For many entrepreneurs seeking to develop and grow the next disruptive technology, accessing venture capital (VC) is a very alluring and seemingly inevitable step on the yellow brick road to fame and fortune. But the VC fund-raising process is complex, frequently painful, and not for everyone. For those who are considering the VC funding route, an understanding of the venture capitalist’s goals, motivations, and operating history, juxtaposed against the startup’s own operating outlook, is a critical prerequisite.
It is essential for entrepreneurs to understand that the vast majority of companies do not need, and thus should not seek, VC. Many industry commentators liken VC funding to “rocket fuel.” Like rocket fuel, it is vital for a trip to the moon, i.e. the vast distance between inception and an enterprise valuation of ten to one hundred times the pre-money valuation. But also it is highly combustible, costly, and too risky for a leisurely drive down the coast, i.e., a business with moderate growth potential that may eventually be worth three to five times its pre-money valuation. In the latter case, far cheaper and simpler forms of capital are worth considering first. These can take the form of equity from friends and family, small business loans, trade financing, and sometimes even bank debt. VCs are seeking high growth, scalable companies with sustainable competitive advantages than can generate huge revenues and high profit margins. They frequently impose very expensive financing terms on company founders, and unless the VC’s lofty growth objectives are met, the founders may see their own ownership stakes severely diluted, their professional reputations tarnished, and their ability to raise future capital severely diminished. Approach and engage VCs at your own peril.
Once the founders determine that they can indeed meet the VC community’s growth and scale expectations, they should ask themselves how much money the company needs to get there, and be well prepared to explain how quickly they can achieve escape velocity. By asking for too much money too quickly, entrepreneurs are in danger of excessively diluting insider equity, reducing the forward return potential of follow-on funding rounds, and creating a toxic culture of capital indiscipline within their company. By asking for too little, they risk bankruptcy and the threat of killing the company in the cradle. The timing of expected corporate growth is likewise important. Most VC funds are structured as 10-year commitments, with initial investments made in the first three years of a fund’s life. They are only interested in companies that can get very big very quickly, and patience with an entrepreneur’s delays and unmet targets is not a common virtue.
The next question for the company is which VCs to target. Though it might seem that VCs are peddling the most commoditized product in the world, money, in reality the choice of VCs with whom to partner can make a world of difference to the entrepreneur. It is generally prudent to target VCs who have successfully partnered with other companies in your company’s vertical. These investors are likely to understand your business well and may have a knowledge base or a contact list of people in the industry that would be very helpful. Size matters as well. A large VC fund may not consider an investment of the size your company is seeking. A small fund may need other partners to co-invest in the round. Another consideration may be the VC’s historical participation rate in follow-on financing rounds. Some VCs are known to fund their startups from seed rounds until an eventual IPO or strategic sale. Others won’t likely stick around once their return objectives for a seed round or Series A are realized, which may leave the company scrambling to find other financing partners later. How much operational support your company wants, needs, and is likely to get from the VC in question – and at what price, in terms of the VC’s involvement in corporate decision-making – should also be weighed carefully. Due diligence of a prospective VC, best obtained by speaking with their current or previous portfolio companies, which should be easy to identify from both public disclosures and word of mouth, should be undertaken as thoroughly and discreetly as possible prior to seeking or making introductions.
Once the founders have identified which VCs to target, they should make a “warm” call to introduce themselves and the company to the VCs by whatever means possible. Under no circumstances should the founders make a “cold” call to a VC. One may think that the courage to pick up a phone or send a letter to a perfect stranger reflect the audacity of the entrepreneur. However, cold calls actually reflect timidity, carelessness and a “can’t do” mentality that are huge red flags to potential investors. An entrepreneur who cannot find some way to get in front of the right investors can’t be expected to overcome the far more challenging obstacles he is certain to encounter later. While some VCs will read a pitch or business plan from a cold caller, they very seldom fund one. If the founder’s own networks are limited, they may consider engaging outside advisors or mentors with wider professional networks and/or prior VC fund-raising experience that can help them make those introductory calls and help them calibrate their pitches for maximum effectiveness.
Lastly, entrepreneurs would be wise to approach the VC investment process with humility, genuine enthusiasm, and fearlessness. Be proud of your company’s strengths and candid about the risks and areas for improvement. Do not burden or hassle potential investors with formalities that are often unnecessary, like non-disclosure agreements. Remember that your company can recover from a loss of financial capital, but not one of reputation. Be prepared for pointed questions and respond to them with conviction and thoughtfulness, not defensiveness. Treat each VC’s rejection as a learning experience and continuously reassess your pitch, your funding needs, the company’s competitive landscape, and its position in the competitive market. Entrepreneurs who can address the aforementioned issues and overcome the attendant challenges will find themselves better positioned for success in obtaining VC investment.
Patrick Monaghan is a principal equity investor, an advisor to several startup companies, and a senior foreign legal consultant at one of Korea’s largest law firms. His legal practice includes cross-border private equity, venture capital, and technology. He can be reached at email@example.com.