But the same is true of anyone of lesser means. Thankfully, things are changing, with more ways to help aspiring VCs raise that initial capital commitment. First, find investors, i. Bob Raynard, founder of the fund administration firm Standish Management, echoes the sentiment, saying that a smaller general partner commitment in exchange for special investor economics is also fairly common.
Explore management fee offsets , which investors in venture funds often determine to be reasonable. How do these work? Use your existing portfolio companies as collateral. When determining how much money you need, be sure to build in buffer room for the unforeseen and unanticipated reasonable, not excessive, buffer room.
Despite what is reported, investors are humans too — we know that even the best-laid plans can go awry, and we understand that sometimes things just happen. As mentioned in the beginning, some investors have a clear and simple rule of thumb when it comes to the relationship between need and ask. Sometimes it really is that straightforward, especially if you are pitching to a well-established, institutional firm with which you or your founding team already have a previous and successful history of working together.
More elements end up coming into play, and it becomes much more of a give-and-take. VCs, on the other hand, need to be incentivized by a large enough ownership stake in a company to make it worth the level of risk and investment of their time, money and energy in the company.
There is a natural tension at play that can lead an entrepreneur to request less than, and can lead a VC to insist on investing more than, what might otherwise be an optimal amount of capital for the raise. Even for experienced entrepreneurs, fundraising almost always takes longer than expected, and startups almost always require more money to get off the ground than expected. Therefore, it is critical that a company manage its cash flow appropriately from an operational standpoint — and also pay close attention to cash flow from a personal standpoint.
Some investors will always want to provide extra capital for troubleshooting any unforeseen cash-flow issues. Yet, other investors, like Fred Wilson , prefer to see startups operate as lean and low cost as possible — so the companies move quickly and stay hungry.
In general, the data does not overwhelmingly support one approach over the other, as there does not appear to be a direct correlation between amount of money raised and startup success. Nonetheless, each VC you pitch will surely have an opinion on the matter, and that in turn will impact your fundraising.
Every investor and firm has some sort of reputation. Do yourself a favor and use specific search criteria profile, preferences, policies to measure potential fit before meeting with investors. Should the company stumble and have to raise more money at a lower valuation, the venture firm will be given enough shares to maintain its original equity position—that is, the total percentage of equity owned.
That preferential treatment typically comes at the expense of the common shareholders, or management, as well as investors who are not affiliated with the VC firm and who do not continue to invest on a pro rata basis. Alternatively, if a company is doing well, investors enjoy upside provisions, sometimes giving them the right to put additional money into the venture at a predetermined price. That means venture investors can increase their stakes in successful ventures at below market prices.
How the Venture Capital Industry Works The venture capital industry has four main players: entrepreneurs who need funding; investors who want high returns; investment bankers who need companies to sell; and the venture capitalists who make money for themselves by making a market for the other three.
VC firms also protect themselves from risk by coinvesting with other firms. Rather, venture firms prefer to have two or three groups involved in most stages of financing. Such relationships provide further portfolio diversification—that is, the ability to invest in more deals per dollar of invested capital.
They also decrease the workload of the VC partners by getting others involved in assessing the risks during the due diligence period and in managing the deal. And the presence of several VC firms adds credibility. In fact, some observers have suggested that the truly smart fund will always be a follower of the top-tier firms.
Funds are structured to guarantee partners a comfortable income while they work to generate those returns. If the fund fails, of course, the group will be unable to raise funds in the future. The real upside lies in the appreciation of the portfolio. And that compensation is multiplied for partners who manage several funds.
On average, good plans, people, and businesses succeed only one in ten times. These odds play out in venture capital portfolios: more than half the companies will at best return only the original investment and at worst be total losses. In fact, VC reputations are often built on one or two good investments. Those probabilities also have a great impact on how the venture capitalists spend their time.
Instead, the VC allocates a significant amount of time to those middle portfolio companies, determining whether and how the investment can be turned around and whether continued participation is advisable. The equity ownership and the deal structure described earlier give the VCs the flexibility to make management changes, particularly for those companies whose performance has been mediocre.
They must identify and attract new deals, monitor existing deals, allocate additional capital to the most successful deals, and assist with exit options. Astute VCs are able to allocate their time wisely among the various functions and deals. Assuming that each partner has a typical portfolio of ten companies and a 2,hour work year, the amount of time spent on each company with each activity is relatively small. That allows only 80 hours per year per company—less than 2 hours per week. The popular image of venture capitalists as sage advisors is at odds with the reality of their schedules.
The financial incentive for partners in the VC firm is to manage as much money as possible. The more money they manage, the less time they have to nurture and advise entrepreneurs.
The fund makes investments over the course of the first two or three years, and any investment is active for up to five years. The fund harvests the returns over the last two to three years.
However, both the size of the typical fund and the amount of money managed per partner have changed dramatically. That left a lot of time for the venture capital partners to work directly with the companies, bringing their experience and industry expertise to bear.
Today the average fund is ten times larger, and each partner manages two to five times as many investments. Not surprisingly, then, the partners are usually far less knowledgeable about the industry and the technology than the entrepreneurs. Even though the structure of venture capital deals seems to put entrepreneurs at a steep disadvantage, they continue to submit far more plans than actually get funded, typically by a ratio of more than ten to one.
Why do seemingly bright and capable people seek such high-cost capital? Despite the high risk of failure in new ventures, engineers and businesspeople leave their jobs because they are unable or unwilling to perceive how risky a start-up can be.
Their situation may be compared to that of hopeful high school basketball players, devoting hours to their sport despite the overwhelming odds against turning professional and earning million-dollar incomes. Consider the options. Entrepreneurs—and their friends and families—usually lack the funds to finance the opportunity. Many entrepreneurs also recognize the risks in starting their own businesses, so they shy away from using their own money.
Some also recognize that they do not possess all the talent and skills required to grow and run a successful business. Most of the entrepreneurs and management teams that start new companies come from corporations or, more recently, universities.
This is logical because nearly all basic research money, and therefore invention, comes from corporate or government funding. The VC has no such caps. The venture model provides an engine for commercializing technologies that formerly lay dormant in corporations and in the halls of academia.
Compensation typically comes in the form of status and promotion, not money. It would be an organizational and compensation nightmare for companies to try to duplicate the venture capital strategy. Furthermore, companies typically invest in and protect their existing market positions; they tend to fund only those ideas that are central to their strategies. The result is a reservoir of talent and new ideas, which creates the pool for new ventures. For its part, the government provides two incentives to develop and commercialize new technology.
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