Funding Secrets Series: VC funding

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The first thing the VC will do is look over your business plan and if they like it, invite you in for an interview. If you manage to get through that they will want to do a due diligence audit* on your business. They will generally only invest once you have proven customers and want to ramp up your market traction and grow to own a market. Remember that most VC companies are in communication with each other so make sure to address the issues of one before going to another. They will normally cross check with other VC’s before investing.

The VC will commit a certain amount to your business and normally set pretty strict milestones and targets that you will have to reach in order for them to release the next chunk of cash. They do this so that they can hold you by the balls and make sure that you are continually working at the pace that they want you to. It also gives them a chance to negotiate new terms or direct you in a certain direction before they release the next batch of funding.

A VC has a very strict mandate from their limited partners^ on what sort of return they need to make. This, combined with the fact that they will loose money on most of their investments, means that they can only afford to invest in companies when they can see the possibility of making 10-20 times their money back.* (See Appendix : VC Returns) On average out of every 10 startups they expect: two to fail outright; four for them to close down and recoup some assets; three to make some return on; and one to have a big acquisition or IPO*. This means that the single company has to cover the losses of about six other companies. Remember that they are not investing for the sake of starting companies – they are doing it to make the interest back for their investors.

This can often lead to a conflict of interests between the entrepreneur and VC as the V often wants the business to aim for a huge sellout, whereas the entrepreneur might want to sell earlier.

For example: If the entrepreneur has 50% and sells for R6 million he would make R3 million, but if he waits and goes through another couple of funding rounds, may end up with 5% of a R40 million sale earning him only R2 million for much more work and time. Whereas the VC may have bought 30% for R1.5 million and would only make 0.3 times return in a R6 million sale. By the second valuation The VC might have bought another 30% for another R3.5 mil and at the R40 million sale would make five times their money back. Obviously the VC will want to push for the second option, but the number of buyers at a R40 million valuation is significantly less making it far harder to sell at that value. More often than not the entrepreneur would be better off selling earlier, before he gives away too much equity.

It is this conflict that leads most entrepreneurs only take VC funding when they really, really have to.

Notes:
^ A due diligence audit is when an investor takes a critical look at your business and looks at all the raw data that you can possibly get your hands on, from market research to Competitor analysis and actual contracts and leases. This is basically where they scour your business and look for evidence to validate every aspect of your business plan. It normally takes a couple of months and is very thorough.
^Limited partners are the people who lend their money to the VC firms to invest. The VC managing the fund is called the “general partner.”
^ IPO stands for Initial Public Offering and is when a company goes public by listing on the Stock Exchange.

 

This article forms part of the Funding Secrets Series.
View the Appendix : VC Returns and Investment example

3 thoughts on “Funding Secrets Series: VC funding

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