The Venture Capital Playbook: A Guide for Startups and Their Supporters (Part II)

Introduction

Continuing from Part I found here, we will be diving into a more term-heavy post that us here at OpenOcean believe every Startup should know.

This is what will be covered in today’s post:

♻️ The Startup Funding Lifecycle
🤝 Investor vs. Founder Perspective
🎓 Key Terms you should know (located in footnotes here)

How does Venture Capital actually work?

This graphic does a good job in depicting the structure of a VC Fund.

Let’s break this down from the top then we will dissect all of the fancy terms below.

1. Structure: The firm itself is a private investment company. It then typically creates a fund⁸ as a limited partnership with investors while the firm itself acts as the General Partner (GP)¹⁰ managing the fund⁹.
2. Fund: To do this, the firm will typically decide on a fund amount and get commitments from the LPs¹¹ to pool together the full amount. Once enough commitments are made there will be a capital call³ where LPs make their investments into the fund.
3. Investment: The firm then finds, does due diligence⁶ on, sets the deal terms⁴ for, and invests into early stage startups.
4. Involvement: Once investments are made, the firm usually uses its resources to advise and support startups.
5. Exit: After a certain amount of time (usually 5–10 years) the firm hopes to exit most of the companies it invested into through a liquidity event⁷.
6. Returns and Reinvestment: If the firm is able to achieve a successful return, then it can compensate all partners and may decide to reinvest some of the profits into another fund.

🛑 Before moving forward; if you would like to review some additional key terms you should know, click here!

♻️ The Startup Funding Lifecycle

Startups can go through several stages of funding, starting with Pre-Seed funding and progressing to Series A, Series B, and beyond.

Each stage of funding is often associated with specific milestones and investment amounts, that align with the startups growth over time. These can of course vary for each industry, geography, and even each startup. However, the stages of funding tend to stay pretty consistent across the board:

• Pre Seed Funding: At this initial stage, entrepreneurs use their own resources, funds from friends and family, or Angel Investors¹ to kickstart their business.
• Seed Funding: This can vary greatly depending on a variety of factors. In many cases, seed funding can be a startups first round of institutional funding from VCs.
• Series A: Startups that have demonstrated promising potential and need additional capital² to fuel growth often seek Series A funding. This stage usually involves higher investment amounts and investor involvement.
• Series B through E?: As a startup matures and expands, it may seek additional funding rounds to scale operations, expand into new markets, or develop new products. The size, valuation, and dilution⁵ at each subsequent stage vary depending on the company’s growth trajectory. We have seen all kinds of examples here with some startups going to Series E and beyond. Anything after Series C can have good or bad implications. For example, it could be the case that the startup is growing so rapidly that they just need the cash to keep up with growth. Or it could mean that things are not so great and they need a bunch more capital to get things back on track.
• Mezzanine, PE, and IPO: All of these types of funding are less about VC investment and more about getting to an exit or liquidity event.

With each round of funding the valuation of the company expands and so too does the total pie of ownership. This also means that at each round the equity stake of the founders (and other stakeholders) gets diluted.

For those interested in learning more about the way funding works, check out these two great books:
Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld and Jason Mendelson

Slicing Pie: Funding Your Company Without Funds by Mike Moyer

🤝 Investor vs. Founder Perspectives

In the next section we will go over all the pros and cons of going down the VC funding route for startups including all the things that each founder should consider before deciding to raise. Before we do that, let’s first look at it from a purely analytical viewpoint using the perspectives of both the VCs and the Founders with a hypothetical example.

Example:

We have a startup, let’s call it Startup X (no not the new Twitter). Startup X is currently 1 year in. There are 2 co-founders each with 50% equity. They are planning to raise venture capital funding to fuel their growth.

Based on valuations of their market, stage, and other similar startups funded in their space, they believe their company is worth $8 million currently (Pre-money valuation¹²). However, they think that their company could grow to be worth $20 million in the next 2 years, if they have some extra capital to ramp up operations.

They decide that they will try to raise $2 million, which will bring the total value of Startup X to $10 million (Post-money valuation¹³). They may go on to raise more money after, but for this example let’s just stop here.

Starting with the founders’ perspective:

First off, where does the original valuation come from? Let’s assume that it is genuine, that they have a really innovative product and that they have already shown evidence of market demand and have a clear path to enough revenues to make that number make sense. Also, they were both experienced entrepreneurs who left high paying jobs and both invested their own time, money, and resources worth about $4 million total. The rest of the value comes from IP generated and initial traction.

To get to the next level, they need more operating cash and they both agree that $2 million is enough to make that work. It seems like the only way to achieve their goal of getting to that $20 million valuation in the next 2 years. If all goes according to plan, they would still have about $10 million worth of equity combined. Individually, they would be going from 50% of an $8 million company ($4 million) to 40% of a $20 million company ($8 million) in two years. Not bad.

Investors:

The general rule in the VC world is that they want to get 3x return on the fund. So let’s say in this case we have a $50 million fund. Over the next 10 years they will be investing into startups with the hopes of returning $150 million by the end.

Usually 10% of the fund goes towards operations as well. Meaning that with the $50 million, only $40 million will be invested. So now, we have to find a way for that $40 million to get to $150 million or more in 10 years. To make the math easy, let’s say we will invest into 10 startups at $4 million each on average (including multiple rounds if needed).

We are aware of the risky nature of startups. And for that reason, we have to be a bit subjective with our bets.

On average of the startups invested into we can expect / hope for:

⅓ will probably fail. Meaning that they will see no return on about $13 million invested.

⅓ will return somewhere between the invested amount and the total fund value ($13 — $50 million).

⅓ will need to really exceed expectations and return $100–137 million at a minimum.

The chances of that are pretty low, which is the reason for investing into multiple companies. All with the hopes that one will be the moonshot or unicorn that brings the 10x or more return.

Going back to the example above, not only will they want their initial $2 million (20%) investment to turn into $4 million in the next 2 years. But for it to make sense, they need to see the potential of Startup X growing to be a $100 million company by year 10 so they can get a return of at least $20 million.

Wrapping Up

🙌 As startups embark on their journey towards success and VC firms seek out the next transformative idea, this understanding of venture capital becomes an invaluable tool, fostering collaboration and propelling innovation in the ever-evolving world of business. For the final post in our three-part blog series, we will cover these topics below:

Why should/shouldn’t Startups consider Venture Capital?
a. Benefits to Startups
b. Risks and Challenges for Founders
c. How to know if it is the right route

[1]: Angel Investors (Angels) — These are individuals who invest their own money in startups. Angels typically invest smaller amounts of money than VC firms and they may not have as much experience in the startup world. However, angels can be a valuable source of capital for startups, and they can also provide startups with advice and guidance.

[2]: Capital — This is the money that is invested in a startup. Capital can come from VC firms, angels, or other sources.

[3]: Capital Call — This is a request by a VC firm to its investors for additional capital. Capital calls are typically made when a VC firm is investing in a new startup or when a startup needs additional funding to grow.

[4]: Deal Terms (Terms) — These are the conditions of an investment agreement between a VC firm and a startup. The terms will typically include the amount of money being invested, the valuation of the startup, and the rights of the VC firm and the startup.

[5]: Dilution — This is the decrease in the ownership stake of a VC firm or a startup when new shares are issued. Dilution can occur when a startup raises additional capital from new investors.

[6]: Due Diligence — This is the process of investigating a startup before making an investment decision. Due diligence typically includes reviewing the startup’s financial statements, business plan, and management team.

[7]: Exit / Liquidity Event — This is an event that allows VC firms to sell their shares in a startup and make a profit. Exits can occur through an IPO (initial public offering), an acquisition, or a merger.

[8]: Fund — This is a pool of money that is raised by a VC firm to invest in startups. Funds typically have a lifespan of 10 years, and they are then closed to new investments.

[9]: Fund Management — This is the process of finding and deciding on which startups to invest into. VC firms typically have a team of analysts who research startups and identify potential investment opportunities. The analysts will then present their findings to the VC firm’s investment committee (GPs and other senior members of the VC firm), which will decide whether or not to invest in the startup.

[10]: General partners (GPs)— The GPs are the managing partners of the VC firm. They are responsible for making investment decisions, managing the firm’s portfolio, and fundraising. GPs are typically compensated with a carried interest, which is a percentage of the profits from the firm’s investments.

[11]: Limited partners (LPs) — The LPs are the investors in the VC firm. They provide the capital that the VC firm uses to make investments. LPs are typically compensated with a fixed return on their investment, plus a share of the profits from the firm’s investments.

[12]: Pre-Money valuation — The value of a startup company before it receives new investment.

[13]: Post-money valuation — The value of a startup company after it receives new investment. It is calculated by taking the company’s total equity and adding the amount of new money that the company is raising.

🎓 Additional Key Terms you should know

• Convertible Note: This is a type of debt instrument that can be converted into shares of stock at a later date. Convertible notes are often used to invest in startups that are not yet ready to issue shares.
• Investment committee: The investment committee is responsible for reviewing investment opportunities and making investment decisions. The investment committee typically consists of the GPs and other senior members of the VC firm.
• Management Fees: These are fees that are charged by VC firms to their investors. Management fees typically range from 2% to 3% of the fund’s assets under management.
• SAFE & KISS: These are types of investment contracts that are used by startups to raise money from angel investors and venture capital firms. SAFEs are simpler and less expensive than convertible notes⁶, but they also offer less protection to investors. KISS (Keep it Simple Securities) securities are typically easier to understand and less expensive than complex securities, such as convertible notes.
• Share Preference: This is a right that is given to certain shareholders of a company. Share preferences can give shareholders priority in receiving dividends or voting rights.
• Syndicate: This is a group of VC firms that pool their money together to invest in a single startup. Syndicates are often used to invest in larger startups or startups that are located in emerging markets.
• Thesis: This is the VC firm’s investment philosophy. It describes the types of startups that the VC firm is interested in investing in and the factors that the VC firm will consider when making investment decisions.