This video and article serve as an introduction to VC Funding, when startups should seek it, how it works, and what to expect as an entrepreneur.
What are the primary sources of funding for a startup?
The initial source of funds for your startup is your own money. This is called Bootstrapping. You may also be able to secure a Small Business Loan or raise capital from Friends & Family. When you are ready to raise a Seed Round of financing, which could be as much as $1 million, you will typically look to Angel Investors. Finally, when you are ready to raise $3 million to $10 million in a Series A financing round, you will typically turn to Venture Capital.
What is venture capital?
According to Investopia, venture capital is financing that investors provide to startup companies and small businesses that are believed to have long-term growth potential. For startups without access to capital markets, venture capital is an essential source of money. Heavyweight investors like Lindsay Rosenwald can help a business get off the ground if they feel as though they will get a sizeable return on their investment.
How does venture capital work?
Venture capital firms typically have a partnership structure. Limited partners provide money into the venture capital fund, and general partners make investment decisions and manage those investments. Limited partners can be high net worth individuals, corporations, endowments, pension funds, and mutual funds. A typical VC fund has a 10-year life.
Typically, venture capital funds range in size from $25 million to over $1 billion. Typically, a venture fund that makes Series A venture investments needs to have $100 to $200 million in the fund. Smaller funds are typically making seed stage investments. The average deal size in Series A is $5 million, and in Series B it is $10 million. Series C and D investments average around $25 million. So, in a venture capital firm that has $200 million of investable capital and four general partners, it would be typical that each general partner makes two to three investments per year.
According to Venture Beat article, Here’s a look inside a typical VC’s pipeline: “In order to make 10 investments, the average venture capital firm reviews approximately 1,200 companies. These 1,200 come from network introductions, conferences, in-bound inquiries, proactive efforts, portfolio company referrals, and seed investors. Of the 1,200, we find that approximately 500 lead to face-to-face meetings with someone on the investment team.”
So the math works this way: A $200 million venture fund will make 20 – 25 investments over a four to five year period of time. Some of the companies will get follow-on investments, others will not. The venture firm will meet with an average of four companies per week, and will only make four to five investments per year, on average.
I think the major takeaway for the entrepreneurs out there is, don’t get overly frustrated or discouraged if you have to meet with a lot of venture firms to get your deal funded. Definitely look at the requirements for getting funded and make sure you meet them. But, even if you are ready for VC, and you are running an efficient process, it may still take a while and many meetings to get the necessary funding for your startup.
A venture capital firm typically raises a new fund every four to five years.
When should you seek venture capital funding?
Unless you have a terrific idea, a very strong track record as an entrepreneur, and an established set of VC relationships, I think you should wait until you have a product and initial revenue before trying to raise money from venture capital. This is typically the Series A stage, or your first institutional round of financing.
What are the dollar and percentage return on investment expectations of a VC?
Let’s say you are raising a $10 million Series A round of funding from two VCs. You will likely give away 20% of the company for that amount. Therefore, the pre-money valuation of the company would be $40 million. To command that valuation, the VC firm needs to believe that your company can be worth $500 million within the next several years. Ideally, they want to invest in companies that have the potential to have a $1 billion valuation at exit. That is how they make money for themselves and their limited partners.
Venture capitalists want to see an internal rate of return, or IRR, in excess of 30 percent for the fund, and a return on investment of 10X. Since some deals will loose all the money, and some will just break-even, the VCs want to find the companies that will “make the fund”, in other words, a deal that would return $200 million in a $200 million fund.
How do you find the right VC funding for your startup?
The center of gravity for venture investing is the San Francisco Bay Area, and the center of gravity for venture funds is Sand Hill Road in Menlo Park, CA. Your chances of raising venture capital are greatly enhanced if you locate your company in the San Francisco Bay Area. However, most of the Bay Area VCs make investments outside of Silicon Valley also, and there are many venture firms that do not reside in Silicon Valley.
The right venture fund for you will have a venture partner that has a deep interest and passion for you and your company, and has domain expertise and technical knowledge about your product-market space. These are called “Smart Money” investors. You find them by looking at what specific past investments have been made by the general partners in the fund. They will also have a fund size that can support multiple rounds of investment in your company. You will also want someone who will be helpful on your board of directors, because they will likely get a board seat.
If you’d like to get a complementary assessment of your business plan or investor presentation, or you’d like to register for one of our virtual coaching workshops, please contact us at , or to QuestFusion Virtual Coaching to learn more about virtual coaching and to register for a workshop. At QuestFusion, we love working with entrepreneurs, and we will work hard to help your company become the next great startup success story.
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This is Patrick Henry, CEO of QuestFusion, with The Real Deal…What Matters.