If your startup is growing, at some point you will likely be seeking venture capital. Unlike angel investors, who typically write checks between 10K to 100K, VCs have an ability to write multi-million dollar checks. This means that VCs support startup growth from seed round, to much later stages.
Because VCs deploy large amounts of capital and expect significant returns, the process of raising money from these so-called institutional investors is far from trivial. At Techstars, we spent time with the companies talking about raising money, and in this post we discuss some of the things you need to know if you are looking to raise venture capital.
1. VC-backable Business
Here is the thing – most founders feel like their idea is amazing, and is worthy of an investment. The reality is that most ideas are worthy of some kind of investment, but not necessarily worthy of a venture investment.
Simply put, different businesses have different potential and because of that, the amount of capital that makes sense to invest in them varies. A small business, like a restaurant, can get a bank loan, but it is not a great venture investment because the upside is typically small.
Venture Capitalists are looking to deploy millions of dollars, and they are looking for multiple times return on that capital. That is why, in addition to founders, VCs focus heavily on the size of the market. If they don’t believe the market is large enough, they won’t invest.
There is nothing wrong with starting a business in a smaller market. You can still get capital, but not necessarily via VCs. Understanding the size of your market before going out to raise money is an important thing to do for every single business.
2. The Fund Size & Check Size
Before raising venture money, understand how VCs make money.
Venture funds have General Partners and Limited Partners. General Partners actively manage the money, and Limited Partners contribute capital and become passive investors. General Partners in VC funds make money in 2 ways – through management fees (typically 2% of the fund size) and through something called carry (typically 20% of the returns). Carry is distributed AFTER the fund returns all the capital to Limited Partners. That is, VCs make no money on the up side until all original money is paid back.
Now that you know that, it should make sense why it is important to understand the dynamic between the size of the fund, and the checks that the fund writes. If the fund is 150MM, it does not make sense to write 100K checks. They won’t be able to deploy capital quickly enough (a typical venture fund is set up to deploy all capital over 4 years). Similarly, a 150MM fund is not likely to put 30MM into a series A of one company.
If you are looking for less than 1MM, your best bet is to go to so-called Micro VCs – funds with 10MM – 50MM under management. If you are looking for 5MM++ series A, you will need to go to a 150MM+ fund.
Find out what the typical check size and the sweet spot is for the funds you are considering to partner with.
3. Fund Cycle & Pace
Sometimes the fund is completely spent. That is, the partners deployed all the capital and are in the process of raising new funds, but they are not taking any new investments. This is a tricky spot, because the partners will still take the meetings and talk to the founders, but they won’t make any new investments.
Similarly, the funds have a specific pace with which they deploy capital. For example, a fund may do 2 series A deals per quarter. If the fund already did 4 series A deals this quarter, it is highly unlikely for the fund to do another one.
Both of these situations are very non-obvious to the founders, but not atypical. As a founder you should always ask how many investments the fund typically does per quarter / year, and have already done this quarter / year.
4. “Warm” Introduction
The basic litmus test that venture funds run on founders is whether a founder can get an introduction to the fund through a network. Cold emails or stalking VCs is not a typical way to get introduced (although it still happens occasionally). These days, VCs expect founders to use their network, and get an introduction.
Why? Because this checks three boxes – the founder’s understanding of how the venture works, ability to hustle to get the intro, and most importantly, a trusted connection via someone who already knows the founder.
Successful founders understand that funding happens when VCs are excited about the opportunity, and are also able to check off enough boxes to mitigate the risk around backing this particular business.
Getting a “warm” introduction helps reduce some of the risk.
5. VCs want to get to know you
This is very much a cliche, but securing financing from VCs is kind of like dating.
VCs want to get to know the founders, watch them execute and make progress before committing to invest. The check is not going to come after the first meeting (unless you are a serial entrepreneur with lots of success and the VC is worried about losing the deal).
Again, VCs are looking to reduce risk. If you are a first-time founder, the risk is reduced by getting to know you and watching you execute over time. If you are a serial founder and have worked with this particular VC before, the risk for the VC is automatically lower.
Successful founders take advantage of the dating game by making it a two-way street. They aren’t just looking for money, they are looking for partners in their journey to build the business. They recognize that not all firms, and not all partners are the same (more about that below), and use the “dating” game to get to know the firm and the partner and to access if this is a mutual match.
6. Lead Partner
VCs are people too, of course. When dealing with a firm you are dealing with actual individual partners. In the end of the day, one of the partners needs to get excited enough to push the deal through.
There are several dynamics that come to play. First of all, each partner has one or more focus areas. Simply put, if a partner specializes in consumer startups he/she is not likely go get excited about your dev tools company. In general, specialization of partners is nuanced, and is important to understand.
Go to each partners’ bio page on the fund’s web site and study their backgrounds. What have they funded in the past? What have they done in their careers before? Knowing all of this upfront will save you a ton of time from pitching wrong people.
Some partners and funds are thematic investors. That means that they have markets they focus on for 12-18 months. For example, folks can focus on crypto currencies or VR or some other current trend.
Other partners don’t have specific trend focus, but instead permanently focus on a specific vertical, like Enterprise SaaS or e-commerce or dev tools, etc. Most partners in larger funds have more than one vertical they are comfortable investing in, and then collectively, a fund can cover a broad range of industries.
In addition to specialty areas, each partner has capacity. Most VCs in larger funds take board seats and rarely would be able to engage with more than 10 or so investments in a meaningful way. This trend has been somewhat changing as VCs sometimes don’t take a board seat, but this is something that founders need to pay attention to. If a partner already has a lot of investments, they may not be able to do a new investment. Again, look this up on the partner’s bio page.
7. The Funding Process
This is a super important thing for founders to recognize – each VC firm has a process and there are similarities and differences between the firms.
The way that most funds approve funding is via partner meetings. These partner meetings typically take place on Monday, and are either 1/2 day long or all day long. During the partner meetings, the partners discuss existing investments but most importantly for this post, they approve new ones. Your goal as a founder is to understand how to get to that partner meeting, and then ultimately, to an approved investment.
Seed checks in the range of $250K – $750K may require far fewer meetings before the partner meeting compared to checks cut for series A and beyond. For the funds that write seed checks, a process may be 2-3 meetings, where the goal is to get 2 partners excited. Then the founders may or may not be invited to present at the partner meeting before the investment gets approved.
For later stage investments, there will be additional meetings before the partner meeting. The steps will include deeper due diligence, meetings with additional partners, behind the scene research done by analysts, conversations with customers, sizing up the market, and other things. In the case of later stage financings, the partner meeting is basically the last step before the term sheet.
8. Term sheet and Due Diligence
When the investors indicate that they want to invest, they offer founders a so-called “Term Sheet.” This is a document that outlines all the key economic and governing terms of the investment. Typically included here are the valuation of the company, investor rights, board composition, option pool, voting rights, and other things.
The purpose of a term sheet is to cover ALL important business terms. That’s why good term sheets spell out everything and avoids surprises once full documents are drafted. Term sheets are highly nuanced and complicated, and you ALWAYS need to have lawyers review and negotiate them.
At the same time, it is also important that founders understand the key terms and what they are signing up for. We highly recommend that you read Venture Deals by Brad Feld and Jason Mendelson to get on top of your term sheets.
Once the term sheet is agreed upon and signed, there is a process of drafting the actual financing documents and due diligence. For later stage companies, due diligence can be very significant and lengthy; up to 2-4 weeks. The ask is to disclose EVERYTHING.
Do not panic. Just provide the information. Be ready with all the financials, employment agreements, option plan, contracts, IP materials – literally anything and everything you can think of will be included in the diligence. This is typical and standard, and not anything specific about you or your business. This is what it takes to raise millions of dollars of capital from VC.
This is a high level overview of some things to consider. Your actual experience may be more nuanced and varied. Raising venture capital is by no means simple, but it helps to know what you are in for.
Engineer, Immigrant. Vegan. 3x Founder, Managing Partner @2048vc. Previously ran @techstars in NYC. I write #startuphacks: http://alexiskold.net .