Founders & Angels: How well do you understand the Venture Capital business model?

An overview of how venture capital works, where angel investors fit in and what some of the alternatives to traditional VC are

Many founders feel that they are entirely dependent on raising Venture Capital (VC) in order to move their startup forward. My view is that it’s important to evaluate all fundraising routes for a business - for some startups VC is essential and for others it’s fundamentally not a fit.

And when VC is assumed to be the default (or only) option to access capital it becomes a goal to be pursued at all costs without question. There can also be a risk that VC investment is implicitly sought by founders for validation (of them or the business) rather than because it’s necessary or the right time for that business to raise.

I think it’s useful to remember that as a founder you’re building a business first, and raising investment may (or may not) be a necessary means to that end. Successfully building the business will make fundraising more efficient, conversely focusing on fundraising too early may leave you stuck with neither a business nor investment.

In this article I break down the VC business model, signpost some wider analysis of the current trends in VC, some disruptors to watch and alternative funding routes.

Here’s a useful guide to VC jargon, I’ve also explained key terms terms as I go along.

Can you return the fund?
You should know the answer to this question.

Sit in the chair of a VC General Partner for a moment. You have raised money from your investors (more on this later) on the basis of your proposed return of 3-10x on their money after 7-10 years. You will personally benefit if things work out well, sharing in around 20% of that return. Your professional reputation and your personal future wealth are staked on the performance of the companies you choose to invest in.

The companies in your portfolio must grow valuable enough and must exit (sell or IPO) within this 7-10 year time frame. In fact, your successful investments must be successful enough to cover the losses of the ~97% of companies in your fund’s portfolio that either fail completely or deliver minimal returns.

So as a founder, before you start pitching to a VC (or any investor), be as informed as possible and run the calculations that they’re going to run. By your own forecasts do you have the potential to provide the returns they are looking for?

In order to be a match for most funds (and to ‘return the fund’) you must have very strong potential to hit a $1bn+ unicorn valuation within 7-10 years. Is your market big enough that you can Triple, Triple, Double, Double, Double your annual revenue to $1bn? Or hit $100m+ profit (with a 10x valuation)?

A quick way you can check your company’s return profile:

A simplistic take is that VC is a good choice if you’re willing to take an all or nothing bet on creating a very large and fast growing company. However it’s important to understand that if at any point the growth rate or overall scale are in doubt then it’s game over. It will be very hard to raise additional funding (necessary as you will be heavily loss making to fund rapid growth) and/or you will be replaced as founders.

And of course there are many interesting and valuable businesses that can’t grow that quickly or that big, more on how they can be funded later.

So VCs are mercenary financiers taking advantage of plucky founders?

This is where I think the nuance often gets lost - founders conflating individual VC behaviours with the nature of the business model itself. The fund’s LPs are risking money on your business for a return on that money, the GPs are there to maximise that return.

Your goals as a founder and their goals as investors may diverge at some point and they will prioritise the fund’s benefit over the founders, if that is the choice they face. I think it would be naive to expect otherwise and it is disingenuous to cry foul.

There is a huge information asymmetry between professional investors working at a fund and founders who’ve never raised capital before. Investment terms are a complex world unto themselves and it’s critically important that founders ensure they are empowered participants who understand the underlying nature of the transactions.

The game is that you get access to huge amounts of capital to risk building a hugely successful business that may create significant personal wealth and success for you. The fund’s GPs have a duty to reduce the risk of their investment and maximise the return for them, no one else.

Do VC funds only invest in $1bn+ potential companies?

This is a market ripe for disruption. As venture funds continue to target larger and larger outcomes, there is a ton of opportunity left on the table that no one is seizing. You could invest in businesses that have an 80% chance of being worth $300M, rather than a 1% chance of being worth $80B. This strategy is an obvious opportunity to make a ton of money. Start by serving the underfunded, slowly move upmarket, and then, suddenly, you’ve disrupted the entire industry.

Evan Armstrong, Venture Capital Is Ripe for Disruption

There are innovative VC funds such as Calm Company (thesis) already pursuing alternate strategies that target more capital efficient, lower risk and lower valuation deals. They have also pioneered novel mechanisms like Shared Earnings Agreements which allow for sustainable, profitable companies to deliver value for founders and investors alike - not always a given in the traditional VC model!

Although the contrarian VC approach is not without its challenges - fascinating post-mortem of the Indie.vc fund by its founder Bryce Roberts:

Turns out when capital is abundant and everything is up and to the right, the way to manage ownership and optionality in the minds of many is simply raising more money at increasingly higher valuations.

What Ended Indie

Specifically with an impact focus there are venture capital funds such as Nesta Impact Investments, Bethnal Green Ventures or Zinc.vc that seek to balance impact with potential investor returns.

Do angels look for the same returns as VC? #itscomplicated

Angels are private individuals with capital available to invest as they see fit - a far more disparate group than professional VC funds. Angels have no Limited Partners to keep happy and they can target the returns that they choose, often investing in founders or startups that align with their own values. In short, they can do whatever they want, it’s hard to generalise what drives their decisions.

Angels often provide the first capital to a startup, taking on a high level of risk in very early stage businesses when there’s not much track record to base meaningful forecasts on. This initial funding is essential for the startup to demonstrate enough progress and potential to be considered by most VC funds.

In my experience some angels make investments in businesses that it’s clear are unlikely to become unicorn scale. Why? Because angels want to see the startup succeed regardless and are more willing and able to accept lower potential exit valuations. And angels being early investors get the benefit of the earliest, lowest investment valuations.

So in reality it’s a muddy combination of a (sometimes) more relaxed attitude to what the returns might be, as well as the fact that they often are investing at such an early stage that it’s hard(er) to work out exactly what the returns (and later valuations) could be anyway.

Of course there’s a big potential problem if a startup is likely to require VC levels of investment to succeed but is not likely to provide the returns that a VC would require. It’s important for founders (and potential angels) to ensure that they reconcile the business strategy (target market, business model etc) with the funding strategy (bootstrapped, VC, revenue based financing etc).

This article at Rational.vc is some useful further reading on where VC and angel investing meets.

VC not a fit? There’s plenty of other options. Bootstrapping, MicroPE and beyond

There’s a long and well documented history of large and successful ‘bootstrapped’ startups that haven’t taken venture capital funding. Less capital may mean slower growth, which may give you more time to get things right or more time for your competitors to eat your lunch. But you do own the whole company and get to do it your way.

Founders such as Arvid Kahl and Sahil Lavingia are good examples of founders turned authors who have documented their journeys following this path.

Also, there is better information available than ever about alternatives to VC fundraising - Considered Capital is a great place to start.

Funds such as Tiny bridge the gap between venture capital and very late stage Private Equity. SaaS M&A marketplaces such as MicroAcquire enable seven figure exits with less friction than ever before.