Third post of a series with all you need to know about private investors for startups and small businesses.
“How should I fund my startup business?”
“How much funding do I need?”
“What’s the best source for funding?”
The short, unsatisfying answer is: “it depends”. Every startup is different, and so is the optimal funding strategy.
It is always thrilling to start a business. However, most startups lack sufficient funding for their growth. As they attempt to finalise their product or service, ramp up sales and achieve traction, it becomes more difficult for them to set aside time to raise funds for their business.
To take some strain off their finances, the startup founders often rely on private investors. So, who exactly are these private investors and how do they fund startups?
In this series of blog posts I’m deep diving into 4 sources of investment money:
- Friends and family,
- Angel investors,
- Venture capital (VC),
- Late stage venture capital.
My goal is to help you make the right funding decision – what kind of startup funding options are available in different stages, what the strategies are for pursuing them, and how founders can determine a funding path that is right for them.
In the previous post I’ve looked into raising investments from angel investors, whereas this post is dedicated to raising private investments from VCs.
Who are VCs?
Venture capitalists are people who work for venture capital firms which make bets on big opportunities like anyone would in the stock market. Unlike angel investors, they are not investing their own money, but rather the money of their employer – the VC fund. They do everything in their power to make sure their bets pay off, so they invest for the long term. Founders need to have a well-established business, a strong management team, and a good track record of success to get investment from venture capitalists.
A venture capitalist is charged with finding a relatively small number of investments (usually less than ten per year) to cover a 7 to 10 year period. While the venture capital firm may look at thousands of deals in a year, they can only pick a small amount of deals to pursue.
How does raising private investments from VCs work?
A venture capital firm is usually run by a handful of partners who have raised a large sum of money from a group of limited partners (LPs) to invest on their behalf.
The LPs are typically large financial institutions or very wealthy individuals which are using the services of the VC to help generate big returns on their money.
The LPs have a window of 7-10 years with which to make those investments, and generate a big return. Creating a big return in such a short span of time means that VCs must invest in deals that have a big potential outcome, i.e. invest in unicorn startups.
These big outcomes not only provide great returns to the fund, they also help cover the losses of the high number of failures that high-risk investing attracts.
A small number of investments
Although VCs have large sums of money, they typically invest that capital in a relatively small number of deals. It’s not uncommon for a VC with a fund worth €100 million to manage less than 30 investments in the entire lifetime of their fund.
The reason for this is that once each investment is made, the partners must personally manage that investment for up to 10 years. While money is often plentiful, the VCs’ time is very limited.
Understandably, with such a small number of investments to make, VCs tend to be very selective in the type of deals they do, typically placing just a few capital injections per year.
Regardless, they still may see thousands of founders in a given year, making the probability of a startup being the lucky recipient of a big check pretty small.
Depending on the size of the firm, VCs will write checks as little as €250,000 and as much as €100 million. They invest both in early and later stages businesses. The most common check is around €3-5 million and is considered a “Series A” investment. It’s relatively uncommon for these checks to be the first capital into a startup. Most startups begin with finding private investors with pre-seed and seed rounds of smaller ticket sizes from friends and family, then angel investors, before turning to venture capital or other financial institutions.
Favored industries for VCs
Venture capitalists tend to focus on certain industries that are more likely to yield a big return. That’s why it’s common to see a lot of venture capital activity around technology companies (specifically software, SaaS and deeptech) and digital business models, as they scale faster and they could be a huge win for potential investors.
The other reason VCs tend to invest in a few industries is because that is where their domain expertise lies. When it comes to big money investing, VCs tend to go with what they know best.
VCs know that for every 20 investments they make, only one will likely be a huge win. Namely, either the startup they invested in goes public (IPO) or has enough business growth to be sold for a large amount (mergers and acquisition or simply M&A).
VCs need these big returns because the other 19 investments they make may be a total loss. The problem, of course, is that VCs have no idea which of the 20 investments will be the big thing, so they have to bet on companies that all have the potential to be the next Amazon.
VCs tend to be very selective in who they take pitches from. They have the luxury of only investing in well-prepared startups with solid business plans.
Often these relationships are based on other professionals in their network, such as angel investors who have made smaller private investments in the startups at an early stage, or founders whom they may have funded in the past.
While some VCs will in fact take pitches from an unsolicited source, it’s best bet to find an introduction through a credible source. These sources are sometimes other startups the VCs have invested into, so it’s often a good idea to check the VC portfolio on their websites and ask for a warm intro through other startups.
You can see a typical breakdown of the favored sectors for VCs in the image below.
Advantages of working with VCs
Similar to angel investors, private investors such as venture capitalists also come to the table with a lot of business and institutional knowledge.
They’re also well-connected with other businesses that may help a new startup, ner recruits that a startup might want to take on, and connections with other potential investors. Many VCs often run acceleration or business incubation programs that can greatly benefit all startups.
Disadvantages of working with VCs
Also similar to angel investors, part of what venture capitalists want in return for their investment is equity in a startup.
That means that a founder gives up part of their ownership when they bring on venture capital.
Depending on the deal, a VC may even end up with a majority stake, more than 50% ownership, of a startup. That means the founder (or small businesses) essentially lose management control of their startup.
Also, founders should be aware of VC investment cycles, as explained above, and should try to fit within their timing. Asking for an investment at the wrong stage of the VC funds often results in rejection.
Where to find VCs
The first step to find venture capital is to make a smart introduction to the venture capital firm the founder wants to meet. Venture capitalists rely heavily on trusted connections to vet deals and some even run their own portal to get referrals, e.g. see the portal Signal below from Point Nine VC.
Founders shouldn’t try to contact as many people as possible; they should try to find venture capital firms that are the best possible fit for their deal.
The more closely aligned the founder is with the needs of the venture firm, the more likely they’ll find venture capital firms willing to write them a check.
Founders should do extensive research both online and through existing networks ahead of time to determine what types of investments a firm makes, as well as whether or not they have any connections with that firm.
Every pitch to a venture capital starts with an introduction to one of the private investors at the firm. It helps to know the exact profile of a venture capitalist to know which level of introduction makes sense. Typically it starts with an introduction to an associate or the fund manager and then founders can work their way up to the full partnership.
Every startup is different, and so is the ideal funding path. Usually founders start by raising early-stage capital from friends and family and angel investors to validate their value proposition, build initial traction and find their first customers. This is what investors refer to as: “early product-market-fit”.
Later, the more mature scale-ups turn to VCs to consolidate and speed up their growth. This often goes hand in hand with their internationalization and foreign markets outreach.
As you’ll notice in the next posts of this series, additional funding alternatives from different sources are best suited for different startup stages. Choosing the right one can give you the boost you need. The wrong one might hold you back or lead you in the wrong direction.
In the previous post I’ve looked into raising investments from angel investors, whereas in the next post, I’m going to take a deeper dive into the pros, cons, and tactics of raising private investments from late stage venture capital investors.