Thursday, March 3, 2011

Lesson #4: How to Raise Capital for Your Startup

Posted By: George Deeb - 3/03/2011


& Comment

Of all the consulting inquiries I get at Red Rocket, fund raising is by far the biggest need of these startups.  And, the problem is, not all startups are venture backable for a variety of reasons, which we will discuss in this post.  Today, we will tackle: (1) is my industry appealing to venture investors; (2) is my business appealing to venture investors; and (3) if so, various ways for attracting capital for your business.

First of all, angel investors and venture capital firms invest in a wide variety of industries (e.g., technology, digital media, CPG, retail, real estate, healthcare, life sciences, manufacturing).  So, before reaching out to any investors, make sure your industry is clearly in their sweetspot and skillset.  That said, there are certain industries that have a LOT more startup activity than others.  As a rule, business that heavily invest in real estate, inventory or other capital risk, are materially less desirable than simple technology businesses.  So, bad news if you are a start-up restaurant, retailer, REIT or manufacturing business.  Good news, if you are a dot com, software or technology business.  The reason for this investor bias is the extra levels of risk that get added to your startup.  Business startup risk is bad enough, with only one in 10 startups succeeding.  But, when you layer on real estate location risks, long term leases or merchandising inventory risks, it becomes a much bigger pill for the startup investors to swallow, unless they have deep expertise in that space.

But, even if your industry is in one of the more active venture markets, there are still numerous hurdles to cross in assessing your specific business.  Are you B2C focused or B2B focused?  Are you a sales driven or marketing driven company?  Do you need $1MM or $25MM to succeed?  Do you have one time revenues, or a recurring revenue model?  Are you the first mover in your market or entering a highly-competitive space?  Is your technology patentable or not?  Is your business easily and cheaply scalable, or does it have heavy overhead investment along the way?  Are you serving a $1BN market, or a $100MM market?  Is my forecasted ROI going to be a 10x return or 3x return?  Is it a first time CEO, or an established veteran?  How deep is the management team?  Has there been proof of concept, with revenues or site traffic to date?  So, as you can see, lots of hurdles to get over to get an investors' attention for your business.

Now, lets assume you are one of the lucky 5-10 in 200 that has a venture backable business.  How do you typically phase in investment.  You can't simply show up at a big Silicon Valley venture firm with your piece of paper idea and say cut me a $10MM check.  Investors are typically segmented by life-cycle stage of the business:  angel investors or friends and family typically get a business off the ground from a piece of paper to a working prototype; Series A venture capitalists will put in $1-$5MM after there has been a preliminary proof of concept, based on revenues, pipeline, site traffic or some other metric; and Series B venture capitalists will put in $10-$50MM to hit the accelerator after the model is finely tuned and scaling.  So, when you are approaching the investment community, make sure you have thoroughly researched not only their industry focus, but their stage of business focus as well.

Once the term sheets start flowing in, how do you ultimately decide who to move forward with?  At the end of the day, you need to follow your gut.  Who is going to be the best partner for my business, bringing a Rolodex of relationships to the table?  Who is going to be the most pleasant to work with around the board table, especially when things start to go wrong (as they always do)?  Who has the deepest pockets to invest additional monies in follow-on rounds?  Who is giving me the best valuation?  Whose term sheets are more or less onerous than others in terms of liquidation preferences and anti-dilution rachets?  So, hopefully, what you are hearing is, not all venture capital is the same shade of green, and it is important you do your homework upfront, to avoid misery down the road.  And, if you are not clear you are making a good decision on your own, ask an advisor to help you.

But, overriding all of this, if you can figure out a way to fund your business, with no outside capital, that is the preferred model.  It preserves the founder's 100% control of the company's equity, board control and the timing of a sale (or not), at terms 100% satisfactory to the founder.  Don't get romanced by the idea of raising venture capital, because it certainly has its strings attached, given the reasons above.   But, if you think you have the next big idea at the scale of a Google, Facebook or Groupon, the venture community will be your best partners, having funded several of those similar businesses and navigated the various pitfalls along the way.

In the words of my old boss at CSFB . . . "Happy Hunting!"

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project rover said...

very interesting post. I am a transmedia content provider and distributor. I have a question:

what is the competitive liquidation preference in 2011 for venture capital today? 1x? 2x? 3x? well you get the idea…..

Thank you kindly. BTW, your email addy kicks back.

George Deeb said...

The liquidation preferences will vary based on overall risk and return assessments by the investors (e.g., the bigger their return or the less the risk, the lower the liquidation preference). I think it is safe to start at 1x in these markets. Email should be working? Don't forget the VC at end of RedRocket.

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Kamel S. Abou faraj said...

great guidelines to follow.

If I have an idea and a plan but no prototype. and I have to approach about 20 potential investor in order to find one who might be interested to partner with me. How can I reveal my idea and plans to such large number of people without risking the idea being hijacked by any one of them. After all, they all have the experience and resources to do the business without me?

George Deeb said...

Kamel, I think you give investors too much credit. It is very unlikely they will want to steal your idea. They are too busy investing, to want to try and build a business on their own. And, most VC's won't sign NDAs, so don't even ask. Just be careful to whom you reach out to for investment, to make sure they don't already have a competing portfolio company in your space.

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