Harry Alford

@harryalford3

What You Need To Know Before Raising Venture Capital

Photo by Jonatan Pie on Unsplash

And How Venture Capital Firms Work

To preface, I challenge startups to be customer-funded rather than being VC-funded. Venture capital can be very positive for startups depending on stage and sector. But if too reliant on VC rather than profitability, it can be a big detriment to the long-term sustainability of your business model.

Sometimes raising funding from VCs can be a shot in the dark if you don’t know what you’re looking for. Below is a brief overview of origins, key terms, VC economics and investment criteria that founders should be aware of before considering raising capital.

The venture capital industry came into fruition by the likes of Georges Doriot and his firm American Research and Development Corporation (ARDC) after World War II to encourage business in the private sector. Alums of ARDC would go on to found prominent VC firms like Greylock Partners.

Venture capital is a type of private equity that is generally provided by firms or corporate venture arms. VCs are investing in tech-enabled startups with high growth potential to generate returns despite high risk. The stage of a typical VC investment or first institutional money usually occurs after seed funding in the Series A round. These investments range between early-stage startups to later-stage companies.

The vehicle that the firm uses to invest in startups is the fund. The firm raises the fund from family offices, high-net worth individuals, public pensions and endownments to name a few. These investors in the fund are known as limited partners (LP). LPs are expecting to see returns based on the investments made by the general partners (GP) and support staff (principal, associates, analysts) of the firm. GP’s are typically paid 2% annually from committed capital to manage the fund as well as 20% carry which is where a majority of their compensation comes from.

A large share of the fund’s returns come from a small percentage of investments and this permeates the thoughts of most VCs. Michael Dempsey refers to this as the Return The Fund (RTF) analysis:

Fund Size / % owned at exit = Minimum Viable Exit

Further delving into how VCs think about building their position over time, I’ve provided some quick math below:

VC Firm has a $20M seed fund investing $1M in startup

  • $1M/$10M valuation = 10% ownership
  • In order to return the fund (not including dilution), the startup must exit for (20/.1) = $200M

Other metrics to measure traction and progress include IRR, unrealized gains, and social validation.

VC firms vary in structure as well as investment thesis. A VC’s investment thesis can help you, the founder, determine immediately if they’d be interested investing in your startup. Many follow certain parameters and invest in specific business models based on years in the space. Some place “higher emphasis on authentic differentiation” to convey their advantage in providing strategic advice to startups.

“This was the birth of a thesis. An observation born out of personal experience, personal interests, and visibility into the inner workings of one of the hottest startups in one of the largest, fastest growing markets out there.” — Stephen Hays, Managing Partner at Deep Space Ventures, states in The Birth of a Venture Capital Investment Thesis

For founders considering raising funding from VC’s, it’s important to understand the VCs mathematical motivations, actionable metrics and criteria revolving around their investments. Among bootstrapping, it’d be wise to consider other alternatives besides traditional venture capital such as revenue-base financing, profit sharing, non-dilutive funding and equity crowdfunding to name a few.

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