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The “Art” of Raising Venture Capital for a Business

April 29, 2016 by Dr. Jon Warner in Finance / Cash Flow

The “Art” of Raising Venture Capital for a Business

It is tempting to believe that there is a system or even a formula for raising venture capital for a business when it is needed but there really isn’t. However, there are a number of broad guidelines that we can adopt and in this brief article we describe eight questions that might be useful to think about before you start the process of raising venture capital. 

1) Determining whether or not you need venture capital?

Many entrepreneurs think that angel or venture capital is the best way to grow their entrepreneurial business. However, very few startup companies can and do raise venture money (it’s not so simple to do). Apart from being difficult to raise, even if successful it can be more costly than other methods including bank loans, grants, funding from foundations, joint ventures, supplier funding and even customer funding or purchase-order financing. Companies therefore should ask themselves what kind of startup they are trying to build and what the most appropriate funding vehicle should therefore be. 

2) Deciding what different types of venture capital could be appropriate?

Assuming that a decision has been made to raise venture capital it is important to think carefully about what stage of venture capital you might need. Although there are many categories of venture funds, in general there is early, mid- and late-stage investment. Early-stage investors typically run smaller funds (perhaps of $50-$100M) and focus on seed and series A investments of perhaps $3M, $5M or $7M. Later stage investors will often have larger funds and will usually focus on the larger series A investments (say $8-15M) and series B investments or a 3rd round of capital (of say $15 to $50 million). Finally, late stage venture investors will look for larger B and C stage rounds, which can mean very large investments often running to 100 million+.  Every venture firm has a primary focus, (not to mention industries and sectors they tend to prefer) and it’s therefore important to understand this and not unnecessarily waste your time or theirs. 

3) Arriving at a Fair Valuation

Many companies value their companies (usually highly) and are then disappointed when it is often valued at much less by a venture firm. Even when a firm agrees with a company’s valuation, the key here is to make sure that it is realistic and that the funds and expertise that comes with the money are the best possible choice for the company and that value can be grown or built.

4) Considering a Convertible versus Priced round of Funding

Convertible notes are essentially loans that (generally) convert to equity upon a subsequent equity investment round. These therefore tend to work well when a company can relatively quickly achieve a large valuation at the conversion-triggering equity round. Priced investment rounds, on the other hand, (or what is often called preferred stock investments) tend to work well for companies that can negotiate a substantial valuation at their seed round and can readily cover the extra legal expense of this transaction over a convertible note round. When companies and investors elect to go for a convertible note, it is often because they are relatively easy and cheap and it keeps the company’s fair market value down (as this is a debt on the balance sheet). Convertible note holders are creditors of the company and therefore receive liquidation preference. In addition, most early stage investors are typically comfortable deferring the negotiation of investor rights to the later stage VC firms involved in the future investment transaction. 

5) Shopping Around for Venture Money

There are two theories about seeking venture capital. One is that this is best done by targeting a small number of well chosen VCs (maybe 3-4) and then seeing them one at a time to see whether there is interest and a possible deal before moving on to the next one. The second theory is that it is best to go to many VCs and “cast a wide net” all at approximately the same time, as investment is both slow and difficult and you need lots of possibilities to succeed. Both approaches are widely used and there are no firm rules about which is better. However, it is better to think about this up front and to recognize whether or not the organization has the “bandwidth” to engage in the latter approach. 

6) Dealing with Founders Ownership and Cash needs

A significant challenge when a founder or founders raise venture capital is when a founder or founders want to extract some cash for themselves, even if this means reducing their overall equity stake or ownership. This is a careful balancing act on both sides. Some small levels of immediate liquidity may be acceptable to an investor but not too much so that it hurts the business – and if it’s too much they may also feel that the founders incentive to work towards the growth goals are going to be lessened. For an investor, any release of cash is often welcome after months and often years of relative fiscal hardship on a personal level. However, this may come at a high price if equity is reduced substantially and is worth considerably more on the next round of financing or on exit in the future. 

7) Facing the Need for Funding Syndication

Another significant challenge to be faced when raising capital is that it may take two or more venture companies to provide the money acting as a “syndicate”. As a founder this usually means more work to find an “anchor” or leader investor, who may supply 40% or 50% of the money that is being sought, who can then help the finder to find other funding sources to then come into the syndicate. Of course, this demands more complexity in terms of additional term sheets and relationships and in terms of who might be involved in the company at board or advisory level (all of which needs to be thought through carefully to make sure that it is good for the business). 

8) Raising the “Right” Amount of Cash (Not too little or too much)

Fairly obviously, raising too little money for the needs of the business means that it may simply not have enough “runway” and run out of cash before revenues have kicked in strongly enough. But less obviously, raising too much money can also have its problems. Firstly, it might dilute founder equity more than necessary and mean that operations may not be run quite as tightly as they could be (founders being commonly seduced by thinking that they can spend a little more lavishly than necessary in many ways because they have money in the bank). As a result business founders should raise just enough capital to take it towards the next milestones, while keeping a healthy cushion for adverse events or outcomes.

Summary

Raising venture money is a step that many entrepreneurial companies consider at some point but it is not without its difficulties and challenges. Founders should plan for this activity very carefully and make sure that they have sound answers to all of the issues raised above before they make the leap.

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About Dr. Jon Warner

Dr. Jon Warner is a prolific author, management consultant and executive coach with over 25 years experience. He has an MBA and a PhD in Organizational Psychology. Jon can be reached at OptimalJon@gmail.com

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About the Editor and Primary Author

Jon Warner

Jon Warner is an executive coach and management consultant and in the past has been a CEO in three very different companies. Read more

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