Chances are, if you follow the tech sector closely or invest in public markets, you are aware of the venture capital industry. Household names, like Spotify, Revolut, Deliveroo, and Reddit have become so due (in part) to their massive funding rounds from prominent VCs, and therefore garnered a large amount of publicity.
But as a Founder is obtaining funding from venture capital firms really the panacea for tech start-ups? Or is it synonymous with jumping from the frying pan into the fryer?
Once you have designed your car (idea stage), and created the car (build stage), you then need to fuel it. There are different options for fuel, all with their benefits and drawbacks. Start-up fuel is no different.
Venture Capital 101
Venture capital is based on a 2+20 remuneration structure, similar to hedge funds. This means that after they receive funding themselves (from Limited Partners, typically for a 10 year fund), they take 2% of the fund for management fees over the next 10 years, and then 20% of profits from the investment, similar to commission. This profit is called ‘carry’ in the VC world and is an important part of their remuneration.
The firm will invest a cheque (anywhere from $100k Pre-Seed, all the way up to $100m for later rounds). This gives the Founder more cash runway and the ability to invest in additional hires, marketing campaigns, and future product development. In return, the VC firm receives an equity stake in the company (typically 25%) and plants a few employees on the board to advise and observe.
VC has been a common route to growth for early stage tech start-ups, as VCs typically have in-house expertise, either from their experience as ex-founders themselves or from learnings of other portfolio companies. These learnings can be invaluable guidance for founders, as they navigate hurdles through growth. There’s also a prominent marketing angle here as well. A non-VC funded company is unlikely to make an announcement that they receive a bank loan to fund operations, or that they are growing organically at a slow rate. It’s just not as compelling a read. If a company raises $10m in a Series A, by comparison, then it’s headline-worthy. With the VC firm and their wider network helping your start-up get views, trials, subscriptions, etc., it’s clear to see how there is value in this approach.
The VC business model requires the firm to return their capital back to LPs, with a return, of course. This requires multiple early-stage bets across several companies in their portfolio. The upshot of this model is that the VC firm then relies on so-called ‘moonshots’ - portfolio companies that will experience hyper-growth and then return the entire fund itself, essentially leaving the other investments as write-offs or cherry on the top of the cake, depending on how they perform.
The downside to this model for the Founder, is that if your start-up is not considered a 'moonshot' for the fund then it can quickly become de-prioritised by the VC firm. This can be subtle signs, like a fresh-faced associate holding the board seat, or a significant drop-off in support offered by the firm.
What is certain is that venture capital funding is growing at a significant rate. This is due to institutional investors looking to diversify their portfolios and seek outsized gains, as well as the rise of angel investors and solo capitalists.
Despite this, Founders need to be wary of venture capital. It's important to complete your own due diligence on a firm so you can establish whether they have expertise and experience in your specific vertical, they have a 'founder-friendly' reputation (in reality, as every firm will say they are founder-friendly), and have the funds available to participate in follow-on rounds as your venture grows.
The amount invested in European start-ups since 2016, as researched by Atomico in their State of European Tech report 2020:
Venture Capital isn't going anywhere anytime soon, and will remain the most popular way to scale your start-up (although I'm dubious as to how long the hyper-growth trend of becoming increasingly loss-making in order to gain new customers will remain a thing).
Be cautious though, as if VC funding is the rocket propelling your start-up, ensure that it's propelling it up to the moon and not into the ground.
Angel Syndicates
An increasingly common option these days, particularly for pre-Seed and Seed stage rounds, is to receive investment from Angel Syndicates. Angel Syndicates are groups of individual investors, 'Angels', who are able to cut cheques of various sizes. These Angels then group together in a syndicate to provide a meaningfully sized cheque for your start-up. A key benefit to going to a syndicate rather than individual angels is that you have a primary point of contact for the entire syndicate, streamlining comms and reducing the admin burden.
In general, Angel Syndicates participate in the earlier rounds of your start-up, and tend to be less involved than venture capital firms (both a benefit and a draw-back). Similar to VC firms, the best syndicates are comprised of Founders and ex-Founders who can draw on their experience to add value to your start-up.
Whilst Angel Syndicates are perhaps not viewed in the same light as venture firms, they perform a similar function and have a similar dilutive impact on your start-ups Cap Table. They won't have the deep pockets that a VC firm will have, and as a result are unlikely to be able to participate in follow-on rounds.
A key benefit to working with Angels over VC firms, is that Angels invest with their own money. Therefore they're not reliant on moonshots as VCs are. Whilst this makes no difference to you if you are the moonshot, if you're not, the Angel won't mind so long as there is some form of ROI.
It's still crucial that you perform your own due diligence on the Angel Syndicate in question, to ensure they are a match to what you're looking for. If you're only after the cash, this doesn't matter. If you're also looking for someone you can reach out to for advice, you need to think carefully about who you go into business with.
Venture Debt
If you want to avoid dilution on your cap table, then another option for raising funds is to go down the venture debt route. Venture debt is more popular in the US than in Europe (where only 5% of venture capital injection is venture debt).
Start-ups are not credit-worthy so you can't stroll into HSBC and get a traditional loan, enter venture debt. Venture debt is similar to a traditional loan, typically structured for three years, although the agreement contain clauses whereby you're agreeing a certain % of your equity goes to the lender if there is an exit event (sale, IPO). The % of equity is usually on a percent or two, and therefore leaving 20+% still with your start-up. The amount of the loan is typically 30% of the last fundraise and includes an interest-free period.
Venture debt is unlikely to be an option for your first financing round, but can work for your second onwards. Having a first financing round is a sign of traction (so is a more attractive loan proposition), and the lender is loaning against the creditworthiness of the VC firm or syndicate, rather than the start-up.
Whilst the minimal dilution is certainly attractive with venture debt, you need to be confident you won't default on your loan, which will then (like a mortgage or any other loan) give the lender the right to call the loan, resulting in a liquidation or forced sale of your start-up so the creditor gets some money back.
So if your Cap Table is looking busy, and your slice of the pie reducing at an alarming rate, consider Venture Debt for your follow-on rounds, but tread carefully.
Bootstrapping
Whilst VC funding is perceived as the best route forward, for Founders with the savings, or with access to a friends & family round, then bootstrapping is a great option. You retain all (or most) of the equity in the company, and don’t have VC board members influencing decisions. Whilst VC board members can be great assets to a company, they can also be detrimental, with some Founders being pushed out by the VC firms.
Bootstrapping means you have no outsiders exerting pressure on you to do a certain initiative, or change how you're running your business. You can also grow at your own pace. As identified in an earlier newsletter, you may prioritise work-life balance over growth at all costs. A lot of investors won't like the sound of that but if you're bootstrapped then their opinions are irrelevant - you can do things your own way.
For me, there are three main draw-backs to bootstrapping:
Access. Most people do not have a large savings account, a trust fund, or family money to use as seed money for their start-up. Depending on the venture this can, in some cases, immediately rule out bootstrapping as an option. Further compounding this issue is that the Venture Capital industry does not serve under-represented founders. Pale, Male, Stale has been the industry's mantra to-date.
Advise. First-time founders are bound to make mistakes along the way. Having an advisor who has navigated these mistakes before, who can be a sounding board for key decisions, is undoubtably beneficial. As above, if you're from a privileged background you may have a rolodex of friends in high places which mitigate this, but for those who are not as lucky, this can be a key drawback.
Marketing. Bootstrapped Founders can't leverage the brand, reputation and networks of their venture capitalists to expand their start-ups reach and attract the best new talent. It's certainly possible to build a great marketing department in a bootstrapped start-up to get the word out there, as well as a great, holistic remuneration package and company culture to attract the best talent, it'll just take a little longer than those who take the VC route.
As long as you have the funds to bootstrap and are aware of the above draw-backs, it's definitely the way to go. You can always find other Founders to lean upon for advice.
If you can bake the pie with your own money, try to keep the pie (you should still share up to 20% of the pie with employees to give them skin in the game though).
Parting Shot
In all of the media craze that surrounds funding round after funding round, oftentimes the company isn't profitable and has no realistic plan to get there. Both Airbnb and Uber mentioned in their respective IPO prospectus' that they may never be profitable.
Herein lies the ridiculousness of the venture capital industry - pumping the money of LPs into companies that, whilst trendy and novel, are struggling to work out how to become profitable. Whatever happened to business fundamentals and unit economics?