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You’re a founder who has raised a couple of hundred thousand from friends, angels and/or a seed fund. You’ve released your first product and now it’s time to scale. Cash is often the answer to scaling fast. Raising money from a VC seems the next step to accelerate. But is it? This article discusses whether VC funding, typically associated with a late Seed or Series A round, is right for you.
Since the mid-2000s, the emergence of VC-fueled, high-profile, tech monoliths such as Facebook, Twitter, Uber, etc., who have grown huge very quickly have given the feat of raising money from a VC firm more glamour and prestige than ever before.
And it is a big feat to raise money from a VC. It’s a huge dedication of time, effort and money which detracts you from running your business. Done right, the significant capital raised from a VC could be vital to your progression as a business. But, don’t think it is necessarily the be-all and end-all for your company to become successful.
So, ask yourself this question, is VC money right for you?
The answer to this depends on two things:
To answer this it’s vital to understand what a VC expects from investing in your business, which is ultimately tied to how a VC’s business model works.
By investing in your company, the VC needs your business to:
Why is this?
VCs want, or more aptly need, the above to happen because they sell their investors the promise of a high and relatively fast return. VCs have to fundraise too!
The typical VC fund model aims to return around 3x cash invested over a period of 10 years. That targeted return is not governed solely by how much cash is given back to investors but more importantly how quickly the cash is given back to investors. A 3x return over 10 years is the equivalent of a 12% interest rate – it’s a high rate to achieve but then the risk of investing in venture businesses is like no other.
It is this target return that follows on to the crucial thing the VC needs to see in your business, and that is your business’ potential to return the fund. This is an industry term in VC which essentially means the VC’s investment in your business alone has the potential to give them the desired exit proceeds for their entire fund. Not only does this give the VC a great return for their investors, but it also makes the VC very wealthy as they share in the profits they make for their investors if they beat that effective 12% interest rate mentioned above (this interest rate is known as the ‘hurdle’, and if the VC beats that the profit they get is called ‘carried interest’ or ‘carry’).
If you’re speaking to a VC, ask what the size is of the current fund that could invest in your company and how many companies they are looking to invest in from that fund.
Let’s say the fund size is £100m, here’s the maths:
That’s a high expectation! But it’s an expectation that’s driven by the risk profile of investing in venture businesses, which is incredibly high.
But a VC’s investment decision isn’t all just tied to their current fund. VCs also, like you, aspire to run a self-sustaining business. Most VCs will only ever make their money from the management fee on their fund – this is the fee they charge to investors to find, choose and make investments. The typical fee is anywhere between 1-2.5% per annum for the first 3-5 years of the fund, and then the fee drops to 1-2.5% on the amount invested by the fund.
Theoretically therefore a VC running a £100m fund, will get anywhere between £1m-£2.5m a year for the first few years (which pays staff and business expenses) but if all the money is invested after year 5 and the portfolio companies have all gone bust, the VC gets precisely nothing (1-2.5% of a portfolio worth £0 is £0) and the VC is out of business. How does a VC sustain itself then? Simple, it raises a new fund from either existing and/or new investors and therefore takes in new management fees (and it will raise a new fund whilst still managing the existing one).
So when a VC invests in you, not only are they thinking about the return they could make for their current investors or themselves but they also know that a series of bad investment decisions could gravely affect their future as a VC. The stakes are high and the expectations even higher. Rework those financial forecasts, revisit the addressable market then ask yourself honestly, is my company one which works within the VC mode. And even if it is…
Well aside from the question of ‘does your business need money or not?’, for you, the founder, there are the questions of, ‘how do I want to be running my business and where do I see my business in 5-10 years’ time’? Consider the following:
If the answer to any one of these questions is no, then think carefully about going the VC route.
As you can see, VCs work on the basis that 95% of their investments will either fail or won’t generate a substantial return, and 5% will generate most of the value. For a fund making 20+ investments that may be fine, but it’s the opposite of what you as a founder are looking for. Imagine telling your spouse that you’re planning to spend the next 5 years on a business which has a 95% chance of going nowhere, a 5% chance of being a unicorn. They’ll probably tell you to get a proper job!
Instead, as a founder what you want is a high degree of confidence that you’ll create a vibrant, growing business. If you have a 70% confidence of generating a 3X to 5X return for you and your investors in 3-5 years, that would be a wonderful outcome.
And that just happens to match what most angel investors are looking for, coupled with SEIS/EIS tax savings for their investment.
Which is why, for most businesses, angel investment is a much better fit in the early stages.
And, it’s also why if a VC tells you that “your market size is too small, it needs to be £10 billion or more” or “love your idea, come back later” don’t lose heart, now you know why.
Remember that if you can’t or don’t raise from a VC that doesn’t mean it’s not a good business or that it can’t become a unicorn (if that’s what you’re after). With the right business model and plan, and a focus on profitability, a company can grow quickly by re-investing the profits into the business and thus never have to give equity away to external investors. Mailchimp for example has not raised a penny from VC and is a multi-billion dollar business. These situations do happen, albeit rarely!
Still unsure whether VC funding is the best fit for your business? Book a slot in with one our experts below to get the best advice for your business’s needs.