Speaking the VC language across the Startup/VC lifecycle — PART 1

I recently had the pleasure of hosting a Masterclass at Web Summit all about “Speaking the VC language”, in which I aimed to provide more clarity around the stages of venture capital funding and best practices for successful fundraising. By popular demand, I’ve shared my talking points from the session below…

One of the main challenges we see with very early-stage start-ups (pre-Seed and Seed) is, of course, getting access to VC funds, but also, understanding what’s expected of them when going through the various stages. This is also the feedback that we’ve gotten from our own founders who, even after we have invested, have said that they didn’t fully understand the process of securing VC funding. So, the purpose of my session at Web Summit and in sharing my talking points with you here, is to, as best I can, add some much needed clarity around the entire process. I may have missed something so feel free to reach out with questions/comments.

Note: I also try my best to attend a session every Thursday to answer fundraising questions from startups with StartUp to ScaleUp Club and the most recurring question we get is either “How do I get VCs to talk to me?” or “What do VCs want?”

Understanding VC and if it’s right for you

Firstly, how does VC work?

To be able to effectively speak to VCs I think it’s important to understand how they really work. Seems like an obvious one but I’m often surprised how little clarity there is on this when speaking to early-stage founders. I’ve outlined the basics below:

Who funds a VC?

Limited Partners (LPs) — Endowments, Pension Funds, PE Funds, Other VCs, HNWI, Financial Institutions, Governments. Most of the times, the Partner that you might end up speaking to might have invested a bit in their own fund, but the vast majority (95%+) of capital comes from institutions that partners have a responsibility towards

How long does a fund last?

Usually 10 years — 5 years for investment period, 5 years for follow-ons/exits. If a fund has been created 6/7 years ago, it is very likely they don’t have capital to invest in you.

How does a VC make money?

Management Fees: 1.5–2.5% of total amount raised per year. This is meant to be used for operating costs, like salaries, legal fees, marketing and others.

Carry: usually, 20% of profits. This is where employees (from Partners to Associates) make money individually. LPs will need to first get returned all the money they invested and, only then, will the General Partner (GP, or the ‘fund’) will start having a fraction of what is left — very similar to liquidation preferences for startups

How many investments do they make?

Varies between funds, and decreases as they invest in more mature companies

Who makes the decisions?

Usually, this is at Partner level, and sometimes, it includes external members. However, you might have your first discussion with an analyst or an associate — more on that later

What do VCs require from founders?

When VCs invest, they not only get shares but also consent, voting, and information rights, liquidation preference and growth. Familiarize yourself with these terms!

Next up, you want to think about how you want to raise money and if you need to raise VC money.

It’s important to note that VC funding might not be right for everyone, and that there are other ways to raise. But if VC money is your chosen option, you need to be excited about going on a steep growth trajectory, and be comfortable with having to eventually exit the business.

The graph below shows how much the average founder needs to raise and how much they can expect to sell their business for, depending on whether they exit through M&A or an IPO. A founder that has its company acquired by another company usually needs to raise almost $30 million and can expect to sell for just over $150 million, while an IPO exit requires, on average, more than 5 times the amount of capital for only 3 times the return.

Source: Crunchbase

The above is even more interesting if we take into consideration a founder that only decides to raise an initial round to get the business going and sells for a smaller amount. Bear with me through the exercise:

Source: Techcrunch

The average startup usually has about 1.85 founders, and it will take them several rounds to get to an exit. For an exited company, you can expect on average 25% dilution, over a few rounds, meaning that at the end of an exit, after paying all the investors their liquidation preference (i.e. the money they originally gave you) and the amount respective to their ownership, you’re left to split the total for the 1.85 founders that own the rest of the business (very simplified). A very back of the envelope calculation shows that, usually, founders are better off with raising less capital and actually selling for a lower amount and still beat the returns of a founder that took VC money.

While it might appear that you should never raise VC money, there are instances where this is exactly what you should do. Let’s dive into the why.

So, should you raise VC money?

One of the main questions I ask the hundreds of founders I talk to every year is “Why do you need to raise VC funding?”. A simple question, but that most often doesn’t have a proper answer other than a form of “because it is cool”. But there are very valid reasons on why you should or could raise:

Product
You have something that is unique in the market, with a Unique Selling Proposition (USP), but need help properly commercialising it (product-market-fit).

Team
You and your team (co-founders) have a set of skills which comes with expertise in the industry, technical capabilities and a drive to disrupt incumbents.

Market
You have found a particular problem that doesn’t have a good solution and customers are demanding it — you want to conquer it before anyone else. (Do not find a solution for a problem that does not exist!)

These three criteria will be most of what early-stage VCs will be looking for. This is an answer to the “why” you need VC funding, but “what” will you use it for?

Tech development
While the product is great and some people will pay for it, it needs additional development to be best in class.

Fulfilling a Bold vision
You make VCs think you’re crazy with how ambitious you are. In my opinion, if you start with a small vision, you will never get there. And going after a bold vision required bold additional team members

Company evolution
You have accomplished a lot so far, but the next stage involves developing new processes, customer success resources, admin, etc, etc. This all costs money and you’re competing with larger companies. You don’t want to lose customers because you weren’t prepared.

The startup/VC lifecycle

So you’ve reach out to a few funds and they want to talk. Now what?

First let’s understand the startup/VC lifecycle and the various touchpoints from your first meeting to exit (there will be many more than mentioned here but it gives you an idea of the key steps).

What to expect on your first call/meeting

• Most likely, a meeting with an Analyst (or an Associate, if you’re lucky).
  You will be asked about your team: who’s part of it, what roles, why you, how did you meet.
• Expect some odd questions, such as what do you do during your time off?
• Competition is key — most VCs are thrown off by founders that saying ‘no one else is doing it’. Most likely, they are, you have to prove why you’re better.
• They will ask about traction.
• The VC has all the power here and you need to prove to them that, out of all the opportunities they have access to right now, you are the best option.

So how should you prepare for the first meeting?

My advice is to…

• Be nice to everyone. An analyst might be the driving force behind your investment and, although Partners will be the most likely to vote, VCs at all levels are known to be quite vocal and will defend their deals if they believe enough.
• Make sure you have an equity story. This means that you need to explain what you have done up until this point and what you are yet to achieve. And why now is the right time to back you.
• Don’t get upset about odd questions. Most of the times, VCs like to test how you react to different situations.
• Be honest about what you know, what you think you know and what you don’t know (but are keen to find out).
• Find your own definition of traction. This is tricky about early-stage startups and usually boils down to monthly recurring revenue (MRR). But MRR isn’t everything and doesn’t apply to all industries — VCs want to see some proof points that great things are about to happen
• Practice reverse-pitching: why is this VC right for you? Make sure you know the VC and what they do before you even book the call.
• Practice pitching. Come up with a list of your top 100 VCs and start from the bottom. By the time you reach your favourites, you’ll be ready.

So now you’ve been through due diligence and you’ve agreed on a term sheet. Next up is the Investment Committee for final approval…

What to expect from an Investment Committee (IC)

• It can be short, but most likely, prepare for a couple of hours in front of a lot of people you don’t know.
• A lot of the questions will be very similar to what you’ve been asked before. (Which can be annoying…)
• There has been a ton of due diligence work done in the background (by this I mean, a lot of the investment team involved). This can include but is not limited to scenario analysis, customer calls, expert calls, deep dive research, among others
• You will be quizzed on new things you never thought mattered
• Their answer might come 5 minutes after the call or a few days later. If you’re lucky it might take them 30 mins.

What to prepare for an Investment Committee (IC)

• Do VC due diligence! You might consider it to be odd, but most VCs will respect founders much more so if they reached out to portfolio companies to understand what their fund is about.
• Again, don’t get thrown off by odd questions or even, by the same questions you’ve answered in the past 5 meetings. Consistency is key
• VCs intend to invest their investors money and will make sure they can remove as much risk as they can. While VC is not rocket science, don’t think it is just throwing money at cap tables.
• Make sure your demo is flawless. Remember, VCs will hang onto anything to say ‘no’, so every detail counts
• Having a proper data room is imperative. Best start-ups have a ‘sample’ data room to entice investors

All being well, you will receive positive news following the IC, and you’ll embark on closing processes…

What to expect when closing the deal

• If a decision is positive, you will receive a term sheet. This will outline basic commercial terms.
• After the term sheet is signed, you need to make sure the rest of the round is ready to go, because VCs will expect to go into legal paperwork as soon as possible
• ‘Legals’ typically involve a plethora of documents — investment agreements, articles of association, ESOP, service agreements, compliance, side letters
• People will fight over menial things. Who sits on the board, who has a certain class of shares, investor thresholds, petty cash, even D&O insurance

How to prepare

• INVEST IN A GOOD LAWYER — lawyers are expensive but, if chosen properly, will save you so much time that could be spent running the business. If I look back at all the rounds we’ve invested in, the smoothest ones involved great lawyers for every stakeholder involved
• You will have to pay for legal fees. Be smart about it and don’t accept to pay for everyone’s — only the lead VC and more relevant investors should be entitled to this
• Make sure you know how to understand the terms and how to pick your battles. The two main issues you should have to discuss at this stage are founder vesting and board composition

Great, now you’re a portfolio company! But what does that mean and what’s expected of you?

Stay tuned for Part 2 to find out…

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