Who finances the Startup journey

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Learn the game of VC fundraising from scratch

 

At TheVentureCity Growth Program, we, the Bank team (ahoy!), help founders to crack the “VC game”. Our goal is to help founders to a) be efficient when fundraising (so they don’t lose focus) and b) Optimize their equity value through their startup journey.

When you raise funds for your startup, one of the first challenges is to know who is willing to fund it, at which stage, and why. Also, before raising, make sure that you understand the stages of a startup and whether VC money is or is not the right thing for your startup (we will blog about that soon).

“The most important thing is not to let fundraising get you down” — Paul Graham

(*) Red line = Earnings of a startup. Source: “Technological Entrepreneurism” — Mario W. Cardullo (1999)

In the pic above, you will find an illustration matching, in general terms, the stages of startups according to its revenues with different sources of funding over time, assuming the correct milestones are achieved. As discussed in our previous post, each of these milestones reduces the risk of the startup.

Depending on the risk tolerance, we will find a different type of investors at each stage. And the risk tolerance will ultimately define the investment criteria of each type of investor at each stage.

(1) Risk “perceived” by Startup Investors over TIME — Less Risk = Higher Valuation (Ceteris paribus).

Raising capital/ Financing: Debt & Equity.

As you may know, raising capital, aka Financing, is the process of providing funds for business activities; that includes both Debt (Loans) and Equity.

Debt is a loan that businesses must pay back with an additional interest; it is not an investment. On the other hand, Equity is also an inflow of cash but it relinquishes ownership stakes to the shareholder that should generate returns (via dividends or an exit); it is an investment. It is important to note that the cost of equity is typically higher than the cost of debt. For the moment, just remember that both debt and equity have their advantages and disadvantages.

Why Banks Say NO to Startup Business Loans

The goal of banks, a regulated industry, is not to invest but to finance business and people (remember now the difference between debt and equity noted above).

Normally, banks finance businesses with positive cash flows, or at least, cash flows that are relatively easy to predict. You can imagine that a business with a relatively less uncertainty (risk) around its cash flow will enjoy a relatively lower interest rate on its loans (cost).

Unfortunately for banks, the mature businesses also face challenges and, sometimes, businesses can’t repay their loans (for instance, Toy’s R Us in 2018). However, thanks to the profits made by the majority of the loans, banks have a profitable business. On the other hand, because the majority of the startups fail, and banks can’t predict which ones will do, lending money to startups is not a popular business as of today.

Here is why Banks typically don’t finance startups…, read the full article at Crunchbase

However, despite the daunting startup survival curve above, some pioneering banks, such as Silicon Valley Bank in the US, have partnered up with equity investors to offer debt to startups.

Finally, it is also worth mentioning that non-bank lenders like venture debt firms offer loans to late-stage companies. They combine their loans with warrants, the right to buy equity, to compensate for the higher risk of default.

Private Equity Investors

Because the equity of startups is private (not listed on a public exchange), we say startups raise capital from (early-stage) Private Equity investors. Private equity investment comes primarily from institutional investors, which are organizations that invest on someone else’s behalf, and also from accredited investors, individuals who can dedicate substantial sums of money for extended time periods.

If we look at the stage when these institutional investors invest, we can classify them in the following three groups:

  • The Early-Stage Private Equity investors are typically investing in companies searching for a Product/ Market fit and a business model that scales. Basically, we are now talking about Business Angels, Seed Capital investors and Venture Capital investors.
  • The Late-Stage Private Equity investors invest in fast-growing companies that they already know how to create a profit, but they are delaying their profitability to win markets before their competitors do. These investors will be Venture Capital firms managing Growth Capital funds and, sometimes, investing in companies before going public. Interestingly, the Corporate Venture Capital funds, the investment arm of large corporates, are rapidly gaining share in this segment.
  • The remaining Private Equity investors, which generally are called just like that (PE investors), are those investing in companies that had gone beyond generating revenue with profitable margins, stable cash flow, and can serve a significant amount of debt. Their target investments can be public or private companies.

The classification of these investors depends on their risk tolerance, which will ultimately affect their criteria in the fields like the size of investment tickets, the type of investment (e.g. convertible note vs. equity), the return targets (e.g. 50% IRR vs 20%IRR), the profile of the investment team, etc.

Source: The Corporate Finance Insititute

Early-Stage Private Equity Investors

The typical Early-Stage investors are Business Angels, Pre-Seed, Seed, Micro VCs, and VCs (fund-size +$100m). But, in the product-based software industry, nowadays, when do they invest?

  • Business Angels, Pre-Seed and (some) Seed Investors invest when the founders are figuring out the product (aka “ideation phase”) and/ or when the product is already gaining initial traction (aka “user/ product fit” phase). That is mostly the Pre-Seed and (first) Seed rounds.
  • Seed Investors, Micro VCs, and (some) VCs invest when the product has been successfully accepted by a market (aka product/ market fit). Nowadays, that is mostly the (second) Seed and Series A rounds.
  • Most VCs firms normally invest when, in addition to the product/ market fit, there is also a business model that is repeatable and scales. Nowadays, that is mostly the Series A and Series B rounds.
Source: David Skok, www.forentrepreneurs.com

Note that I haven’t mentioned “Friends, Family, and Fools” (aka FFF) because they rarely are accredited investors. However, they are usually the very first to invest in a startup and a great source of energy for the founders.

As a conclusion, and as a reminder, if to make the trip of your startup you need to access financing from investors, remember that one of the keys to making the fundraising process efficient is to understand them; that is, understand what they are looking for, when and why.