Are You Actually Looking for VC Money?

I hear a lot of people say they want to raise VC money but…sometimes they don’t actually know what it means and they’re actually looking for friends and family or angel investors. The terms aren’t interchangeable.

First, “VC” stands for “venture capital” and refers to a firm that has raised one or more funds (pools of money) with the specific purpose of investing in startups. But not all money comes from VCs. Here’s the general landscape:

  1. Friends, family, and fools
  2. Incubators, accelerators, etc.
  3. Rewards and equity crowdfunding
  4. Angel investors
  5. Venture capitalists
  6. Strategic investors
  7. Private equity

Let’s walk through each, but first let’s talk about portfolio theory. Professional investors estimate that every ten companies they invest will have seven failures, two moderate outcomes, and a single home run. That tenth one makes up for all the other losses in the portfolio. Since no one knows which one will succeed, it’s important to invest in all ten in order to make a profit.

Amateur investors only invest in one or two companies, and are therefore way more likely to lose all of their money.

1. Friends, family, and fools: This is exactly what it sounds like. You may just have an idea, and you probably don’t have much revenue and/or user growth (“traction”). These are people who believe in you personally and are willing to risk a bit of capital.

These investors may or may not be sophisticated. Keep in mind that they probably have money precisely BECAUSE they don’t like throwing it away. I like to make sure that I can actually pay these people back if things don’t work out, because money can sour relationships.

2. Incubators, accelerators, etc.: These are boot camps for startups that include training and strategy from people who’ve done it before. They may or may not provide funding. They pretty much always take an equity stake (although at Venture Hive we don’t). These may be structured programs—like the 12-week Accelerator we’re launching next month—or arrangements where you can work out of a space and receive support indefinitely.

You’ll receive mentoring sessions, introductions to investors, and a ton of networking opportunities. You’ll also be invited—and sometimes required—to work out of a shared space.

3. Rewards and equity crowdfunding: Rewards crowdfunding is the Kickstarter and Indiegogo business model. This is different than equity crowdfunding—which just became legal under the JOBS Act—where hundreds or even thousands of people buy actual shares of stock in your company.

Venture Hive is hosting a free crowdfunding workshop with Sherwood Neiss—co-author of the crowdfunding framework used in the JOBS Act—on Tuesday, Sep 13th starting at 8:30am.

4. Angel investors: Professional angels invest small amounts of money in a bunch of different companies—because they understand portfolio theory.

Their initial investment gives them a seat at the table for future funding rounds at successful companies. Smart angels will keep some “dry powder” that they can use to buy more of the winners.

5. Venture Capitalists: VCs are firms made up of successful entrepreneurs who also understand portfolio theory. They look at a ton of pitches but only make a few investments. They’re holding out for the best, so your company needs to be one of them.

The typical misunderstanding, and what prompted me to write this article, is entrepreneurs thinking that VCs want to invest in their idea. Maybe. But it’s more likely that they want to invest in your working business that is already growing exponentially.

VCs are looking to add rocket fuel to the engine you’ve already built.

And they want to believe that you can hit it big. I asked one of my investors about this and he said, “I only invest in companies I think can IPO, because that’s the real win for me. If I can’t envision the IPO then I’ll pass. Granted some of my companies get bought, but I’m always thinking IPO from the beginning.”

VCs also expect your company to take multiple rounds of money. So a VC fund may raise a $100 million fund but only put $1 million into your series A. What happens to the rest of the fund?

Let’s say your company goes on to raise a $5 million series B. In this case your VC fund may put in $2 million and ask you to find other investors for the rest. Your series C may be $15 million, of which they contribute $5 million. So now they’ve put up $8 million of the $21 million you’ve raised.

If they repeat this exercise multiple times with multiple companies they’ll spend the $100 million. But they want to see you succeed with $1 million before they give you more money. They’ll assume you’re one of the seven failures until you prove them wrong.

6. Strategic investors: This is money from big businesses who are interested in your technology. When we were pitching for one of my companies we almost took money from a video conferencing provider rather than VCs. They wanted a way to share presentations over the Web and we were doing exciting stuff.

This is a double-edged sword because these folks often want a seat on the board and can shape the direction of your company. We were told to wait until later in our lifecycle before bringing on strategic investors. So we took the VC money.

7. Private equity: These are later-stage investors who are looking for cash flow. They usually provide an exit where entrepreneurs take money off of the table. In return, the private equity firm takes a controlling interest and does fun things with the balance sheet like piling on debt in order to pay themselves. Founders are okay with this because they get to put a big chunk of money in their bank accounts.

So that’s the funding landscape. Now you know how to sound smart when you’re talking about raising money for your company.

Want to learn how to start and scale a successful business? Join us for the Venture Hive Fall 2016 Accelerator program, starting Sept. 19th, 2016:

It all starts with an idea.

Written by Mike Lingle — Read more practical suggestions for startups at mikelingle.com.