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A version of this article was originally published here.
There’s nothing easy about raising venture finance for your startup. The odds are massively stacked against you as a founder. Statistically, roughly 1 in 100 startups that pitch to a particular venture fund are successful. That’s better odds than the Lotto, but tough odds without doubt. It’s worth remembering that venture finance is just a small part of startup story. The vast majority of new businesses get funded from alternative sources, like loans from banks or initial cash injections from friends and family, or better still, from customers. Roughly 75% of companies that achieve an exit either via trade sale or the public markets never raised venture capital. But venture capital does play an important role in funding a particular class of high potential high growth company.
Let’s assume you have the vision for a great new solution to a customer pain point in a very big market and you have the ambition to run fast to grow a company to develop and sell that solution. What are some of the things to watch out for when raising venture capital? This is a big question of course, and way beyond the scope of this article, but having been on both sides of the table (both as an entrepreneur and a newbie partner in a venture firm) I’ve seen some bad patterns and will walk though some of them here, in no particular order of badness.
You often find that entrepreneurs, particularly if this is their first time, do not fully appreciate the fundamentals of venture financing. The model really only works if the venture firm finds super hits, the big exits that “return the fund”. This usually means the founder must have a big vision and an ambition to build a big company and push for a big exit. You’ll hear a VC say they need to believe you can be a €250m exit or a €500m exit. They’re not just spinning a yarn, bigging themselves up, the model of venture funding literally does not work unless you can find some of these companies in your portfolio, so each investment you make as a VC must be based on a conviction that the company could be that successful, even if, as ever, the odds are never great. This means your plans need to align with this big exit potential. If you show nice, steady revenue growth, getting to €5m year sales after 5 years, and pitch a potential exit of €50m then this is not a VC backable company. That’s a great business, no argument, but it’s just not a VC shaped business.
Of course it’s all too easy to over egg it and pitch amazing hockey curve sales numbers, trillion dollar size of market estimates and Facebook sized valuation possibilities. Rationality is the key here. You need to have a model and a rational argument backing that model to backup your pitch for the size of the opportunity. The model (of sales growth, number of customers, lead pipeline, pricing growth etc.) is the basis for the conversation. You’ll debate it with your VC target, and unless you can backup your assumptions with good intuition and occasionally some facts, then it’s hard to believe it to be credible. I’d say the model is more important than the final number it underpins. With a good model, both sides can ask themselves “what if” questions, and it gives scope for optimism bias to push deals across the line.
This goes to the very heart of every business, and it’s surprising how often founding teams have difficulty in really understanding the pain point of the customer and how their solution truly solves that pain point in a meaningful way. You need to be able to put yourself in the place of your customer, feel their pain and have a sufficient understanding of the customer’s business and processes to be confident your solution is appropriate, effective and deployable. Sometimes the pain point isn’t really a pain point, or is not a priority for the proposed customer, or other times the proposed solution would bounce off the organisation, requiring too many changes to existing systems to adopt it. In an ideal world the product solves a significant pain point that is a priority for the customer, is close to what a customer would choose to build themselves if they had the resources and where the cost of adopting it is commensurate with the scale of the pain point it addresses.
There’s no greater turn off during a pitch by a founding team where the founders are talking over each other fighting to be heard or contradicting each other. If that’s the way it is in a pitch, then that’s likely exactly how it is day to day in the company. Founding teams need to draw clear lines of responsibility and authority and demonstrate their understanding of the need to, and how to, grow a team, bringing in top talent into a structure built to scale. During a pitch you quickly get a sense for this. You like to see a clear leader who drives the narrative but who also defers to others on the team for their specialist input (like a CTO to talk about technology strategy or a CFO to give a financial deep dive). You also like to see this interplay between the team members to be free flowing and clear, illustrating a team that already has a good dynamic where each individual takes ownership but understands their role.
It’s relatively easy for a team to present big numbers for the size of market they are addressing. A quick google will generally unearth some analyst report or other with a suitable large number of billions of Euros to validate their chosen market. It’s much more interesting when a team can credibly walk through a bottom up marketing sizing to identify their specific market, the type of customers they are targeting, how those customers buy, the alternatives a customer has (there are always alternatives), the cost of the routes to market and the margins that are possible. A classic gap in understanding would be a failure to realise a dominant channel (e.g. partnerships or agencies which cannot be bypassed) which entails a very different cost structure (e.g. you might have to give the channel a significant portion of the sale). This is where having someone on the team that comes from the market and is a domain expert really helps. They should have a real intuition for the dynamics of the market and the value chain you need to align with.
There are many shapes and sizes of VC firms and partners. It’d be a real mistake to assume that they all behave similarly and are looking for the same types of companies. The reality is that VCs typically invest in only 1 out of every 100 companies they see. This is not because the other 99 companies are bad, it’s simply that they do not fit what the VC is looking for. Before choosing firms to pitch to make sure you’ve done your homework on the stage of company they invest in, the geographic areas they are looking at, that they have money to invest, that they are specialists in the type of business you are building and the sector you’re operating in. Once you’ve established what you think is a good potential fit, then research the partners and find that partner who sounds like they would be most interested in your company. Either the partner has invested in similar types of companies (e.g. deep tech, or marketplaces, or enterprise infrastructure, or hardware). VC firms should be thought of as somewhat aligned collections of individual investors. Focus on the individuals to find that partner that best fits you and will be your champion in the firm.
Bad advisors at best slow down deals and at worst can cause funding rounds to collapse entirely. It’s always a mistake to use your family’s trusted lawyer to represent you when negotiating a deal with a VC firm. Use a lawyer that has done it before, that knows what is standard and what is unusual and that can guide you through the process based on their experience of having done it many times before. There’s a real pattern to investments, and it’s a real waste of everyone’s time and money when industry norm terms are disputed by inexperienced advisors. This extends to financial advisors (using esoteric or just plain wrong accounting practises), to mentors who’ve never experienced running or growing a business and basically anyone you rely on for their judgement. Do your own due diligence on their expertise and develop a network of trusted advisors that know the ropes.
Company valuations are both emotive and abstract things in the early stages of company growth. In the first few years of a business there are no real metrics to draw on, no revenues of significance to multiple, no cash flows to discount. Valuations are driven more by comparable valuations of similar companies and the then state of the market (supply of funding and supply of companies to invest in). When negotiating a deal with a VC, optimising purely for valuation is always a mistake. Driving hard for a target valuation that is out of typical ranges will nearly always lead to deal terms that are punitive (e.g. participating preferences, double dips, shares with strange future rights, more aggressive anti-dilution) and make it that much harder to raise the next round, as well as leaving little downside protection for the founders if things don’t go according to plan. Suppress your optimism bias and consider the deal as a whole, where valuation is an important but just one element of the recipe for success you are creating.
It’s incredibly painful if you end up having to chase an individual currently enjoying a 6 month trek across Australia, in order to get their agreement to assign, to your company, any IP they may have been involved in creating while employed as a summer student a few summers ago. Situations like this happen all the time. A normal condition of investment is that all IP is either owned by the company or you have an appropriate license to use that IP. This means that anyone who ever is in a position to contribute IP to the company whether as an employee, an intern a contractor or just a helpful contributor, everyone must assign that IP to the company, or otherwise you do not have clear ownership of what it is that you are selling, and you will not be able to raise finance for the company. It’s a very good idea to keep records right from the outset of all IP used or created within the company and make sure you are fully licensed to use it.
The number one killer of companies in the early stages is running out of cash. The number one reason for running out of cash is you spent too quickly. The number one reason for spending too quickly is being over optimistic about sales and prematurely scaling the company. The unfortunate reality is that 99% of all companies are overly optimistic about their sales, and as a result, a general rule of thumb is to always raise more than you need when you’re in a position to do so. It may be very invigorating to bet the shop on everything working out exactly as you’ve planned, but the smart bet is to build in a healthy dose of contingency. Sh*t happens. Try to ensure you operate at a cash level that gives you some optionality, some ability to take corrective action, when things inevitably do not go according to your plan.
There are hundreds more things that could be listed here, but hopefully some of these resonate and will be helpful to you if you’re planning to raise venture capital. I wish you every success if you are.