Funding 101, Part 6: Venture Capital

In the 6th part of her excellent series about funding, Elizabeth Crowell looks at venture capital, a source of investment which is often talked about, but frequently misunderstood. To read Part V of the series, about angel funding, click here.

Need more dollars than an angel round can bring? Your business might be right for venture capital. These two words solicit a host of reactions, but venture capital is a vital part of the funding ecosystem, meeting the needs of a small group of companies every year.

It's helpful to understand venture capital's place and purpose in the funding world to evaluate whether it makes sense for your own endeavor.

First off, if you raise less than one million dollars, VCs are not the right source. Why? Probably a hundred or more companies a week cross a VC's desk, and as you can already guess, nearly all of them are rejected.  Howard Morgan, of First Round Capital, recently quipped at the Venture Forward Conference presented by Gust, that his job is saying “no”. Therefore, most VCs don't have the bandwidth to look at a company that is raising less than $2-3 million. And although some VCs invest in pre-seed or seed stage companies, about 60 percent invest in early or expansion stage companies. VC money tends to be geographically focused as well.

More than 80% of VC money goes to companies based in and around Silicon Valley, southern California, New York and Boston.

Starting a software company? That's good news for venture funding, since about 50% of companies that VCs invest in are in the software industry. Sadly, VC funding is an area that is completely male-dominated: 92% of companies funded are comprised of male-only founders. Ann Winblad, Co-Founder, Hummer Winblad Partners, who keynoted the Venture Forward Conference in New York in June, was a fountain of information about the trends in venture capital. She took us through an exercise of deciding whether the Twin Cities tech start-up that she successfully grew and sold would make the cut today. The short answer was: probably not.

If you are still game for going for VC dollars, here's the clincher: Will your company produce a 100X return on investment?

Whether it's start-up, seed, early or expansion stage, venture capitalists gamble for high stakes. So if your company is valued at $1 million, they are looking for a $100 million valuation by fund maturity paired with an exit through a merger, IPO, or sale. 

Taken as a whole, it's no wonder that only 2500 companies a year are funded by VCs, with only 1000 companies receiving their first round of capital from VCs. But VCs not only bring their connections and strategic insight, they also bring a ton of cash. Upwards of $30 billion a year is invested by VCs, so if you are up for the challenge, securing VC dollars may be well worth it.

With all the start-ups looking for capital each year, how can a founder make it into the lens of a VC?

Beyond meeting most of the criteria I’ve discussed, you must work your network. A personal introduction or indirect connection may at least get you onto the desk. Christine Herron, Director at Intel Capital, said referrals from entrepreneurs who were previously turned down were her top deal source. This makes the case that networking among your peer founders is time well spent. Accelerators are also emerging as a source for VCs, essentially funneling high quality options to VC firms. Finally, proven, trusted attorneys who work with start-ups tip off VCs to interesting and potentially lucrative opportunities.

And, crucially, not all funding/investors, and in this case, VCs, are the same. Reputation and track record matter, so aim for the most well-respected, top-notch, expertise/industry aligned VC you can find. This is important not only for the immediate impact on the day-to-day operation of your business, but also for later funding options.

Entrepreneurs frequently overlook how VCs are compensated. Unlike individual investors, they earn their salary whether or not your company is successful.

This is because they collect management fees from their investors in addition to taking a cut (usually very large) of returns down the line. If you haven't already guessed, VCs virtually always take an equity stake (and depending on how much you are raising and valuation, a hefty one) plus a board seat. Here's a helpful online simulator from DevelopmentCorporate to estimate the decreasing ownership stake that a founder retains as more and more outside equity investment is secured.

Still on the fence as to whether venture capital is right for your business? Ponder this summary of venture capital, as explained by John Mecke, Managing Director of DevelopmentCorporate. "It is important to note that Venture Capital is a high risk business – most investments never pay off, and for those that do, they need a very high rate of return. Conversely, most entrepreneurs cannot fund the development of their startup on their own – they lack the personal wealth or bank credit. It is certainly better to own a very small piece of a valuable company than to own 100% of something that has no value. One fact of venture capital investment you cannot escape is that for a very successful company, the VCs will make three to five times as much money as the founders in any successful liquidity event. If your company has better than average success, you might be lucky to return the investors’ original investment, which means that as founders, you end up with practically nothing. If you are not comfortable with this reality, then funding a startup with venture capital is not for you.”

Elizabeth Crowell is the co-owner of Sterling Place, a multichannel retail company that sells eclectic antiques, fine home decor and specialty gifts. Profitable from year two, the business has steadily grown, with two store locations in Brooklyn, as well as a website. Sterling Place has been profiled by the NY Times and Elizabeth has been a repeat guest expert on Martha Stewart Living Radio. In 2011, Elizabeth was selected as one of 10 in the inaugural class of Pipeline Fellows, a program designed to train women to angel invest in women-led triple bottom line ventures, ie. profitable, environmentally responsible and delivering social impact. She is in the process of building out her own angel portfolio. For more information on Elizabeth, see her profile.

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