What’s life like in the startup funding business?

8 tips for funding your company, so you can change the world and the rest of us can live better as a result

funding startup businessesSome folks tell me they don’t think it’s important for founders seeking startup funding to understand VCs.

I get it. VCs occupy a complex world and often there’s a highly contextual finance component that might be foreign to some founders.

But in my experience, it’s a real advantage.

You wouldn’t build a presentation without considering the audience, or start a marketing campaign without learning in detail about your target customer. Funding your startup is no different.

Understanding your counterparts won’t transform a bad company into a good one, but all things being equal, it gives you a competitive edge.

If you know the enemy and know yourself, you need not fear the result of a hundred battles. –Sun Tsu

The world VCs live in

Many founders have images of VCs as deified rich folk who maniacally force entrepreneurs through complex hoops before whimsically bestowing unlimited cash on a lucky few.

The reality is that venture capital is a dynamic but risky and difficult business. This section outlines key concerns and realities that VCs deal with, which may not be well understood by founders.

#1 One thing every investor believes

Entrepreneurs often mistakenly view the role of investors as validating them and their company. They think investors are waiting around looking for causes to believe in or moral justification for handing over the cash and that they will invest if the founder can just convert the investor into a believer in their company.

But investing isn’t philanthropy.

And all types of investors make investments for the same reasonthey believe the value of their investment will go up.

While investors may ultimately be swayed by a belief in the company and its founders, that doesn’t happen unless they first believe that they will see a return.

#2 Startup funding arbitrage

Venture capital businesses generates returns by funding startup companies at early private valuations, then selling at later (often public) valuations which are higher. Early companies are way more risky, but there’s also more equity available for the investment dollar.

A stark difference between these investments and investing in public companies, is that VCs can influence the outcome. They can do things to improve their chances of a return.

Venture capital isn’t just a ho-hum stock purchase, it’s a value-changing event for the portfolio company, both now and in the future. After investing, VCs often nurture the value of their investment by providing important connections, mentorship and advice, board oversight, and connection to subsequent stage capital.

Privy to intimate details and in a position to influence the outcome, funding startups is in many ways a legal form of insider trading.

#3 The price of liquidity

Why are public companies typically worth more than private ones?

The answer is that they provide greater liquidity to investors.

While private, you often have no market or path to turn your equity into cash. This is what it means to have an illiquid investment.

Your chance for a return comes when the company sells or goes public.

Contrast that with an investment in publicly traded stock. If things start going poorly for a public company, you can sell anytime.

Fred Wilson, startup funding venture capitalist with Union Square Ventures

Fred Wilson, Union Square Ventures

Most obvious during 2015–16, the relationship between public and private valuations got a little upside-down for a few private companies. This prompted the following comment from New York-based Union Square Ventures founder, Fred Wilson, on CNBC in 2015,

Public markets are doing a good job of valuing technology companies, but the same cannot be said for private investors. The big problem: Start-ups can get much better valuations in the private market, so when they go public, their shares may end up trading below their last round of financing. Private markets need to be ratcheted back, but how that will happen remains to be seen…

A deeper look at startup funding and private overvaluation is available in Rise of the Paper Unicorns and the subsequent overcorrection in Irrational Cynicism.

#4 VC is the X-games of investing

Most startup companies fail, making funding startups an extremely risky choice for building an investment portfolio.

In 4 Strategic Startup Risk Components for Investors, I mentioned that VCs need great fortitude to invest in startup companies where the SBA says these companies have a 50/50 chance of going out of business before their 5th birthday.

If you wonder why your VC is picky to the point of paranoia, it’s because of VC is the X-games of investing. One false move means a devastating loss of capital.

If you wonder why your VC is picky to the point of paranoia, it's because VC is the X-Games of investing. Click To Tweet

Only the very experienced or the dangerously inexperienced play here.

Additional Reading:
204 Startup Failure Postmortems, CB Insights

#5 Four exits only

After startup funding there are only 4 possible exitsVCs may not be able to predict the future, but there are really only four possible ways an investment can end.

In other words, each startup investment only has four potential exits: it could IPO, it could be bought up via M&A, it could limp along throwing off cash, but never really growing to significant size, or it could crash and burn.

Only the first two are acceptable to venture investors.

They risk the last, in order to have a shot at the first.

#6 VC firms are often startups themselves

While its true that there are a number of legendary name brand mega-VCs, many venture capital investors are young and investing from relatively small and nascent funds. They are in effect, startups themselves.

It’s hard to build a successful VC firm. In the past 10 years, 20 percent of firms have gone away. As of 2015, there were 798 VC firms in the U.S. and not all of those are “active.”

A recent article in Fortune suggests that there are less than 100 active VCs investing in technology and that there are many “zombie” VCs which are riding out their funds but no longer make new startup investments.

Which serves to increase performance pressure and the risk aversion among startup investors.

#7 VCs don’t invest (much of) their own money

Most of the money VCs use to invest belongs to limited partners (LPs) who are in turn investors in the VC fund.

These LPs are essentially investing in the VCs and hiring them to invest their money competently. As a result, VCs typically do not invest from the fund the same as they might invest personally.

They are often constrained by their fiduciary obligations to the investors in their fund. Which means they may have their hands tied no matter how much they like your company personally. Their obligations may limit their ability to invest.

No matter how much a VC likes your deal personally, their fiduciary obligations to the fund may limit their ability to invest. Click To Tweet

timing affects startup funding#8 Capital as inventory

All of that LP money is burning a hole in the VCs pocket.

Quite literally the clock is ticking to generate returns on the LP investment. In the VC business, money is like inventory that must be turned if they are going to generate a profit.

 

All of this is to say that your VC may not view the dollars he is considering investing in your company the same way you are.

It will be much less personal, and she may feel urgency and constraint around terms that you aren’t even aware of.


The content of this article originally appeared as part of 101 Venture Capital Pro Tips. You can read the original as well as 84 additional tips for founders looking to understand the world of new venture financing there.

@chadjardine is the Head of Marketing for @goreact, an edtech startup that makes game film for the classroom. He also teaches courses in venture financing @uutah

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