Common misconceptions of tech venture capital
(A version of this first appeared as an opinion piece in the Australian Financial Review 16 April 2018).
For the past year I’ve been learning about how to setup, raise capital for, and run a tech venture capital fund and it’s surprised me how little people in the tech startup community know about how startups operate, and why. Here are some of the common misconceptions I’ve observed, with the reasons why they’re misconceptions.
All I have to be, is great
The most common mistake among startup founders is to think that venture capital is about backing every great startup, and all you have to do to raise capital is to be great. You’d need infinite investment capital to invest that way, since there is effectively an infinite supply of great startups to invest in.
Instead, most venture funds have a finite size, a start date and and end date, and investors in the fund have an expected return on investment the VC needs to meet or exceed. Which means the VC’s focus is to invest in the best of the great startups, not just every great startup they see. Your goal is not to be investible, it is to be the most investible right now.
You get more investible by proving out more of your assumptions in your assumptions about your target customer, the problems they face, your solutions for them, and the commercial opportunity if you can solve them well. Everything you change from assumption to proof (proof is data over time) effectively reduces the risk for your investors and improves their odds for a great return on investment (which is what VCs are being paid to do by their fund’s investors).
Don’t resent VCs for this – they’re still taking a much greater risk than anybody else other than you, your cofounders and their families.
VCs are always looking for new investments
Some larger VC firms manage multiple separate funds but many Australian VC funds (such as M8vc) manage only one fund at a time. Each fund has a lifecycle, usually lasting between 7–10 years, usually no less than five years and no more than ten.
Most VCs run their funds such that the fund makes most its new investments in the first few years, then ‘follow on’ with additional investment in the more successful of those startups over the years to come. That means most funds are most actively looking for new startups like yours in the first few years of the fund’s life, and decreasingly likely to be interested in you from the middle of their fund duration onwards. Every VC firm will have a different variation on this and it can save you a lot of time if you can find out what funds are currently under management, which are still looking at new investments, and what the fund’s focus is.
Sometimes, if a fund’s initial investments aren’t meeting expectations, a mid-life fund might bust out and place a flurry of new first-time investments. It’s hard to optimise for because they won’t disclose this but look for a bunch of new small investments from a fund you remember announcing it had opened for investment a few years ago.
VCs are unaccountable, have all the power, toy with us like a cat with a mouse, and don’t even care
Some of us may have big egos, but we are not gods (well… some of us maybe suspect we might be gods but are waiting for more data before declaring it publicly.) That may be because what we’re setting out to do is really hard! Just as hard as it is to be a successful startup.
We’re accountable to our customers just like you’re accountable to your customers. A customer of your SAAS startup would be rightly shat off if you pivoted your product in a totally new direction after they’ve paid for a year in advance, right? Well, a VC firm’s customers are its investors.
You’re trying to create a $100M company in five years with a couple of friends? Yeah, that’s tough. As tough as it is for a VC to pick which startups from the hundreds seen each year will be worth $100M in five years, because >90% of the others will fail. We can’t get our customers the investors the returns they’re expecting by waiting until the successful startups are already successful. We have to somehow get good at picking them before they’re actually successful. That’s damn hard and most VCs don’t succeed. So those who do succeed may be a little smug – they’re great at doing something really hard.
If we’re a great startup, they’ll invest even if we don’t match their usual criteria
Investors choose one VC fund over another to invest in because they’ve been persuaded of the value of its investment criteria (often called their “investment hypothesis” or “methodology” to make it sound more impressive and scientific, though sometimes there’s not a lot of data behind it).
The fund’s investment hypothesis will drive the fund’s focus – the range of cheque sizes it’ll write, whether it likes to be the lead investor or to follow other funds, the industry or technology being employed, etc.
A larger VC fund may have several funds under management, each with a different hypothesis. When you’re pitching a large VC firm you’re not pitching to just one fund, so try to learn which most closely matches what you’re pitching and pitch to that.
It’s sometimes possible to front up with a startup so good, doing so well, offering equity at such a low valuation, that you can persuade a VC firm to bend the hypothesis and invest in you even though you don’t meet their criteria, but it’s hard, because they’re accountable to their customer, the investors in the fund. And raising capital is hard enough without trying to make a fund do what it wasn’t set up to do.
If you must do this, the best way is to lock-in another fund whose investment hypothesis you do meet, and try to use FOMO (Fear Of Missing Out) to lure in the other funds whose criteria you don’t meet.
Approaching a fund cold, without knowing their investment criteria, or worse still, knowing you’re not a match but wasting their time with a pitch anyway, is a great way to piss people off, which is never a great way to raise capital.