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-fuelled, 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. But, done right, of course 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 that depends on two things:
- Whether VC money is right for your company.
- Whether taking VC money is right for you personally.
Is your company right for VC funding?
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:
- grow very fast, and
- exit (be sold) or ultimately provide liquidity (e.g. via IPO) to the VC within around 5 years from the time they invest.
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:
- They’ll be looking to make £300m out of that £100m given to them by their investors.
- However, management fees will eat up around £20m of that fund (this is the annual fee that VCs charge to their investors for managing that money, i.e. renting office, hiring employees, having the resources to find the best deals to invest).
- That leaves £80m for making investments, which will likely be split 50:50 between new and follow-on investments to protect the VC being diluted too much in subsequent rounds.
- A typical VC fund will hold around 20 companies, leaving around £2m per investment in this example.
- Let’s say they invest £2m in you for 10% (£20m post money).
- Assume the VC’s stake will be diluted if you raise further capital (it doesn’t matter if you don’t intend to, the VC won’t think like that) to, say, 5% when you exit. The VC may put some follow-on money in but don’t take that as guaranteed.
- Taking the law of averages, this would mean each company on exit has to be worth on average £300m for the VC to return their fund (£300m exit value times VC’s 5% ownership times 20 investments = £300m).
- But VCs however don’t look at it like this, they know that more than 95% of investments never make stellar returns, and realistically only a few investments from that fund (or more likely even one) will make up the bulk of the returns they make. That means, when VC’s look at your business, they most likely will ask themselves whether your company itself could return the fund to compensate for the failure of others.
- That means the VC’s 5% stake in your business alone at exit needs to be worth £300m, which means they have to see your business having the potential to reach a £6bn valuation, and VCs generally like to see a path to this in on average around 5 years.
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…
Is VC right for me?
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:
VCs can take a relatively large chunk of equity (15%-30%). Before deciding to take on venture capital, are non-dilutive alternatives a reality for you? Crowdfunding, commercial loans, government grants and tax incentives, bootstrapping? These all have their pros and cons, consider them.
VCs will most likely want a board seat and have some rights over key decisions, most importantly removal of key management (including you the founder) and also approving or blocking an exit. It could be the VC blocks an exit because the proceeds are too small for their fund’s return (but it would be a great deal for you) or they force an exit to meet their return (while you think there’s room for more growth).
You may have encountered already with taking seed fund money, but taking on VCs generally comes with a higher level of scrutiny. More board meetings, more reporting expectations made of you.
- Commitment to growth
Remember the above, the VC’s investment in you means they’ve banked on you growing extremely fast. If you had visions of more of a lifestyle business, are you prepared to give that plan up?
Pursuing VC money takes a huge amount of time and can often be a fatal distraction for those teams who are already resource poor.
If the answer to any one of these questions is no, then think carefully about going the VC route.
Angels may be the better fit
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!