Photo by Clem Onojeghuo
What is venture capital?
Venture capital (VC) is funding given to businesses from investors.
It’s called venture capital funding because it’s funding from the specific investors known as venture capitalists.
Investment from venture capitalists can be more than money. In addition to cash, VCs often invest in the form of technical or managerial expertise. It’s not their first rodeo, so they can impart some wisdom.
Who are venture capitalists?
Venture capitalists are usually professional investors who pool money together from other from well-off investors, investment banks and any other financial institutions. They then invest the pooled money and sometimes their expertise into companies where they see long-term potential growth.
Why do VCs invest in companies?
Because they see an opportunity to make money in the long run. VCs want to give you money to buy into your company and have ownership. As owners, if and when the company does well, the owners can participate in the gains by being paid distributions or dividends. Alternatively, there may be an option to sell their ownership shares at a higher price than they were purchased, ergo making a profit.
Let me explain with a cute example. Let’s say that down the street from where I live, there is a kid who lives in a house that has a few avocado trees. Every year, there are too many avocados so this kid sets up a stand and starts to sell the avocados to the local avocado-loving population.
A couple years later, the kid builds an app for a school project where he pairs local urban farmers with locals who want to buy their excess of avocados. For whatever reason - the idea is good, the timing is right, and the kid is really cool - so people start to really use this app and it starts to take off.
Then kid graduates high school and wants to pursue this thing he’s created. He wants to get investors, venture capitalists, to invest (buy ownership) in his company. Let’s say his uncle is a finance dude, helps him build financials that show how the company make billions of dollars becoming the “Uber of gardening” or whatever the fuck. Ultimately the company can’t grow to a billion-dollar company unless they have a cool $1.5 million to invest into the business to make it happen.
So the VCs from different funds start to invest in the hopes that they’ll get paid more than they invested in the long run. They love the kid, his story, his finance uncle. The love the story the financials tell. It’s a perfect storm.
Now that we’ve got the key terms out of the way and you have an understanding of what VC is, let’s dig into the implications of this type of funding. It’s not all avocados and billionaires.
Do you have a venture-backable business?
If you’re thinking about VC funding for your business, the first thing you should do is understand whether or not your business would be attractive to venture capitalists. Not all businesses are attractive to VC investors.
So what makes businesses venture backable? (I’m sure backable isn’t a word, but I hope you still respect me for using it). Scale is a key factor. Your company has to be able to scale. Scalability means your business can go from selling products or services or experiences to a few to a shit ton (technical term).
Going back to the kid with the avocado app, without the app, the business isn’t really scalable. Because then it’s just a kid selling avocados from his trees. But if you can bring together the farmers and get paid for every transaction that takes place, then there is scalability. There’s an opportunity to make a lot of money.
Another example of a company that has scalability is Lyft. Lyft is scalable because there are a lot of drivers and a lot of riders and the company gets paid on every transaction.
So if you’re a service provider and it’s just you and you can’t scale your offering, VC’s are probably not for you because you won’t be able to generate a big return on their investment.
VCs are pretty much swinging for the fences. It’s not uncommon that most VCs are looking for a return that is 10x. That means whatever they invest, they want to see that they can get a return of their investment multiplied by 10. So an investment of $500,000 with a 10x return is $5 million.
Beware the Hidden Sacrifice in Promise of the Reward
Fundraising Is Full Time
Fundraising in the VC space isn’t just Soylent for lunch and drinks after a full day at the office. It’s often a full-time gig for the founders. A good rule of thumb is as follows: each fundraising round is around six months long with a few months to close. That’s a lot of time to be dedicated to not focusing on the thing your company is supposed to be focusing on. But if you need the funds, that is the tradeoff. There’s the rub.
And while the funding may be integral to your company actually launching, be prepared for the road that lies ahead. Do you have a team and does your team realize the attention you’ll need to take away from the company for that long? Will you be able to feed yourself? Will your business partners be able to live off of Soylent alone? Will the company survive?
Giving Up Equity
Fundraising happens in rounds. So companies can ask for money over time. For example, a company can try to raise $500,000 in the first round for startup funding, $1 million in a second round to reach a growth milestone and $2.5 million in a third round to become a juggernaut in their industry.
Each time founders raise money, they are diluting their ownership in the company. The average equity round results in founders giving up 10% to 30% ownership. That’s pretty significant.
So if that is something you’re not willing to do, you should consider your options. There are different ways to finance your company. You can apply for a small business loan or a grant. You can finance it on credit cards or bootstrap.
Each option has it’s pros and its cons. With bootstrapping, you don’t give away any ownership or owe any money back, but growth is a lot slower because you’re limited to what you invest personally.
With a small business loan, you could get the cash injection you need to start, but interest could be expensive and you have to pay back to the money you’ve borrowed. Applying for a grant could just be a total pain in the ass for not that much money. It might not be worth the effort.
It’s important to understand the costs and implications for each financing option.
Giving Up Some Freedom
From a day-to-day perspective, taking VC funding means you are not fucking around. It means you’re committed to exponential growth. It means you don’t have the luxury of working less because you’re making enough money. By taking on VC, there is the expectation that you’ll work your ass for growth. And if you don’t, you run the risk of being replaced.
In the longer run, VC investors will want the business owners to exit the business in five to 10 years. The pressure to exit could result in a shitty deal for you economically or for the company structurally.
Most people in the general population give up some freedom for money. This is a daily negotiation we have in different areas of our lives.
Taking Direction from Others
Some entrepreneurs suck at taking direction so they become their own boss. Others are attracted to the freedom of working on their own terms. Some are so committed to the vision that they can be uncompromising. As soon as you have investors, all of that changes. You’ll have formal board meetings and you’ll to answer to the shareholders instead of just yourself.
It’s a balancing act when it comes to taking on investors. Investors have interests that could be conflicting with the founders and employees. VC investors will also tend to be more involved than banks by offering advice and connections. Investors want to work with CEO’s who can take direction and input from them.
Selling the Company
In the long run, if you don’t want to sell your company and laugh all the way to the bank, you probably shouldn’t take any investments from venture capitalists.
You Have to Learn (Some) Finance
You have to demonstrate that you understand finances to investors who will ask you questions about the company’s finances.
You will likely either hire a CFO or accountant or some kind of finance person to help you build out projections.
You’ll be pitching to investors. They will not just invest because they financials are attractive. They’ll invest because they like you, they like your idea, they believe in the thing you’re selling, but you’ll need to get comfortable with some of the numbers.
You don’t need to be full finance bro talking about P/E ratios and shit, but you have to understand how much money your company needs, how it will use the funds, how much it will cost you to create your product or your service, how much will it cost you to acquire a customer and how much revenue can you expect to earn from each customer?
So the moral of the story: don’t rush to get that million dollar check from old uncle Morty’s long-time business buds until you understand exactly what you’re getting into.