Inside Venture Capital

Wire

Many entrepreneurial companies seek to become backed by venture capital (VC) because such backing signals strong buy-in from a large investor asset class who believes in the company’s business model. Venture capital also helps a company grow. But, as many know, the venture capital community is tight-knit. For companies seeking VC for the first time, there are aspects as to how the VC community operates that one should know and integrate into how one approaches them. In this article, we share some important considerations.

The sheer numbers

There are approximately 800 active venture firms in the United States, and that is down 20 percent from the 1,000 that existed in 2005, according to the National Venture Capital Association. This equals 1,224 VC funds in existence. The size of an average VC fund is $135MM, and the average venture capital under management per firm is $207MM.

In terms of those receiving the venture capital, in 2016, 42 percent went to California based companies, while 22 percent went to New York and Massachusetts based companies. 16 percent of all companies were based either in DC, Texas, Illinois, Colorado, Pennsylvania or Virginia. The rest of the United States made up the remaining 20 percent.

Each partner within a VC firm sees between 300-500 investment opportunities a year, and of that, they invest in only 1 or 2 companies, placing odds of sourcing capital from VC at less than 1 percent for issuers. Often, a VC’s initial investment into a company is only a fraction of the total capital that they will reserve for that issuer in that in later rounds they often add 2 to 3 times their initial investment. If you identify a current fund size and divide that number by 20 to 30, that is likely the total amount of reserve capital they are able to invest in your company. For their initial investment, they often ask for a 20 to 30 percent ownership stake. For the issuer, the number that matters is referenced as the “promote.” Promote is the percentage of ownership you, the founder, has after the VC round is completed. For example, if after the VC invests, your company has a $10MM post money value, and you have a 20% interest, then you have a $2MM promote, or said another way, you have $2MM in value that you are carrying forward.

How to get the attention of a venture capitalist

The process of securing venture capital necessitates a well thought out plan. Ideally, company owners will want to meet the venture capitalist well in advance of the company actually needing the capital investment. If the formal discussions should begin 6 months prior, the introduction and informal conversations should begin ideally a year or more in advance. Why such a long runway? It is because venture professionals like to track the story and watch it unfold rather than be contacted at the last minute, so to speak. Establishing a conversation early allows the VC professional to hear about the milestones company owners hope to accomplish over the next 6 months and then learn whether they hit those milestones or not.

How does one create a connection with a venture firm?

The introduction itself is critically important. The most valuable introduction is through someone that has already made money for that particular venture fund. A former owner of a portfolio company that the VC fund has already exited that was highly successful would be one example. The next best connector would be someone the VC has already worked with, likes, and trusts. Next, a solid network connection can also be credible. The most common VC sourcing strategy is to combine their own efforts, with reviewing opportunities from the investment banking community. Increasing competition has caused about half of all VC funds to plan to change and improve their process for sourcing, fundraising, and portfolio management. Investment bankers make up about a quarter of VC deal generation, according to Teton.com in 2016.

Once the introduction is made, the initial connection could be a 3-minute email response by the VC professional. That could open the door for a 1-hour face to face visit, which could then be followed up by a second, longer, face to face visit. In that meeting, the VC professional might begin to dig deep with Q&A time. That could result in a full-fledged due diligence effort. That effort leads up to a partners’ meeting where partners vote on whether to make the investment or not. At that stage, at the partners’ meeting, company owners are likely asked to make a presentation.

What are VCs looking for?

Large addressable market size and potential market share are critical. If the company’s total market size is not significant, even if one can establish a 20% market share, it will not make for an attractive 25% to 60% required rate of return (return depends on what stage of VC one is seeking), and they will pass. They also are looking for an attractive business model. This could mean unique IP or technology, or even a business model that is hard to duplicate. A company’s proven ability to attract and retain a high caliber team is strong on their priority list. Finally, they want to like the owner. How one shares the investable story and can defend all assumptions made matter to them.

Clearly there are many hurdles to jump in order to secure VC investment. It is not an impossibility though. Through June 30, 2017, year-to-date, 1,137 companies received VC funding for the first time. When one is able to marry a compelling business model that serves a need that is in high demand or could be in high demand, with a world class team, expect the unexpected in VC firms wanting to get to know you better.

Sources: Bussgang, Jeffrey, “In VC deals, price doesn’t matter – but the ‘Promote’ does,” http://bostonvcblog.typepad.com (July 15, 2009); Cook, John, “The Number of Venture Capital Firms has shrunk by 20 percent in the last 10 years,” www.geekwire.com (March 8, 2016); Harvard i-lab, “Mastering the VC Game: How to Raise Your First Round of Capital” (April 26, 2012); 2017 Pepperdine Private Capital Markets Report; S&P CapitalIQ; Pitchbook.com; Teten, David, “Where Are The Great Startups” www.teten.com