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Startup Funding: Venture Capital and Alternatives

In this article we'll be discussing your startup funding strategy and specifically the VC community. For your funding strategy it is critical to understand the inner workings of venture capital firms and what they are looking for in evaluating startup pitches.

Let's start with an with an outline of what a VC firm is and what some of their characteristics are. Then we delve into the valuation method , followed by describing how VC's evaluate your pitch. In closing I'll give you some alternative funding options.

Venture capital (VC) firms are investment firms that provide capital to startups and early-stage companies in exchange for an equity stake. They typically specialize in funding high-growth businesses with significant potential for returns.

Here are some key characteristics of venture capital firms and factors that founders seeking funding should be aware of to secure funding for scaling their business:

  1. Focus on High-Growth Potential: VC firms are primarily interested in startups with substantial growth potential in large and emerging markets. They seek companies that can disrupt industries, introduce innovative solutions, or address significant market needs. Startups targeting niche markets with limited growth potential may find it challenging to attract VC funding.

  2. Long-Term Partnership: VC firms often take a long-term view and seek to build lasting partnerships with the startups they invest in. They provide not only financial support but also guidance, expertise, and access to their network of contacts. Founders should consider the alignment of values, vision, and goals when selecting a venture capital partner.

  3. Equity Investment: VC firms invest in startups in exchange for an ownership stake in the company. Founders should be prepared to dilute their ownership and understand the implications of giving up a portion of their equity. However, having a reputable VC firm as an investor can bring credibility and open doors to future funding rounds.

  4. Investment Stages: VC firms typically invest in different stages of a startup's lifecycle, such as seed funding (early-stage), Series A, B, and beyond. Each stage has specific funding requirements and expectations. Founders should target VC firms that specialize in their stage and align with their funding needs.

  5. Due Diligence and Metrics: VC firms conduct rigorous due diligence to assess the startup's business model, market potential, competitive advantage, team capabilities, and financial projections. Founders should be prepared with a well-documented business plan, solid financials, and evidence of early traction or market validation to impress potential investors.

  6. Scalability and Market Size: VC firms prioritize startups that demonstrate the potential to scale rapidly and capture a significant market share. Founders should articulate their plans for scaling the business, including strategies for customer acquisition, distribution channels, and expansion into new markets.

  7. Team and Execution: VC firms pay close attention to the founding team's capabilities, expertise, and track record. A strong team with a complementary skill set is more likely to attract funding. Founders should emphasize their team's strengths and highlight past achievements or relevant industry experience.

  8. Competitive Landscape: VC firms assess the competitive landscape and market dynamics before making investment decisions. Founders should be aware of their competitors, differentiate their offering, and communicate a clear value proposition that demonstrates their ability to outperform existing players.

  9. Exit Strategy: VC firms invest with the expectation of generating a significant return on their investment. Founders should have a well-defined exit strategy, such as a potential acquisition or IPO, to demonstrate the potential for an attractive exit for investors.

  10. Network and Referrals: Building relationships with VC firms often goes beyond submitting applications. Founders should actively network, attend industry events, and seek referrals from trusted sources to increase their chances of securing funding. Personal connections and warm introductions can help grab the attention of investors.

The VC Valuation Method

The VC method, also known as the Venture Capital method or the Berkus Method, is one of the commonly used approaches to value early-stage startups. It is primarily employed by venture capitalists and angel investors to estimate the potential return on investment (ROI) when considering investing in a startup. The VC method focuses on the future exit value of the company and involves the following key steps:

  1. Determining the Expected Exit Value: The first step is to estimate the potential future exit value of the startup. This typically involves projecting the company's future revenue, market share, and growth potential. While there are various approaches to estimating the exit value, a common approach is to use industry benchmarks, comparable company valuations, or assumptions based on the startup's growth trajectory.

  2. Estimating the Investment Horizon: The next step is to estimate the time it would take for the startup to reach an exit event, such as an acquisition or an initial public offering (IPO). This time frame is referred to as the investment horizon. Typically, venture capitalists consider a period of 3 to 7 years for early-stage startups.

  3. Determining the Required ROI: Investors then determine the desired return on investment (ROI) they expect to achieve for the level of risk associated with investing in the startup. The required ROI is usually set as a multiple of the initial investment amount, such as 5x, 10x, or higher. The specific ROI multiple depends on factors such as industry norms, the startup's growth potential, and the level of risk involved.

  4. Calculating the Pre-Money Valuation: Using the expected exit value, investment horizon, and required ROI, the pre-money valuation can be calculated. The pre-money valuation represents the estimated value of the startup before any new investment is made. It is calculated by dividing the expected exit value by the required ROI and adding the initial investment amount.

  5. Determining the Post-Money Valuation: Finally, the post-money valuation is determined by adding the new investment amount to the pre-money valuation. This provides the estimated value of the startup after the new investment is made.

The accuracy of the valuation heavily relies on the quality of assumptions and projections made regarding the future growth and exit of the startup. You can find my post about valuation here.

How VC's evaluate your pitch.

The venture capital funding model requires investing in a very specific type of businesses. If your startup doesn’t fit the model, and most early-stage startups don’t, you can either change your business plan to fit the venture model, or you can find a source of funding that better fits the business. Before wasting time pitching angels and venture funds, make sure your startup meets the following criteria to be suitable for venture funding.

1. Likely to reach $100M in revenue.

VC investor turn to the revenue projections right away. Your revenue growth shows the potential return and this needs to meet a certain threshold. Big funds need big returns.

2. Geared for Hypergrowth.

VC funds have a typical life cycle of 10 years which means that their investments have 5-7 years to an exit, necessary for the fund to close successfully.

3. Barrier to Compete.

Can the startup protect itself against competition and copycats. For example is the proprietary technology patented. Has the management team unique knowledge necessary to scale the company. Is the brand protected with trademarks. Intellectual Property is near to my heart and every startup needs to have a look at their IP strategy.

4. High multiple acquisition.

In certain industries it is common that acquisitions are with high multiplies such as in pharma, medical technology and software. In essence their 'business development' R&D pipeline is outsources to startups. In other industries with a commodity profile, such as chemicals, multiples are lower. Similarly, private equity buys up profitable businesses based on a moderate multiple of profits. This means pitching "PE" as exit to VC investors is a red flag.

5. Acquisition Oriented.

The ultimate goal for VC investors in your startup is to reach a successful exit at a high multiple. An important question for founders is: do you run the business for yourself or to get acquired. This founder mindset is again critical for VC investors, as they need acquisition orientation from the founders.

What are the alternatives for VC funding?

VC funds seeks startups with the investment profile outlined. Basically they are investing in rocket launches, with a high percentage of failure and few successes, that have to make up for the failures. If your startup doesn't mean the VC requirements it doesn't mean it isn't a great business. With smaller funds the numbers will be smaller but the principles remain the same.

Here are a few other ways to fund your startup:

  • Personal and family funds including second mortgages, lines of credit, and credit cards

  • Bootstrap from sales

  • Government grants and awards

  • Project finance & private equity

  • Partnering with a large company

  • Adding an operating partner/experienced executive

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