside track on their relationship with the VC. Talk to a corporate finance adviser about the current funding landscape and how to get in front of the right players. Most of the major venture firms will not respond to cold approaches: they require an introduction from a trusted advisor. It’s also worth digging into where your target VCs are in their fund cycle. Sometimes VCs will still go out and meet founders when their current fund is already spent even though it will be many months before a new fund is raised, so beware.
5 - Successfully pitching for funding
Like most things in life, getting great at pitching takes practice, so invest as much time as you can into honing your craft. Make sure that the first VCs you pitch are towards the bottom of your “want” list so that if you make mistakes, there is time to iron out the creases before you meet your top three. There are lots of resources online that can help you create a pitch deck (you can even find the actual pitch decks from firms that successfully raised VC). A basic rule of thumb is that you need:
An introduction: what does the business do and who is on the management team
What is interesting about your product/service
The market size, growth rate and other metrics that prove your growth potential is uncapped
Your key competitors in the space versus your USP
Customers broken down by segment and geography
Unit economics, from cost of acquisition to churn rate to customer lifetime value
Historical revenue, profit, growth and projections for five years
Level of investment required and how it will be spent
There is no “one size fits all” when it comes to pitchdecks. Some investors prefer fewer numbers and more evidence of ambition, others wants to see every metric. The key is to show clear evidence of historical growth and projected growth, and an explanation why you and your management team are the right people to take the company to the next level. If you have built and exited a business before, make this clear, as investors prefer to back seasoned founders. Make sure you know all your numbers by heart – or bring in an FD who can take those questions for you.
6 - Due Diligence And Term Sheets
Due diligence can be a painful process so make sure you have your house in order before you embark on raising VC. Members warn that however thorough you are, there will doubtless be a few tricky questions to answer, so make sure you leave time in your schedule for these eventualities. For example, it is increasingly common for VCs to request psychometric testing for the whole management team to understand how they communicate and what drives them. Right before the deal is done, you’ll be sent a term sheet outlining the financial obligations and terms of governance. Read up on term sheets in advance and make sure you have a lawyer you trust reviewing these documents. Don’t forget your own due diligence: your prospective VC will probably contact your customers, both current and former (so if you have any disgruntled customers, manage them beforehand). You need to do the same. Speak to investee businesses that have gone into liquidation – if the fund refuses to offer any names, this may be a red flag.
7 - Managing Your VC Relationship
VCs – like all investors – don’t like surprises. Members and partners advise being open with investors long before issues become pubic knowledge. If you’re unlikely to deliver on expectations, be forthright and explain why, and have a plan for moving forward. To keep the channel of communication open, try sending your investors a quarterly newsletter outlining updates, successes, new additions, and plans. Have ad hoc meetings with shareholders every couple of months and send through a monthly management update with your latest numbers and any changes to your approach. It’s also worth meeting investors individually every now and then to ensure they’re onside. Some members have created a separate Investor Board to the Operational Board but set up guidelines on who can make what decisions and at what level. A non-executive chair can also help to manage investors and back you up in times of crisis.
8 - What To Expect Post-Deal
As part of the terms of the investment, your VC will expect you to reach key milestones. Not all will be financial; they could also refer to building out the team or acquiring complementary businesses. If you hit these milestones you are generally guaranteed reinvestment. If you take on investment but aren’t hitting the numbers the VC will begin to push for an exit. They may find a new (and less attractive) investor to buy them out. If you don’t already have a chairperson and chief technology officer, your VC will push you to find these within the first six months. They may also try and place a non-exec on your board so make sure you are clear about your expectations for that individual or demand input over that decision.
Taking on a VC can help you to professionalise your business with stronger governance, reporting and financial management. They can also help to define the goals for the business, and get everyone aligned around them to achieve the best outcome. VCs usually come with great networks and have access to an impressive senior talent pool too. However, their expectations will be high so prepare for a lot of straight-talking and hard conversations. Remember that taking on a VC is like getting married. Take your time dating several suitors and only get into bed with the VC/s you like, trust, and respect.