Andy Areitio
When you’re running your own venture — especially if it’s your first — it’s unlikely you will find the time to deep dive into how venture capital firms work. Fundraising is distracting for founders and can even hurt their company in the early days. But if you only start learning about VCs when you’re already down the fundraising path, you’ll already be too late.
Founders tend to make a series of classic mistakes when raising funding. Error number one (and two) is to raise the wrong amount of money and to do it at the wrong time. This double whammy results in founders being very diluted too early or not raising enough money to reach the next funding stage.
They can also put all their eggs in one basket too early. I made that mistake. I had signed a term-sheet (a nonbinding agreement) for a €2.5 million Series A round, passed the due diligence process, and the investment committee had approved the deal. But at the very last minute, a claim from one of the angels on my cap table made the prospect investor change his mind. In a Point Nine Capital survey, founders said that the two most stressful elements of raising venture capital are not knowing where in the fundraising process they are and not understanding why VCs have rejected their proposal.
On the other hand, if you know what VCs all about, you’ll be geared up for the ride, know the kind of investor personality you’re aiming for, and crucially — you’ll optimize the value of your equity in the long run. Founders who manage to raise more VC funds end up having a greater value stake in their company when the time comes to IPO, according to statistical research. The learning curve is steep; you’re not just studying VC as an industry, but the individual investors themselves. So, I’ve decided to share the main lessons about VC that I wish I’d known when I was a startup founder chasing venture capital.
1. It’s not about raising, it’s about raising the right amount at the right time
Startups are all about reaching two milestones: (a) product/market fit and (b) a profitable, repeatable and scalable growth model. Once those two corners are turned, the risk of a startup decreases enormously, which is normally reflected in the valuation. As an early-stage founder, if you want to protect your ownership, make sure you’re raising small amounts of money while your valuations are low.
Save your cash until you de-risk your early-stage startup. Then, raise aggressively when you finally have hard evidence that you have a strong product/market fit and a clear growth model. Be sure you understand when your company reaches that stage and becomes a scaleup. You don’t want to be a founder that has successfully raised a Series A round but has very little ownership and a very long road ahead.
Sometimes, the timing is out of your hands. The price of equity in startups is governed by the supply and demand of capital. Investors themselves have to raise money from another type of investor called Limited Partners (LPs), who may hold stakes in a variety of assets. If LPs have a strong interest in VC assets, there is more supply of capital and the price of startup equity will rise. But the opposite is also true. If you take a look at the last two recessions in the United States (2000 and 2008), you will see that the stock market crash coincided with corrections to valuations in the VC market.
So, be strategic and raise when “the market” has a strong appetite for your equity; otherwise, stretch your runway and wait for the right time. Right now, it’s common to see startups postponing their next raise to 2021, looking for stronger winds.
2. Location: Tell me where you are and I’ll tell you how much you’ll raise
I see two conditions for startups to raise a large round: (a) a large market that can justify a sizable exit, and (b) a large VC fund (small funds don’t need super sizable exits to be successful).
Assuming the first condition is met, where can we find those large VC funds? Typically, they’ll be in locations close to large markets, with a track record of sizable exits.
However, here is some good news for founders located far from mature tech ecosystems. Because the cost of starting a software startup is a fraction of what it was 20 years ago, there is a new breed of startups who serve these large markets but are based out of emerging tech hubs like Barcelona or Austin. VCs are paying attention to this trend and are investing farther from home.
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Having said that, understanding the size of the local VC funds in your tech ecosystem will give you an idea of how much money those external funds are willing to dish out. Chances are, if you are growing fast, you will need to raise from international funds at some point. The following map lays out the amount of VC investment per capita in cities worldwide between 2015-2017.
3. Many fast-growing tech companies never raised venture capital
Paul Kedrosky, entrepreneur, investor and a senior fellow at the Kauffman Foundation, states that less than 20% of the fastest-growing and most successful U.S. companies had venture capital investors.
However, because some VC-funded startups became global success stories, carving out entire new markets, the press has fixed its eye on the VC industry. You might get the impression that only companies that raised VC money become successful, because they’re the ones that make it to the news. That train of thought is flawed.
I see more and more tech companies not raising venture money, and I also see more and more startups not sharing news about their latest round because they want to fly under the radar. A successful fast-growing company is the one that dominates a market and makes its customers recurrently happy. The way that company financed its growth does not necessarily speak to its journey and value.
From the perspective of founders, sometimes raising the capital to fuel a venture comes with a heavy toll in terms of the decrease in ownership, dilution or other hard-to-swallow deal terms. Here is an interesting snapshot of how much equity founders actually have when their company finally IPOs. Spoiler: It’s about 15%, split between the co-founders.
4. Only raise venture capital if you dare to win (and suffer) big time
In VC, the rule of thumb is that only 10%-20% of all startups produce substantial returns on average; the rest would only return the original investment or fail. So, if you are a venture-backed founder you are fighting against the odds. But more importantly, your investors will be pressing your venture to be one of those few that becomes a home run. And your early employees will be expecting the same outcome, since they’ll have passed up other opportunities to join your startup.
Basically, there will be enormous pressure on you to grow extremely fast and dominate your market. Don’t get fooled by success stories you read in the news. Building a successful venture-backed company takes a decade of back-breaking work, not overnight inspiration, and the founder’s ass is always on the line. So only go down the VC route if you dare to win and suffer big time.
5. Build a personal relationship with an investor
Besides delivering returns to their LPs, a good VC will help founders be at their best, which will translate into a higher trajectory for the startup. There are several ways a good VC can help founders: Giving them access to a large customer base or a new investor; sharing their operational expertise around the key areas of product and growth; finding a key hire; or advising on internationalization.
But the most valuable support is the one that helps the founder excel in their performance — and that typically has to do with their mindset. Founders, not investors, are the ones doing the driving. Sometimes the best an investor can do is cheerlead and believe in a founder even when the market does not. Other times it’s about telling a founder the hard truth or telling them to push further. When the going gets tough, you will need people to have faith in you until the good results come back.
When choosing an investor, find the one that will foster a personal relationship with you and will be there to motivate you through thick and thin.
Knowing what you need to know about VCs also means recognizing if this path is not the right one for you, or if it’s not the right year to take the leap. But if you do ultimately bet on venture capital, remember that you’re betting big and have to be prepared to power through the entire way.
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