Wednesday, February 10, 2016
Lesson #226: What Exactly is Venture Capital?Posted By: George Deeb - 2/10/2016
I have been writing about how to raise venture capital for years. But, I got a very unexpected question the other day: what exactly is venture capital? I just assumed everyone understood what venture capital actually was. But, for those of you who are new to the startup or fund raising scene, this post is for you!!
THE STAGES OF A COMPANY'S GROWTH
All companies start as a piece of paper idea and can grow into billions of dollars of revenues from there. And, there are specific types of investors that help investors along each step of the way. All the way from venture capital, at a company's very early stages, to private equity capital through its middle stages, mezzanine capital which is typically a bridge to the next stage, which is an initial public offering or some other liquidity event. We are going to focus on the very early stages in this post, which is truly the venture capital stage.
THE STAGES OF VENTURE CAPITAL
Even within venture capital, there are investors that focus on different stages therein. "Seed stage" venture investors help get a company off the ground; think $0-$1MM of revenues. "Early stage" venture investors focus on taking a company that has successfully proven its concept, and help them to accelerate their sales and marketing efforts; think $1-$10MM of revenues. "Growth stage" venture investors basically pour kerosene on top of a company that is already "on fire"; think $10-$50MM of revenues. Seed stage investors cut $100K-$1MM checks; early stage investors cut $1-$5MM checks; and growth stage investors cut $10-$50MM checks. And, at each stage herein, most investors have some type of industry expertise that they focus on.
THE FORMS OF VENTURE CAPITAL
Most investors think money is money. But, it really comes in all shapes and sizes. Within the venture capital space, the two most typically used structures are equity and convertible debt. Equity is issuing common stock or preferred stock (with some type of liquidation preference rights). Once invested, equity is owned outright until some type of sale or liquidity event of the company. It does not need to be paid back.
Convertible debt, like its name suggests, is a debt instrument that technically has a maturity date and does need to be repaid at some point in the future. That said, most sophisticated convertible debt investors in venture capital are treating their investment like equity, and are prepared to "convert" their debt into equity of the company, upon the company's next equity round. It is often a "bridge" financing to an early stage or growth stage financing, in a way that doesn't have to set a formal equity valuation of the company. Re-read Lesson #109 for more detailed distinctions between equity and convertible debt.
VENTURE INVESTOR EXPECTATIONS
Venture capital is the riskiest type of investment an investor can make. The odds of a company successfully hitting a "home run" (10x return) is one in ten. Most venture investors are lucky to get their original capital returned, and many investments are simply written off in their entirety. So, from an investors' perspective: buyer beware! Don't think you have the next Google or Facebook on your hands, as you most likely do not. And, from a company perspective, if investors are asking you for certainty of payback or other onerous terms, raise capital elsewhere, as they clearly don't understand the venture world.
WHAT VENTURE CAPITAL IS NOT
It should never be a senior, secured note, like you would get from a bank or pure debt lender. As any investment that has a chance to "strangle hold" the company in the event of it not hitting its plans, is a recipe for disaster for all involved (when not hitting plans is the norm!). Expensive interest rates that need to be paid in cash, or restrictive financial covenants based on your balance sheet metrics are simply not reasonable in the venture world. There is too much uncertainty in the success of the base business itself, to layer on even more hurdles for the company to cross. Forcing bankruptcy for a company with limited assets or ability to repay to start, most always results in a zero return for all involved.
WORDS OF WISDOM
Raising venture capital is not easy; it is more of an art. Not only does the business need to have a good idea, team and traction to get an investor's attention in a very crowded market, but you need to know the right type of venture capital to be asking for. Are you seed stage or early stage? Are you technology industry or retail industry? Within technology, are you B2B or B2C? Are you raising $250K or $2.5MM? Are you raising equity or convertible debt? Your answers to these questions will dictate which investors you need to reach out to. So, do your home work, and don't waste your time with known dead-ends based on the investors target investment, most typically detailed on their website.
As I have said many times in the past, hopefully you have learned: cash is not always the same shade of green! Find the capital that is best for your stage of growth, with industry expertise and a proven team of investors that have been through the "war" many times before (hopefully, bringing great learnings and relationships to the table, in addition to their capital).
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