Here’s how dark things have been. The National Venture Capital Association has made available an analysis by Cambridge Associates of the internal rates of return for the average venture-capital fund that normally has a 10-year life.
Simply put, VC has been underperforming the average stock index since venture returns peaked in 1999. In the decade ending in 1999, the average VC generated a whopping internal rate of return of 83.4%. By 2010, the typical VC fund was a big money-loser, generating an internal rate of return of -5.2%. But by the mid-2012, the typical VC fund had recovered to generate a positive internal rate of return of 5.3%.
In the past two years, I have interviewed about 200 entrepreneurs from venture-backed companies. From what I can tell, issues such as a possible recession, rising raw-material costs and unstable capital markets that seem to bother big companies do not seem to trouble many start-up CEOs. What keeps them up late is worrying about how they’ll turn their vision into a reality. But they don’t see macroeconomic forces as the impediment.
They are concerned with keeping enough cash in the till to pay their suppliers and their people. For that, they rely on a ladder of cash sources: customers who pay enough for them to make a profit, suppliers who extend generous payment terms, their own frugality when it comes to items that don’t add value to customers, friends, family, angels, and venture capitalists – many of whom can be supplying cash at the same time.
The capital is mostly for paying talent chart-topping salaries. When it’s in short supply, they must mint their own emotional currency to continue hiring and motivating their industry’s top stars. Given the war for talent, this means start-up CEOs are concerning themselves with how to craft a vision that persuades the best job candidates that they will be missing out on a great opportunity unless they join their start-up.
In the past several years the battle for that talent has intensified because so many individual investors have become fabulously wealthy in recent years. According to a start-up chief executive officer I interviewed recently, these wealthy investors have been pouring seed capital into start-ups at the earliest stages of development without sufficient discipline.
These investors expect only one in 10 of these companies to succeed. But the availability of the seed capital is driving up the salaries of top technical talent.
And that means entrepreneurs cannot compete for that talent unless they can pay top dollar and offer a compelling mission. Not only that, but the rise in seed capital has been accompanied by a plunge in the availability of Series A funding. This means that unless a start-up can become cash-flow positive after using up its seed capital, it will struggle to get the next stage of funding – cheques in the $5 million to $10 million range.
Silicon Valley insiders will be closely following:
- Breakthrough products: At trade shows such as the Consumer Electronics Show and others, from time to time there are big surprises that become game-changers. When they appear, venture investors could be motivated to place more capital in those companies and related businesses.
- Quarterly NVCA reports: If the NVCA reports show rising VC-fund internal rates of return of higher than 8%, it could become be easier for the funds to go to their limited partners and raise fresh capital. And it would be particularly useful for entrepreneurs if those reports show high single-digit returns for Series A investors.
- The Startup Visa Act: This proposed measure would change U.S. immigration laws to create a new visa for immigrants who can raise $250 000 for their start-up company. Another possible legislative change would be to expand the existing EB-5 visa program for immigrant investors.
These changes, should they occur, could point the supply of venture capital in a new direction. The supply of talent would rise and start-ups would be better off.
Winners and Losers
Winners in 2013 will be owners of enterprise information-technology companies that go public, while losers will be those who bought consumer Internet companies at their initial public offering prices and investors in clean tech.
Start-ups in enterprise IT are also more likely to come out ahead, whereas start-ups in the consumer space are likely to have a harder time getting funding.
For the New Generation of Venture Capitalists, Their Advice Is More Valuable Than Their Money
For example, SugarCRM, an enterprise software company, is expected to go public in 2013. And if it follows in the footsteps of another enterprise software IPO winner, Workday, an enterprise software-as-a-service provider whose stock popped from $28 to $50 on its first day of trading in early October and is now at $55, more such start-ups will go public in 2013.
It’s the consumer-tech companies that seem to be having more trouble. As of December 20, people who bought Facebook, Groupon and Zynga at their IPO prices are underwater to the tune of 11%, 81%, and 75%, respectively.
An NVCA survey of 600 entrepreneurs and venture capitalists conducted between 26 Nov and 7 Dec 2012, reveals that many believe a shift in VC investment is underway that will benefit some sectors and hurt others.
More specifically, capital is expected to flow into start-ups that provide information technology to businesses. More specifically, 61% of respondents expected increased investment in business IT, while 57% predict a rise in investment in health-care IT.
Consumer IT investment appears to have peaked out, with only 35% of respondents expecting an increase in that field. But pessimism reigns for investment in other sectors: 61% see a drop in clean-technology investment, 53% see a drop in medical devices backing and 40% expect biopharmaceuticals funding to decline.
My sense is that these expectations are based on the returns to investors in these sectors. For example, Facebook’s disappointing IPO and a flood of money into consumer IT have created something of a bubble aftermath. Meanwhile, VCs expect companies to spend more heavily on enterprise IT, thus boosting the prospects for start-ups that sell IT to business.
And the absence of attractive investment returns in clean technology, medical devices and biopharmaceuticals is also dimming expectations in these areas.
When it comes to liquidating their investment, VCs are more optimistic than CEOs in 2013. Of those VCs who responded to the NVCA survey, 40% expected a boost in 2013 IPO volume, while 52% envision a boost in IPO quality. Start-up CEOs are less optimistic: 29% see an increase in IPO volume and 37% envision IPO quality to improve.
Moreover, VC optimism for IPOs is higher for those sectors, such as business IT, where they expect to see more capital and lower for life sciences and clean technology where they see a drop in capital.
The coming year promises to be a mix of old and new for VCs. The old: Entrepreneurs will execute on strategies to boost market share, raise capital and attract top talent, while VCs will try to maintain their slow upward trajectory after more than a decade in the desert.
The new: That success will depend on whether VCs are right that enterprise IT will generate high internal rates of return after disappointments from consumer Internet, clean tech. and medical devices.
The Truth About Venture Capital Funding
Before you plough hundreds of hours into securing your dream investor, consider if VC funding is the best fit for your business.
Venture capital is often regarded as one of the most attractive and sought-after sources of financing for start-ups, and rightly so, especially due to the range of value-added services that a venture capital firm can provide to help the start-up grow and succeed.
For any founder considering venture capital, it’s important to keep in mind that there are many driving forces behind the scenes for the venture capitalist, which may cause problems for the founder team and the start-up. This could be anything from pressure from the VC’s own investors, or other deals that have gone wrong for the VC in the past.
Not all VCs are created equal
A point that was commonly brought up by founders is how their expectations have not been met. Not all venture capitalists are the same, and they vary in terms of the extent to which they are able to provide value-added services.
There were several cases from the start-ups interviewed who stated that their expectations had not been met. In certain instances, this is a result of the venture capitalist not living up to their word, but it is often because the founders’ expectations are not set at the correct level.
Your move: The best way to manage this is by doing extensive research on the venture capitalist you are engaging with. As a founder, you should not be afraid to speak to other entrepreneurs who have dealt with the VC to gain an understanding of what to expect if you engage with this particular firm.
Chasing funding is time consuming
As a founder, it’s important to manage your time carefully, and getting involved with VCs makes this even trickier. Generally, founders will need to go to countless meetings before they are able to get any investment. Over and above meeting with investors, the process of fundraising can be very time-consuming, especially if you enter a due diligence phase with investors.
You should not underestimate the time required for this, which is further elaborated by the founder of a firm that went through several fundraising rounds: “It was really a strain on the business during the fundraising period due to the time and effort involved in engaging with VCs. And actually, a lot more than we thought. It really took a lot of time and work to get the money and I think that’s the most disruptive thing to the business.”
Once you have VCs on board, another time element is introduced. Of course, a lot of time would be spent on productive tasks with the VC, which is beneficial to the company. However, several founders criticised the amount of time that they felt was wasted on non-productive tasks — the type of administrative tasks and reporting that VCs generally require. This requirement varies amongst firms, but it’s understandable. They have their own investors and reporting requirements.
As a founder, you generally will have key roles across the board, and your time is extremely valuable. If you become involved with a venture capitalist, the non-productive time spent with them generally can’t be avoided, but it’s something that should be taken into consideration, and a key part of your planning.
Your move: Approaching multiple investors, conducting due diligence and reporting to your VC if you close a deal are all extremely time-consuming tasks. Does your business need the funding, or would your time be better spent building the business while you bootstrap it?
Who holds the control?
From the perspective of the venture capitalist, one of the most important aspects is control. Although loss of ownership and control for yourself as a founder may be obvious, there are several implications to consider.
First, a VC with less than 50% ownership of a company (which is often the case) does not necessarily mean they have no control in your firm. They usually have a variety of control mechanisms, which, in practice, give them control of many elements of the business.
A VC can, under certain circumstances, replace the CEO or founder team, even if they don’t have majority control. This can happen for a variety of reasons, such as a lack of growth, internal conflicts, or a high employee turnover rate.
Second, as has been seen in several VC-backed firms, when the venture capitalist has control and is able to influence decisions, this potentially leads to several conflicts. One of the founders interviewed had this to say: “We were at a point where we needed to make a critical decision on the strategy of the business. Our venture capitalists were pushing for a change; one that I was not happy about. This caused a lot of conflict and confrontation. In the end, the venture capitalists were able to enforce the change by convincing some others on the board. Ultimately, this decision didn’t work out and the business suffered substantially.”
Your move: The ability of a venture capitalist to enforce a decision is dependent on numerous factors, and especially the investment contract. The structure of the investment contract is critical, as it can determine the future relationship with your investor. Consider all these factors as you enter into an agreement.
The problem with too much money
A point that may seem counter-intuitive at first is that receiving venture capital can actually put a sin into your business model. Why? Because a big cash injection can distract you from your core business operations. You’d think that suddenly having lots of money (when you’ve been trying to get an investment) is a perfect situation.
Generally speaking it is; but there’s also a very real danger that not managing that money correctly can put you and your business in a situation where you’re even worse off than before receiving it.
Inexperienced founders are the most likely to experience this problem. Many start-ups interviewed talked about how they initially wasted money, overspending and putting it into the wrong areas. The classic problem is that in order to grow your business and improve your results, you hire people, but you don’t necessarily grow a business by hiring people. It’s absolutely essential to manage this money wisely and to avoid the money serving as a false sense of security.
Your move: In almost all cases, it’s advisable for any new entrepreneur to bootstrap for as long as possible. Don’t see funding as the first option. Try to raise as much as you can yourself, get revenues as early as possible, and focus on your fundamental business operations. It’s amazing what you’ll learn about business when you have to be very careful with your cash — and be cash generative as quickly as possible.
The exit question
Venture capital investments are generally governed by a life-cycle based on when to enter and exit from investments. These are typically around ten years.
When the fund gets close to the end of its life cycle, the fund managers, or investors, will be under pressure to gain liquidity for their investment. An important consideration for a founder is how old the fund is.
The closer the fund is to the end of its life cycle, the more challenging things can become, due to this additional pressure for liquidity.
Related: New Ways SMEs Can Find Funding
As many founders have experienced, the topic of an exit, or liquidity event, can often be a difficult one, especially if the founders are not ready to exit. “The discussion around the exit was a major confrontation because they wanted to sell, and we didn’t want to sell,” says one founder. Who makes the final decision is dependent on a variety of factors, and especially the terms that are written in the investment contract.
Your move: Carefully consider the life cycle of the fund that will be investing into your business. If you’re just at the beginning of your start-up journey, selling too soon could cost you a lot of money. Rather find a different VC firm or funding route, and hold onto your equity for longer.
Bringing it all together
All in all, venture capital is a great source of finance and its value should not be discredited.
There are numerous benefits to venture capital, and receiving professional mentoring, assistance and resources from people who have the knowledge and experience can be an invaluable tool.
Just the fact of having your firm backed by venture capitalists serves as a type of ‘stamp of approval’ for other players in the market. The points mentioned above do not necessarily represent every venture capital investment, but it is important to understand some of the potential impacts of going the venture capital route, and with this knowledge in hand, you can better prepare yourself for the process.
How Giraffe Played The VC Game (And Won Funding)
Local start-up Giraffe has accomplished what many entrepreneurs would consider impossible: Not only did it win the Seedstars World’s Best Global Startup Award, it has also secured funding from Silicon Valley VC firm Omidyar Network. Here’s how the founders have managed it.
- Players: Anish Shivdasani and Shafin Anwarsha
- Company: Giraffe
- Established: 2015
- Background: Giraffe is a fully-automated mobile recruitment agency service that enables businesses to recruit medium-skilled workers quickly and affordably.
- Visit: giraffe.co.za
Most start-ups would kill for the sort of trajectory Giraffe has enjoyed over the last 18 months. Since launching early in 2015, the company has enjoyed solid growth and traction, received some great PR, walked away with an international award and managed to secure funding from a Silicon Valley VC firm.
This is all incredibly impressive, and there’s no doubt that most start-ups would love to emulate Giraffe’s success. So how have company founders Anish Shivdasani and Shafin Anwarsha managed to get the whole world talking about Giraffe? Here’s their advice on attracting VCs to your start-up.
Solve a real problem
“We looked at the South African landscape and identified unemployment as a real problem. Then we asked ourselves how we could use technology to address and remedy the problem in the short term, if not solve it,” says Anish Shivdasani.
“We did this for two reasons: Firstly, we felt that there was a certain obligation to try and solve a real problem that the country was dealing with. Secondly, we realised that by looking at an emerging-market problem, it was not something that Silicon Valley start-ups would be looking at. We wouldn’t be competing with large and well-funded companies.”
So what does Giraffe do? Essentially, it allows jobseekers to upload a CV to the company’s mobi site for free. When employers need to hire, they simply submit a staff request at www.giraffe.co.za and algorithms sort through the thousands of CVs in the database and automatically identify, contact and schedule interviews with relevant candidates.
“We wanted to make the hiring process as easy and hassle-free as possible, both for employers and jobseekers. This meant coming up with an innovative solution. We created a system that allowed a CV to be completed quickly, but that didn’t require a lot of text. The system navigates a jobseeker through various options, ascertaining his or her skills and experience. So you don’t need to deal with hard-to-understand text,” says Shivdasani.
Lesson: Come up with a truly innovative product or service, and you’ll find that funding isn’t nearly as hard to come by as people often say. Build a solid company that addresses a real problem, and funding will find its way to you.
Bootstrap as much as possible
Unless you’re a hot Silicon Valley start-up with unicorn potential, you’re unlikely to attract funding until you’ve shown some traction.
Shivdasani and Anwarsha didn’t even think about funding during the early days of Giraffe. “We were focused on getting the platform and the business going,” says Shivdasani. “We had put our own money into the business and managed to give ourselves 12 months of runway. For that period, we didn’t give any thought to VCs and funding.”
“We also found that VCs will usually be reluctant to invest if you haven’t bootstrapped for a while,” adds Anwarsha. “They want to see that your company has some traction, and they want to see that you’re invested — that you’ve put your own money into the business and that you are committed to making it work.”
Lesson: Bootstrapping your business is a good idea. The best way to build a sustainable company is to spend as little money as possible up-front and get cashflow-positive as quickly as possible. Depending on funding for survival is risky. What if the money falls through? Create a business that can sustain itself. Rely on funding only for scaling.
Let the money come to you
“While we bootstrapped early on, we also met with investors. These were mostly people we had been put in contact with via our own personal networks,” says Shivdasani. “Importantly, we never asked for money. In fact, to this day, we haven’t asked for money. We simply introduced ourselves to investors and placed Giraffe on their radar.”
By introducing potential funders to the company, but not asking for money, the founders of Giraffe let the company’s performance speak for itself.
“We simply stated our intentions when we met with investors. When we saw them again six or twelve months later, we could tell them that we had followed through on our plans. We had attained some real traction, which made us worth investing in,” says Anwarsha.
Lesson: It is a stark reality of the start-up scene that the companies without much of a need for funding are usually the companies that attract it. This is hardly surprising. Investors want to fund companies with growth potential, not start-ups struggling for survival. So, focusing too much on attracting investment can be counter-productive. Instead, get the fundamentals right. Build a sustainable business. If you do that, the money will eventually come to you.
Don’t underestimate the value of PR
“While working together in the boardroom, I received an email from SeedStars to take part in the South African leg of its global start-up competition,” recalls Anwarsha.
“Anish told me to forget about the mail and get back to work. We were very careful not to be distracted from our primary goal of building the company, but I was keen to give it a try. Anish said it was okay, but there was one condition: Make sure you win.” Anwarsha did win, and it had a profound and immediate impact on the company.
“Until that moment, we had underestimated the impact that good PR could have,” says Shivdasani. “I was interviewed by John Robbie on 702 for a few minutes. Suddenly our servers were being overrun with new jobseekers and employers. It made us realise that entering things like start-up competitions is a good idea because of the PR it can generate.”
Lesson: Marketing can be useful, but nothing compares to great PR when trying to introduce your start-up to the world. Winning a start-up competition — of which there are no shortage these days — is a good way to do it. Another is to contact media houses and pitch your story. It’s important, though, to focus on the problem you are solving. Journalists are particularly interested in companies that are either innovative, or working at solving social issues.
Don’t just take the money
It’s very hard to say no to VC money, but before you grab anyone’s cash, it’s worth taking a moment to consider the long-term implications.
“It’s important to get on with the people who will be investing in your company. You need to be able to work with them. We were approached by another investor as well, but we ended up going with Omidyar Network — who had approached us after we won the local SeedStars event — because the firm was asking the right questions. They grilled us hard, but we realised that as an impact investor, they could bring value to the business,” says Anwarsha.
Giraffe has also been careful in how much investment it has actually accepted.
“After winning the local SeedStars competition, I travelled to Switzerland to represent Giraffe in the global event,” says Anwarsha. “To my complete surprise, I won. It was a surreal experience.”
The prize came with a maximum investment from SeedStars of $500 000, but Giraffe was reluctant to take it.“We had already closed a round of funding and had enough runway for at least 18 months,” says Shivdasani.
Lesson: Equity in a start-up can be cheap, and many founders have kicked themselves for giving away too much too soon. That’s why it’s important to keep operating with that bootstrapping mentality, even if you’ve received some investment. You want money to last as long as possible. The less money you need, after all, the less of your company you need to give away.
If no one is willing to invest in your idea, you should take another careful look at it. Focus on solving a real problem and the money will usually follow.
Before You Pitch Investors, Ask Yourself These 4 Questions
To set yourself up for success, here are some guidelines to follow when raising money.
Over the past couple of years, a narrative has existed in the start-up community that has led founders to believe that to succeed you need to grow at an irrational pace and to grow quickly you must raise monster rounds of venture capital at “unicorn” valuations. Based on my experiences that’s not sustainable and it’s not true.
Being thoughtful about the amount of money you are raising and at a valuation based on growth metrics will get you much farther in discussions with venture capitalists. It will also provide a greater degree of freedom, as it relates to your options for exits and future capital raising.
Before you set out to fundraise you need to determine the right amount of capital at a reasonable valuation. The answer is definitely more of an art than a science and no two situations are the same, but as a venture capitalist I’ve been pitched by hundreds of startups and have seen and heard from companies asking for too much, too little and everything in between.
Below are my tips and guidelines when raising money:
1Do you need venture capital?
Venture capital is not always the right kind of investment for every business – or perhaps it’s too soon for venture funding.
Do your research, there are more ways to fund your business than ever before. For example, a small business like a bakery is likely better off with a SBA or bank loan.
Recent equity crowdfunding rules have also made it easier for companies to raise money from anyone interested in investing in start-ups. The most important thing to consider when raising VC money is the size of your market. This number should guide you towards how much money you need to raise.
2. What phase is your start-up?
Carefully consider the stage of your start-up and where you hope to be in the next one to two years. While it’s important to have a long-term vision of your business, in the early stages it’s all about executing on the limited set of milestones and deliverables you’ve promised to your investors. It’s the best key to securing additional capital.
3. How will you use the money?
Raising too much capital too quickly can be a bad strategy for an early-stage start-up without a clear plan to deploy the capital in productive value-creating ways. Tying this use of cash with a set of clear milestones is critical to articulate in your pitch to prospective investors (“We’ll hire X salespeople and invest $Y in marketing to produce Z results”)
The industry your company is in matters. For example, an internet-based company might not require as much cash as a hardware company. Or if you’re operating an ecommerce business you will have more inventory, which requires more upfront capital than a software company. And VC’s aren’t immune to investing around hype, like the recent “Uber for X” trend.
4. What does the VC market look like?
Consider the macroeconomic environment and factor that into your long-term planning. If there is less venture money in the market you would be wise to raise more money once instead of having to return to the market to raise more money a year later.
Finally, recognise that raising money is time consuming work and the leadership team needs to make time for building the business, too.
This article was originally posted here on Entrepreneur.com.
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