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1. Why is startup funding so important?

Building a company is hard and often requires a lot of investment.

In the beginning, you need to build an MVP based on your original idea and find your first customers, which might require you to hire your first developers.

Later, when you have a great product-market fit, you might need to build a sales organisation in order to catch the market opportunity. And let’s not forget about the infrastructure costs, development costs and marketing costs along the way either.

All this is to be paid before you can make any profit.

In fact, throughout the entire lifecycle of a business, you are required to make investments today for profits tomorrow. Without them, your business is unable to grow. Investments are the fuel of your business.

At some point, you will be profitable enough to save enough cash reserves to be able to pay for those investments, but not from the start.

In fact, not having access to the required cash is known as one of the key reasons that startups fail.

Startup funding is the tool that enables you to bridge that gap between investments and profitability and get the necessary cash reserves. That is why it is so important.

A. What are the wrong reasons to look for startup funding?

In short, if you are able to maximize the potential of your business without ever taking outside funding, then you should.

Startups and its investors have become popular in modern culture. A big part of it are the public deal announcements with lofty valuations. They speak to the imagination of every entrepreneur and are often seen as a measure of success.

Convincing investors to believe in your idea and your ability to execute is certainly a milestone, but it is not a measure of business success.

The true measure of success is the value of your share of the business, the success of your customers, and the impact on your employees.

Every time you take outside funding, you are either selling a share of the business (equity) or making additional financial costs (debt) to serve your current needs.

Don’t get misled by the announcement of startup funding rounds. With these types of deals, the devil is in the details (the terms and clauses).

Look at funding like you look at a tool. It’s one of the many tools you might need to use in order to maximise the potential of your business.

B. Know how much funding you need

Once you have decided that you need funding, it is very important that you decide on how much you need.

This process is also known as calculating your startup runway. For a detailed look at how to calculate your runway, take a look at Part One of our Masterclass, “How Long Should Your Startup Runway Be?”.

Calculate your startup runway

As a startup, you are often running out of money. It is key to understand what this means exactly. One week or twelve months… how long can you continue to work towards your goals without having problems to pay the bills?

In order to calculate this, you need to have a good understanding of your monthly cash costs and your remaining account balance.

Ideally, you also continue to grow your business, which probably means that you are required to even make additional costs. Make sure to include these when calculating your runway.

Now that you have a view on how long you can continue, it is time to take a look at how long you should extend this runway by taking startup funding.

Extending the runway

Deciding on how long to extend the runway is deciding on how much funding to raise and, in essence, this is a balancing act between two key factors.

On the one hand, you do not want to raise too much capital too early, as your business should improve in the near future. This means that if all goes well, you should be able to raise funding at better terms down the road, or even better, you might not have to raise funding again.

On the other hand, every time you need to raise funding for your startup, there is a great chance that it won’t go as planned. Either there is not enough interest in your business or it is taking too long. If you don’t raise enough capital now, there is no guarantee that you will be able to do so in the future. Additionally, your business might hit a rough patch or you might be behind your planning at that particular point.

If you force us to make you a recommendation, we would tell you to aim at a startup runway of something between 12 and 18 months. Of course it also strongly depends on what you can get at decent terms.

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First, what is a term sheet?

A term sheet is a written document that includes the important terms and conditions of a deal. The document summarizes the key points of the agreement set by both parties, before actually executing the legal agreements and starting off with time-consuming due diligence.

The document will later serve as a template for the legal teams to draft a definitive agreement. It is, however, non-binding, as it reflects only the key and broad points.

For example templates of term sheets take a look at what Y Combinator and Capital Waters have shared.

 

What is the term sheet negotiation about?

As an entrepreneur, you try to raise the needed capital while retaining upside, keeping control and limiting downside risks.

The term sheet is all about dividing the upside and risk between parties. To do so, there are a number of standard clauses that can be included. Any situation might differ, but understanding these clauses is already a good first step towards making the right decision.

Never forget that this document is also a key moment to see who your investor really is. Depending on what they push for or don’t, you can get a good feel for where they stand.

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If you’re looking for advice on how to build up your slides, check our previous post on how to make the perfect pitch deck. 👈

If you’re ready to nail the delivery of your investor pitch, read on!

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To whom and why

Before making any presentation you should always understand your audience and clearly define the purpose of your presentation.

Understand your audience

Understanding your audience will be the first step towards convincing them.

Expect your audience to have the following characteristics:

• Limited time for your pitch
• Looking at several pitches every day
• Looking for opportunities by finding clues of successful businesses (investor mindset)

Therefore your pitch deck should aim to offer those clues, by answering the most important questions an investor has. And it should do this in a clear and concise fashion.

Work with a purpose

When you go about creating your pitch deck, you should do this with a clear purpose in mind.

As we discussed in our article on VCs, investing in startups is a very uncertain business. Most investments will go nowhere and the industry is heavily reliant on a limited amount of big wins.

So remember that this is what the investor is looking for. Your presentation should convince your investor that your company has the potential to be that next 10x company.

Your pitch deck is however not the sole document that will be used to make an investment decision. Refrain from including every possible detail and metric. This document is all about getting the investor excited and setting yourself up for further discussions.

Typically investors are looking for the following items in your pitch deck.

Market opportunity

The upper limit of your company’s potential will always be the addressable market.

So before anything else, you need to convince the investor that there is a market for your product and that one day you can generate a lot of profit from that market.

A good market opportunity is typically a combination of the following factors:

• A relevant problem that needs to be solved
• Existing products/companies that do not provide the right solution
• A timing component that enables a new solution (regulation, customer behaviour, etc.)

Ability to execute

Once the investor is convinced for the market opportunity, the question arises whether you are the right team for the job.

Investors are looking for teams that are able to execute. Determining the strength of your team is a crucial part of their investment decision, as they would rather invest in an A team executing a B product than the other way around (trusting an A-team to eventually move to the right product).

Therefore show off your team, the team’s track record, and your wins so far, to highlight your ability to execute.

Scalability

Once a market opportunity is defined, it is also a matter of being able to deliver on the opportunity.

An important indicator of success for investors is the ability to successfully acquire and grow customers in a scalable manner.

Make sure to focus on the ability to scale both in terms of product and business model.

Competitive advantage

Any big opportunity will draw several competitors.

Investors are looking for startups that can compete in the long term. The first step in doing so, is understanding and correctly assessing the competitive landscape.

Show your knowledge of the market and highlight your unique competitive advantage; whether it is a network effect, hard to replicate technology, or the ability to out-execute everyone else.

Take a look at what investors see as sustained competitive advantages, or “moats” as Warren Buffet calls them.

Positive momentum

Finally, investors want to see as much evidence as possible that the business will work out. A good start is a lot of positive momentum.

Try to show your momentum by your results in building a team, creating your product, getting customer traction, and of course growth in sales.

 

Prepare the pitch deck

Now that we clearly understand our audience and the purpose of the pitch, let’s become more practical.

Form

Before diving into the content, a few words on the form of the pitch deck.

Limit the number of slides

First of all, people are not good at understanding more than 10 concepts at a time. Additionally, they are also not very focused.

Make the most of your audience’s attention span and limit yourself to the key concepts and points that will truly make a difference.

We recommended having around 10 – 15 slides and only one message per slide.

Don’t be too dense

As people limit the number of slides, they also tend to cram more information on them.

Don’t. Try to boil down your messages to the utmost important items.

If the investor walks away after having read your slides, what are the key things that she should know? Make sure these points are made and leave out any distractions.

Tip: Use clear and concise wording, refrain from overusing examples and data points. A great way of limiting yourself is by using a big font (30pt).

Formatting

While this is certainly not about who is best at PowerPoint, the look and feel do matter.

Almost all companies also rely on a brand and an associated feeling to sell their products.

As you are trying to convince an investor that your company can win, this brand is also of importance. Therefore, you should protect your brand at all times and especially during an investor presentation.

Tip: Using a good colour scheme and a clear font goes a long way.

Content

Now that we have settled on the right form, let’s dive into the content of your pitch deck.

What better way to illustrate this than by using the AirBnB pitch deck.

0. One line summary

Aim to define your company in a single declarative sentence.

Don’t list features of your next product. Instead focus on communicating a clear mission or purpose for your company; one that should last for many years.

This will be harder than it looks and it should be.

1. Problem and opportunity

What problem are you solving? What pleasure are you providing?

Not only define what you are trying to solve in your pitch deck. Also define for who, how it is being solved right now, and what the major shortcomings are of the current approach.

2. Define your solution

Now focus on your business and product.

Clearly, illustrate how your business will provide the right solution and why this is awesome for your customer.

Do you save people time, money, generate revenue for them, or provide them with much-needed entertainment?

Make sure the investor fully understands the pitch to your customer and why this is so compelling to them.

3. Why now

A lot of great companies had a great sense of timing when starting out.

Perhaps there is a recent technological breakthrough, change in regulation, or a change in customer behaviour that makes your business a possibility today.

If you can convince an investor that you are part of a strong wave, you will present a very compelling investment case.

This slide is not always easy to include. If you can, definitely do it, if not, no worries. As you can see this slide was also not included in the Airbnb pitch deck.

4. Market potential

Clearly identify your customer and the associated total addressable market.

Generally, there are two approaches to find your total addressable market:

• Top-down: Start from an existing market from which you expect to take a piece
• Bottom-up: Start from possible clients willing to spend a certain amount on your product

Try to leverage existing research. Company filings, equity research reports, and whitepapers by consultants can be great resources.

If you create an analysis yourself, make sure that it is easily verifiable. Explain your estimates, provide details for your assumptions, and source any data points that are used.

Put all the information out there for an investor to come to the same conclusion.

For example, if we make the claim that our CRM software for small B2B businesses is a significant improvement over the existing software, then we can take that market as our total addressable market.

5. Competition and alternatives

For almost every problem your customer will have a number of possible solutions.

Make sure to understand the entire competitive landscape. If the investor can find more relevant competitors with just a Google search, it will reflect badly on you.

Provide a good overview of who the direct competitors are, what the adjacent markets are, who the possible entrants are, and what the possible substitutes are.

Also clearly define in your pitch deck where you differ from others and why you should win this competitive battle.

Refrain from doing a feature by feature comparison and instead focus on differences on the level of strategy and focus, things that last beyond the next major product update.

6. Business model and strategy

This section is all about explaining why you are potentially running a hugely profitable business.

Explain to investors how you plan to make money. Use current unit economics but also clearly indicate how they can change in the future. You need to sell them on the future potential and use your current metrics to establish confidence.

Start off by answering the following questions:

• How have you acquired customers in the past and how will you in the future?
• Where did you find your previous customers and what have been the associated costs (acquisition costs)?
• What are your conversion rates?
• How many customers continue working with you (or the opposite: churn)?

Also clearly illustrate the plans for growth going forward.

Will you increase your sales and marketing team, penetrate new markets, or upsell current customers?

This is the place in your pitch deck to clearly and concisely explain it all.

7. Team

It is time to show your team.

Investors are looking for the right team to execute. Include bullets on previous achievements and complementary skills to strengthen your point.

You can possibly also add key positions that you are looking to fill.

8. Metrics and historical financials

Depending on the stage of your company and your recent performance, it can make sense to include some metrics and historical financials in your deck.

The key thing to show here in your pitch deck is your positive momentum and traction.

This slide should not just be a copy of your spreadsheet but should grab the attention of the investor to the relevant line items or metrics that prove your thesis.

If you decide to use a graph, make sure that it is well formatted to support your point, but refrain from being too creative with the axis.

9. Plan

Now that you have hooked investors, it is time to explain why you are raising capital and how you will use it in the following period.

Items to include are:

• The period during which the money will be put to use (e.g. runway)
• Product and business milestones/goals in this period
• Key hires to make

As a way to support your plan, it can be good to include high-level financial projections.

Make sure to cover the same period as the period for which you are raising capital (e.g. 12 – 24 months) and support your numbers by clear projections on the number of users and customers that will be required.

Everyone knows that financials are a shot in the dark for startups.

A well structured financial projection can however give investors an idea on where things are headed, what the key levers are, and how grounded management is.

10. Round

Finish off by going into detail on how much money is being raised, whether there are any previous commitments, what the timing is of the round, and any other relevant round details.

 

Other documents to prepare

Start by creating the pitch deck, as this will be the main story that you are trying to sell to investors.

Once you have settled on your pitch, you can leverage this work to create the other necessary materials.

Other materials:

• Teaser
• Due diligence documents
• Legal documents

Tip: Structure these documents in directories in a shared folder, make sure to have clear naming, an index file, and the right permissions.

Teaser

The ideal outcome of a teaser is that the reader wants to see you pitch.

Additionally, it serves the following purposes:

• Enables you to pitch to the investor
• Warms up the investor before your pitch
• Enables the investor to share your story within the firm

In order to accomplish this, the document should be a summary of the key aspects of your company in an easy-to-read document (A4 page | Long email).

Make sure to highlight the following key aspects:

• Product: Explain the product and why it matters (Problem / Solution)
• Market: Highlight the market opportunity (Addressable Market / Timing)
• Team: Show the execution team

As you can see the content of the teaser is highly overlapping with your pitch deck.

Due diligence

Your pitch deck is all about convincing investors to take an in-depth look into your company for future investment.

Now, as investors do this, they will come back with a bunch of detailed questions.

You can be prepared for this and cover 90% of their due diligence questions upfront. This way you not only speed up the process, but also leave a good impression.

Tip: As you are in a due diligence process, try to keep control of your documents by limiting who sees them at what time.

Product documents

A key aspect of the investor’s due diligence is to better understand your product and the associated technologies.

You can prepare the following documents to support this discussion:

• Technology outline: Provide detail on the technology (PDF, Word)
• Product outline: Provide detail on the product (PDF, Word)
• Product development outline: Provide detail on the development roadmap (PDF, Word)

Key metrics

A lot of investors will also do basic spreadsheet modelling before making an investment decision.

This is not to forecast your business, but this effort allows the investor as an outsider to understand your business and the key levers for success.

In order to support this effort, investors might come back with a lot of metric related questions.

For a start, you should prepare the basic historical financials on a monthly basis:

• Revenue
• Cost of goods sold
• Customer acquisition costs
• etc.

Depending on your sector, you should also prepare a detailed analysis of the relevant metrics.

Generally, the investors will be looking for additional details on three key items:

• Cost to acquire a client
• Sales value of a new client
• Cost to serve a client

Depending on your sector, this can result in some form of cohort analysis, customer acquisition analysis per channel, unit economics analysis, etc.

Marketing and sales

As part of your pitch deck, you probably made some claims on future growth.

These needs to be backed up by a solid marketing and sales plan.

During due diligence, investors might request more detail, so prepare the following:

• Marketing plan (PDF, PPT)
• Sales plan (PDF, PPT)
• Sales pipeline (XLS)

Financial plan

Finally, investors also want to understand how it all ties together and how you plan to use their investment to create value in the next 2-3 years.

Therefore, it is important to prepare a 3-year financial plan that builds from your sales and marketing plan and provides a detailed overview of future spending.

Make sure to include the following in your spreadsheet:

• Historical financials
• Revenue, COGS, CAC, etc.
• Customer growth
• Personnel growth
• Product development costs

Legal documents

Typically these documents come into play once you have signed a term sheet, but it is best to have the preparations done beforehand.

Make sure to have digital and physical copies of the following:

• Contract signed by the company
• Previous investment agreements
• Articles of Association

When preparing these documents, make sure to separate them as much as possible. As with the documents shared during the Due Diligence process, it is best to keep as tight an access control as possible.

Or check out this summary of the Startup Funding Masterclass.

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Before we explore how to find the right investors, let’s first take a moment to decide: is it time to go into fundraising mode now?

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Before starting, let’s freshen up your knowledge on the differences between shares and options. When discussing equity ownership in the context of employees and advisors, we are often speaking about granting stock options versus actual shares.

For those of you who have a good understanding already, feel free to move on to the next section immediately.

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Pre-seed

You just spent 3 months tinkering on your initial idea and convinced one of your friends to become a co-founder. Guess it’s time to go official and register your company. 🖋

Beyond picking an awesome name 😇, there are a number of decisions that need to be made to ensure your business is future proof and attractive to investors.

So go ahead and read up on the following items:

• Incorporation structure
• Licensing requirements
• Intellectual property
• Option pool for future employees

Your pre-seed round used to end right here, but as competition has been increasing at the next startup funding round (Seed), so have the expectations been growing.

Before being able to properly raise seed funding, expect to need a well-developed minimum viable product (MVP), a strong core team, early traction and great customer experiences showcasing the opportunity for your business.

Your pre-seed money will hence be used to get to the next startup funding round.

Investors in the pre-seed round are typically friends and family or business angels, with investments ranging from $50,000 – $200,000 for a 5% – 10% equity stake. They provide you with enough runway to develop your MVP.

 

Seed round

Did you just launch your minimum viable product? Did you manage to get your first users and customers? But did you also realise that it takes more capital to truly develop your initial product and prove your product market fit, so that you can really take off?

Then this is a great time to be reading about seed financing.

In the seed funding round, you raise capital from family and friends, incubators, angel investors or/and venture capitalists. This finances product development and initial market entry, with the purpose of proving product-market fit and initial growth.

Investments typically come in the form of equity or convertibles, so make sure to read up on these differences in our post about types of startup funding.

When is the right time to talk to investors?

Always, sort of. 😉

It is never to early to establish a relation with investors by having casual conversations on your business, the market opportunity, and what they are looking for in investments. Use this casual contact as immediate feedback that can be used at the time of fundraising.

Refrain, however, from full-blown pitches until you have gathered enough evidence to really convince them. Once you are ready, remember that investors need to be convinced that your idea is compelling, that there is an opportunity, and that you are the right team to execute.

For some founders, a story and their reputation might be enough. But for most of us, it will require a well-developed idea, a good understanding of the market opportunity, a minimum viable product, and some initial traction (take a look at comparable startups that raised funding as a benchmark).

Once you have all those ingredients, it is the right time to pursue an investment.

How much should I ask for?

In an ideal world, you would raise just enough money to reach profitability, while not giving away too much equity.

But this will hardly ever be the case, as for most startups there will be a need for a lot of follow-up rounds before reaching a self-sustaining growing business. 🤑

The key factor in deciding how much to raise is finding out how much you will need to get your company into the next state. Be it initial profitability or your next funding round; it is crucial to find out how much money you will need to get there.

So go and take a look at our following article on how to calculate your startup runway.

Make sure to raise enough to get to your next startup funding round without giving up too much of your company. A typical range is somewhere between 12 and 18 months.

There are significant differences in the amount raised by companies at this stage, but expect rounds to range from $50,000 to $2,000,000.

How should I value my company?

Let’s be real, there is no way to determine a price for your startup at this point. Without the availability of data points, you can’t project sales.

It is also difficult to value the skills of a team that hasn’t delivered yet on such a project. Finally, every investor will value the combination of skill and opportunity versus product and delivery differently.

Focus on raising the right amount of capital to get you into the next startup funding round and try to get this money on the best terms. 💰

Shop around, talk to several investors, and let the market set the valuation or price cap (in case of a convertible note) of your startup. Additionally, take a look at similar startups at your stage for a reference point in terms of valuation.

Realistically, you should expect to give away between 10% and 25% at this point.

This round is all about getting the necessary funding to build your product, to figure out your product-market fit, and to search for that scalable growth channel.

As an added bonus, a good investor can deliver great advice and share his network, while you are building your business as fast as possible.

 

Series A

Once you have found your product market fit, have developed a scalable and repeatable product, and have laid the foundation to create scale in your sales, it is time to super-fuel your growth.

This is where a Series A comes in.

In order to succeed in this startup funding round, it is all about convincing potential investors that your company can become a business with long term profit potential.

Expect investors to look at industry-relevant KPIs and metrics with great focus on your initial revenue and user growth to support their investment thesis.

The capital raised can then be used to truly optimise your product and business for scalability while growing your team to generate extraordinary demand. Following your Series A, investors expect to see exceptional growth.

Typical investors for this round are venture capital firms, with Accel Partners, Sequoia Capital, Benchmark and Greylock amongst the biggest names. But other profiles such as family offices, (super) angels and corporate ventures arms might also compete.

This is also the start of some political moves as you will probably need multiple investors on board.

One of those will take the lead, so make sure to select an investor that is truly bought in, as she will be an important supporter throughout the lifetime of your startup. Initial investors that do not participate in following startup funding rounds is never seen as a great sign.

Round sizes differ significantly per geography as market size matters. Expect EU rounds to be around $1m – $5m, US rounds to range from $2m to $15m, and Chinese rounds to go even beyond, for a 20% – 35% ownership stake.

 

Series B

The B stands for growth. 😂

After making your startup a growth machine with the Series A funding, it is now all about growing the company fast enough to deliver on the generated demand.

Investors need to understand how you can deliver at least 100% revenue growth yearly. They also need to understand where the opportunities are to further scale your business across markets and geographies.

The capital can then be used to grow your team across all key aspects (tech, sales, support, marketing), to enter additional markets, and to really scale up your business.

It is now even more important to find the right group of investors. They should help you to grow your business to be ready for the stock market and/or an attractive acquisition target.

This drags most companies towards VCs, as fueling aggressive growth is certainly in their field of expertise. But there is also a recent trend of bigger investors coming down to these rounds. So don’t be surprised to hear that mega players like Tencent, Softbank and Naspers, or even private equity and hedge funds, get involved for the most promising names.

At this point, investment sizes vary widely, but a range of $7m – $10m for a 20% – 35% stake is often cited as a normal round.

 

Series C or more

We’re entering the big leagues. 💪 From now on it is a race to the exit.

Having made it here is quite exceptional. You are probably running a startup valued at over $100m at this point, with several years of aggressive growth behind you.

There is a clear plan now to the exit.You have probably also had discussions with investors and advisors on what it takes to become a successful public company.

These startup funding rounds are all about optimising your company. You can do this by aggressively growing in key markets, gaining scale to establish yourself as the dominant player in your industry, and hiring mature leaders to bring your company to the next level.

As you have now gone from being a potential acquisition target to a potential acquirer yourself, you might also consider strategic buyouts or several talent acquisitions.

This is also an incredibly demanding funding stage. As rounds go from $50m to way beyond, you should expect grueling and long due diligence processes with a lot of parties involved.

At this point, there is a wide spectrum of investors looking at your deal. Beyond venture capital, expect large corporate investors, financial institutions, private equity, and hedge funds to take part in these rounds. Everyone is looking to get a piece before a potential exit.

With the abundance of capital interested in high growth startups, it is now becoming increasingly attractive to keep raising in private markets while delaying a potential IPO. However, as startup funding rounds keep being added, the investors participating are also increasingly similar to the big ticket names that you would expect to participate in an IPO. They will have the same expectations for corporate governance and due diligence.

 

IPO

Welcome to the grand finale? Kind of.

An initial public offering (IPO) is the process of making shares of a private company available to the public (on the stock market) in order to raise capital. In doing so, the company unlocks a vast amount of potential funding.

Why would I consider an IPO?

Access to more funding faster

Lately, there is a vast amount of funding available in the private market due to the recent success of VCs, the rise of mega funds like Softbank, and the entry of public investors like Fidelity. This is however still small compared to the available capital on the public market.

And it’s not just more funding, you can also access it faster. Being a successful public company allows you to raise additional funding virtually overnight through a rights issue.

Shares as a transparent currency

The company’s listing will provide you with a transparent valuation. This allows you to easily use shares as part of the compensation to the acquiree when doing acquisitions.

The transparency also allows you to easily compensate existing and future employees through the use of stock grants or options.

Liquidity to existing investors

Becoming a publicly traded company provides what is called a liquidity event to existing shareholders. Following the IPO and the subsequent lockup period, investors and employees are able to sell their shares as part of daily trading to monetize their stakes.

This allows investors to close out their positions and return cash to their Limited Partners (more on Limited Partners in this article about workings of VC funding).

Institutionalisation to enterprise standards

A public company is required to comply with additional regulation, increased reporting and improved corporate governance. This all leads to a new level of transparency, trustworthiness and in some sense stature.

Gaining this institutionalization will allow for easier access to debt markets and can be an asset when trying to close larger clients.

What holds me back?

Simple, being a public company is not always easy and it is expensive.

While in the private market you typically deal with professional investors who should correctly assess any risks involved, the public markets are different. In principle, this is the moment that anyone can buy your shares.

Therefore, there are a lot of protection mechanisms to protect such investors, which leads to regulation and requirements.

I guess we all remember the famous “funding secured” tweet from Elon Musk. He would have been in no trouble if he had done the same without being public. Once you are, however, a tweet like this becomes an official release of information. It should always be factual and fairly distributed among the public.

This all means that you should expect to add a layer of complexity to your business. You will need to invest in corporate governance, compliance to security laws, additional reporting, and investor relations.

The process of going public is also a monumental task. Processes can easily take six months up to more than a year. Given the importance and public nature of the event, the top management will be super involved.

Finally, being public introduces a new level of scrutiny. The quarterly or semi-annual reporting cycle can put tremendous pressure on your company to perform in the short term. You also lose the ability to choose your investors, so you better have a strong team to weather the storm of bad performance and unhappy shareholders.

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Who does a venture capital firm work for?

Like all businesses, venture capital firms have a client, who is willing to pay for their services. And just like most businesses, venture capital firms compete based on the quality of the products that they provide. Understanding these two key components is the key to understanding the industry.

The investors of the investors

A venture capital firm sells an investment fund to (usually) bigger investors. 💸

Just like other investment funds in the financial industry, the funds have an investment period (2 – 4 years) during which the money is invested and a final closing date (10 years after opening). After this, the fund is closed, all assets are sold, and the money is returned to the clients.

It is mainly the mandate, to invest in early-stage private companies, that sets VC funds apart from other investments funds.

The quality of the fund is determined by how much money is returned to the clients at the end of the fund. Next to that, it’s also defined by the specific way they achieved this return (through one investment vs many).

Limited Partners

The clients are the so-called “Limited Partners”, who provide the capital for the investment fund. They of course expect to make a significant return at the end of the fund.

Not unlike regular shareholders, Limited Partners have no decision-making authority and no liabilities to the fund when things go bad. They only provide the money.

Limited Partners are typically large investment institutions. These can be university endowment funds, pension funds, insurance companies, sovereign wealth funds, wealthy individuals, or large financial institutions.

For those large professional investors, venture capital is an asset class just like stocks, corporate and sovereign bonds, or private equity. It is important for them to be invested across all asset classes. They actively look for diversification and create a return in excess of their benchmark.

Beating the benchmark

The key thing to understand about those benchmarks is that all these professional investors have access to all kinds of investment opportunities. This includes the easiest investment of them all: the stock market (a.k.a. the benchmark). If they go through all this trouble of investing in a VC firm, and are willing to take this additional risk of investing in early-stage companies instead of simply investing in the S&P 500, they do expect some benefits for this additional risk and work.

Starting from the S&P, which is commonly understood to return 7%, many LPs will look to generate excess returns of 5% – 8% from their VC portfolio, hence 12% – 15% per year. 📈

Applying this expected return of 12% per year to a 10-year period shows that the LP is looking for the venture fund to return > 3.0x the size of their fund at the end of the fund.

1.12^10 = 3.1 or 1.15^10 = 4.0

Management fees

In return, the venture fund management is paid a fee structure.

A commonly referenced structure is 2% and 20%. It refers to a base fee of 2% per year on the size of the investment vehicle (i.e. $100m fund results in $2m p.a.) and 20% of all money returned in excess of the invested amount (i.e. $200m return for a $100m fund results in a $20m fee).

In summary, a venture capital firm sells an investment fund to professional investors who expect a return of 12% – 15% per year or 3 – 4x their money back at the end of the fund.

If you are looking for more details on the economics of the VC industry we recommend this article from Andreessen Horowitz.

 

How do venture capital firms deliver their returns?

Now that we know the goal, the question is how venture funds work to achieve it.

A good indicator to understand how VCs are currently looking to deliver to their clients is by looking at what they did in the past.

This means looking back at the distribution of previous VC returns. And as Peter Thiel noted, these returns are incredibly skewed. They do not follow a normal distribution, in fact, they follow a power law distribution.

What does a Power Law distribution mean?

Have you ever heard of “the winner takes all”, “the long tail”, or the “80 – 20 rule”? They are all manifestations of the Power Law where a small number of companies or initiatives drive the entirety of the result.

Coming back to our VC funds, this effectively means that the performance of the fund is dictated by a small number of investments with amazing returns. Or in other words: it is all about the big home run winners and not about a portfolio of decent performers.

This is further illustrated in the following graph shared by Andreessen Horowitz, which shows that 6% of the deals produce 60% of the returns, while 50% of the deals even lose money.

A fictitious example

Let’s take what we just learned and imagine that we have a $100m fund, Hermans Ventures 😇. Yup, I got my own fund now!

Assuming that we take a 10% ownership in all the companies we invest in, this means that at the end of the period the aggregated value of all our portfolio companies needs to be $3bn in order for us to be able to return $300m to our LPs. If we fail at doing so, chances are that we won’t be able to raise another fund.

Following the above Power Law, our return will be driven by 10% of our companies. As we are a small team, we only managed to invest in 20 startups during our investment period; each worth $50m pre-money at the time of investment.

This means that, in order to be successful, 2 companies of ours will need to grow from being worth $50m to at least $1.5bn. 😲 For the rest of our portfolio we can assume that they will return nothing or even result in a loss.

Focus on huge returns

Our example showed that in order to be successful VCs have to look for companies capable of delivering those magical 30x returns. Additionally, there are the following complicating factors:

• Check size: The ideas and companies need to become big enough, so that our fund can invest enough money to get a $300m return.
• Timing: The return needs to be created within a 10 year period.
• Ownership: In order to maintain ownership and not dilute throughout the life cycle of the company, we need to ensure that we can invest pro-rata in any subsequent rounds.

In summary, venture capital firms are highly dependent on big winners and big ideas. They need to be able to get a major return (30x or more) on a large enough bet to be able to return enough money to their clients at the end of the fund period. 💪

 

What does this mean for startups?

Now that we understand who venture capital firms work for and how they deliver on their promises, we can take a look at some of the common behaviors in the industry and the impact these have on your startup. This will ultimately define when to raise VC money for your startup and when to stay away from it.

Big ideas in big markets

As VCs are looking for the next big thing or unicorn, they are looking for companies with large revenue potential (> $100m – $300m). 🚀

In order to have the comfort that your startup will deliver this revenue within the desired time frame, it is important that there is also a huge addressable market (+$10bn). That way, you can get to the desired result even with a low market penetration.

Go big or go home

Venture firms are highly selective. It is not uncommon for partners to only invest in a few companies each year. They need to get the absolute maximum out of these investments.

This also means that they need to be willing to risk a good offer or deal in the present in return for the potential of an even bigger win in the future.

While understandable from the perspective of a VC portfolio this, of course, can be in stark contrast with the ideal situation for the founder, as she is fully invested in just one company.

Ain’t no time for losers

VCs know that a majority of their bets are bad investments. They also know that it is all about super fueling those winners to the top. Obviously, they can’t predict this at the time of investment, but as the investment shows signs of weakness a VC can quite abruptly decide that it is no longer worth her time.

This is certainly not the case for all venture firms, as there is also a point to be made that the founders of a bad performing firm might be the founders of the next big thing. Still, there certainly is a clear tendency to grant more attention to the winners.

Peter Thiel has criticised the VC industry in the past by making the observation that most VCs spend 80% of their time on “the losers” instead of on the winners.

It is not uncommon for the boards of successful companies to grow rapidly as more and more senior partners are attending, while at less successful companies junior staff is being employed to attend the board meetings.

Grow, grow, grow!

Returns need to happen and they need to happen fast. Getting to unicorn valuations within a 10 year period requires a lot of growth. 🦄

This can lead investors to sacrifice everything for top-line growth, pushing companies too hard or too early. It can also lead to nasty side effects:

• High burn rates without any focus on profitability
• No time to resolve small issues, resulting in big issues down the line
• Acquiring growth at a loss, without any indication that the startup will be able to make back the difference

High growth firms have recently been very successful at raising large amounts of capital, as the investment world was hungry for growth. 🤑

As many of these fast-growing companies mature however, questions start arising on their future potential in terms of profitability. Not everyone can be Amazon and continue focussing on growth for more than a decade. At some point, a company needs to turn a profit and this requires a completely different mindset and focus.

Just look at the investor community’s reaction to the recent IPOs of Uber and Lyft to see how public market investors can react sceptically to the VC ethos of putting growth above everything.

Take more money

Finding new deals is hard, so once a deal seems to start becoming a success, it is in the best interest of the VC to allocate as much capital as possible in the company. 💰

Of course, for every additionally invested dollar, the expected value at the time of exit needs to raise as well.

This can lead to founders getting overly diluted, or to companies being pushed too hard to get an outsized valuation in order to provide enough return. 😔

 

What to ask yourself to know when to raise VC money?

Raising venture capital is certainly not all bad and there are a lot of great cases for VC investments. More importantly, there are a lot of companies which would not exist if not for the ability to raise vast amounts of capital, as it is a key to the success of their business.

So in order to understand when to raise VC money and if venture capital is at all right for your business, we have created a list of questions you can ask yourself. 🤔

Don’t worry if raising venture capital does not seem right for your business. There are a lot of great companies with very wealthy founders that did not raise any venture funding with their companies.

Besides, let’s not forget that we just listed 9 great sources of startup funding, of which venture capital was only one. 👈

Does your startup classify as a “potential big win”?

Do you have a $10bn potentially addressable market?

Could your business reach +$100m in annual revenue within a 7-8 year time frame?

And if so, what would it take to get there (geographies, verticals, markets)?

Is your business insanely scalable?

Does adding new clients hardly increase the complexity of your business?

Do you have a relatively low additional cost to deliver to additional clients?

Do you have a product that is pretty much “plug and play” across markets?

Do you have a product that is ready, and is money the main blocker from getting market share?

Does your business require scale to be successful?

Are you running a marketplace, a micro-mobility provider or any other business that benefits greatly from scale?

Are your unit economics highly reliant on getting the right scale?

Or do you need a big investment up front with promise of great scalability in the future?

Do you mind giving away control?

Do you believe that having 10% of the business with VC money is better than having 80% of the business without?

Do you not mind dealing with and reporting to professional investors?

Are you ready to sell or go public in the next 5-10 years?

Are you ready to start the clock and prepare your business for an exit within the VC timeframe?

Would you mind running a public company with all the public scrutiny it entails?

Or are you willing to sell to another industry player or a financial sponsor at some point?

Do you mind having limited leverage in the exit decision?

 

What should I do if my startup is not right for venture capital?

Now that you understand when to raise VC money, you might find out that venture capital is not right for your business.

First of all, don’t worry, you are in great company! 😃 There are many great firms, with founders that are doing very well, without taking on any venture capital investment.

Your first option is to not take funding at all and let the business finance your growth.

This is often referred to as bootstrapping or running a capital efficient business and it has a number of clear advantages. 👇

• It requires an immediate focus on generating revenue and thus on figuring out what a customer will pay for.
• It’s more resilient to economic downturns.
• You get to keep ownership and control over your business.

In fact, for a lot of niche businesses being capital efficient also makes you a more attractive take-over target as, in contrast to venture backed companies, there is a higher chance to find a deal that is beneficial to all stakeholders.

Great resources on bootstrapping

Just take a look at the following “bootstrapping to exit” list from Sramana Mitra.

There are many great sources on how to bootstrap your way to success, but we couldn’t resist to list a few tips:

• Focus on profitable growth right from the start
• Evaluate every expense carefully
• Become a star in generating low cost publicity
• Become very good at recruiting and only recruit when you have to

For more inspiration take a look at some excellent case studies aggregated by Basecamp.

And if you do need additional capital to grow your business, perhaps another funding source is right for you. Just go back to our previous episode and take a look at the 9 common types of funding. 👈

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Ready for it? Here’s all the details about 9 of the most common startup funding sources! 👇