External funding is one of the most frequent topics when working with startups and SMBs. What's the reason? Sometimes the risk of the new product seems too high to risk the business’ ongoing free cash flow. In other cases entering new markets is a too big and uncertain step for the company. Or naturally that, without external funding, the project investment is just not possible.
Frankly, funding, especially venture capital funding is still treated as if the purse holders are some enlightened, guru-like people who know everything about business and whatever they say (or don’t say) is the one and only TRUTH. I am not implying that VCs act this way (haven’t yet seen any impersonating a guru), but small companies or founders tend to treat them like demigods.
Closing a fundraising round is just like any other sales deal beside some specifics. The key difference, in this case, is that the product is your startup (including yourself). And as in any product sales deal, stepping into your customers’ shoes is of utmost importance.
Your customer in the startup sales transaction is the VC. Seeing their perspective means understanding some basic concepts that founders are usually not thinking about. The people working with the fund think you know, but you don’t know what you should know.
A VC manages a portfolio. It means multiple investments. They are seeking a return on the portfolio as a whole, and not on the individual companies within. In that portfolio logic, some of them have a general IRR applied to each invested company — Internal Rate of Return. The minimum IRR is seldom public, still, typically you can get some insights or indications from industry insiders.
If a fund has 12% IRR targeted, and six years obligation to exit - that means the minimum they will accept after those six years is double the original investment. Let’s assume this VC got a 10% stake in your company. Added to this drag-along right and liquidation preference, and you will see why your company needs to make its value to 20 times the investment to also see similar valuation in your pocket!
To put that in a context closer to early-stage deals: receiving 500k in funding for 10% of the shares with 12% IRR, a 6-year-exit means the company will need to be valued at 10 million in 6 years to reach the minimum threshold for the VC. Somebody needs to either buy the 500k original investment for 1 million (and that’s the bare minimum), better still, buy a more significant chunk, or even the whole company for 10 million. The later they jump on board, the less risk they take and the less the IRR will be, so the math varies.
The goal is to understand, especially with less experienced VCs and select funds outside the US in what type of guillotine you are putting your head in.
A VC will either reinvest in the next round (so-called follow-on investment), stay on board (keep the shares and dilute with further rounds) or exit. Exit through IPO, M&A, acquihire (https://austindalegroup.com/acquihire-vs-acquisition/) or rarely by management buyback. The exit itself does not really affect you in the short term, but understanding the rules the fund has to play by is essential.
Most funds have a definite end date where they have to liquidate their assets and cash out to the investors of the fund (open-end funds vs. closed-end funds). If a fund is closed-end, they will need an exit by that date. So if a fund closes in 36 months, you only have three years until exit, or you have to find another fund to take over the shares. This one is not an easy task as most VCs will do due diligence again, negotiations of course, and besides, later round VCs are not in love with the idea of buying shares from other investors, rather than investing directly into growth. However, there are exceptions to the rule, but it will generate a large amount of extra work for you. Open-end funds don’t have such limitations. Understand the time pressure, if any, on the fund.
Unless you got a senior person from the VC supporting you in your strategic efforts (there are hands-on investors, but that is the exception), investing is a business with its status quo set in stone several decades ago. In most cases, you deal with people who don’t have personal assets invested in the fund they manage or work for. It’s their job to manage the fund - and on a daily level, most of them treat it as a job. They are not investors for pure joy. Don’t take it personally; to them, you are client number 65534, just like in a bank. As you move forward in their sales funnel, the relationship will become more personal, but don’t forget it’s a business.
VCs select deals based on the industry they like. Sometimes it seems rational from the outside, sometimes less so. Does not matter: they decide on the preferred industries and factors they want to consider. Usually, VCs marketing towards startups convey a broader message about what is attractive to them. They rarely admit, but only what they find attractive will pass through the gatekeepers. You can have a great team and numbers, but if it’s not their type of appeal, you won’t meet them. Ultimately they pick a founder and a team. So they will take serious time in vetting you and your team. You should follow a similar approach. If the VC will not let you talk to their investments - well, that is a definite red flag. If they don’t offer such discussions, ask for it.
All in all, you should never feel embarrassed or inferior when negotiating with VCs in any way. For VCs, investment is business as usual; they do it daily. For you, it’s most probably your first time (or second at best).
As you can see, understanding the other side, as in a sales process can help you enormously. Failing to factor in these motivations and behaviors will undermine all your efforts to go big. You will eventually figure it out, but by that time, it will be already too late. You might be employee number one, but never really get paid. If you want to dig into details on VCs, I suggest you read Brad Feld’s VC Bible.
