LN4

### New businesses and venture capital

* New businesses can’t usually get bank financing without revenue or collateral
* They are considered too risky
* They don’t meet the minimum “time in business requirements” and haven’t built a credit history
* Venture capital investors can provide equity financing in exchange for an ownership share in the company

### Seed Capital

* Seed capital refers to the financing used in the formation of a startup
* Typical sources of seed capital are:
* Founder’s own money
* FFF (“Friends, Family, and Fools”)
* Angel Investors
* Startup accelerators
* Fixed-term, cohort-based programs, that include mentorship and educational components

### Angel investors

* Angel investors are wealthy individuals who invest in startups
* They also frequently serve as mentors
* They are willing to invest in promising but unproven business ideas

### Startup accelerators

* Startup accelerators and incubators are mentor-based programs that provides guidance, support and limited funding in exchange for equity
* They typically have a competitive application process
* Famous ones are for example Y Combinator and TechStarts

### How do founders meet investors?

* Personal network and introductions
* Online communities
* Pitch competitions
* Startup events
* i.e. Refresh Miami & eMerge Americas
* Often founders try to make connections with investors already before raising money
* “I’m not raising money yet, but I will be in the next 6 months or so.”

### Signals that can help a founder

* Receiving an investment from a top-tier investor
* Especially if the “star investor” invests on the same terms that the startup is offering to others
* Media attention in a top outlet
* A top-tier entrepreneur or advisor is recommending the company and is throwing their time and reputation behind it
* Introductions made through other investors even if they have chosen not to invest in the company

### J Curve

* The “J Curve” depicts how startup profitability varies over time
* The stages are illustrative and vary across businesses

### Valley of Death

* Valley of death refers to the time period when a startup has begun operations but has not yet generated revenue
* The name comes from the shape of a startup company’s cash flow burn when plotted on a graph
* During this period, the company depletes the initial equity capital provided by its shareholders
* Many companies fail simply because they run out of money

### Most startups fail

* The conventional wisdom is that 90% of startups fail
* Failure can be hard to define but
* 2/3 of startups never show a positive return
* Approx. 20% of new small businesses don’t survive the first 12 months

### Startup budgeting

* “How did you go bankrupt?” “Two ways: gradually and then suddenly”
* Many startups die simply because they run out of money - realistic budgeting is important both for the founder and the investors

### Cash burn rate

* __Cash burn rate__ represents the speed at which an unprofitably company burns its cash reserves
* Gross burn rate = total monthly operating costs
* Net burn rate = gross burn rate - (monthly revenue - cost of goods sold)
* As a rule of thumb, a startup should have 6 to 12 months of expenses on hand

### Runway

* A related concept is “runway,” which tells the amount of time the company has before it runs out of money
* Runway = total capital available for expenses / monthly operating expenses
* Example: if a company has $1 million in bank and spends 100k per month, its runway is 10 months
* This is a metric that both the founders and investors should be interested in
* Basically you gotta “take off” before the runway runs out or you’re going to crash

### Typical components of a business plan

* market analysis
* company and product description
* Competitive analysis
* Execution plan: operations, development, management, marketing
* Current ownership structure
* Current and projected financial information
* Planned budget and use of capital
* Information on the management team

### Funding rounds

* Startups raise money from investors through funding rounds
* At each round, the startup receives more money from investors and typically new investors come along
* Funding rounds are typically categorized as
* Seed (sometimes preceded by pre-seed)
* Series A
* Series B
* Series C
* Series D, E
* There are no strict formal definitions for these terms, but they are connected to the stage of the business

### What happens during a funding round?

* The startup receives more capital, which helps it reach the next milestone
* New investors come along
* Ownership structure changes
* The original investors get diluted (own a smaller fraction of the company)
* The startup gets revalued
* Board composition may change
* Operational and strategic changes
* The startup often enters a new lifecycle stage with different goals
* Sometimes the business strategy and goals change
* Employee compensation plans may get revamped

### Pre-seed - description

* In this round, the founders are first getting their operations started
* Money is used for early-stage product development
* There is a business/product idea and often the goal is to develop a minimally-visible product as “proof of concept”
* The plan is to prepare the startup for more serious fundraising
* Some companies go directly the seed stage

### Pre-seed - planned use of funds

Early-stage product development

### Pre-seed - who invests in this round?

Typically founders, friends, family, angel investors, and accelerators

### Seed - description

* The first “official” equity funding stage
* You need to show that there is a market for the product and a good product-market fit
* Fewer than 10% of seed-funded companies will go on to raise Series A funds

### Seed - planned use of funds

Typically financing for product development, market research, and the first steps of the business

### Seed - who invests in this round?

Angel investors, specialized in seed funds, and VCs who invest in early-stage ventures

### Series A - description

* In this round, you are usually seeking funding to get the business seriously started
* You need a business model that can generate long-term profit
* You need to tell convincingly how you are planning to make money with the product
* In 2021, the median Series A funding was $10m

### Series A - planned use of funds

The funding is often used to get the actual business fully started

### Series A - who invests in this round?

Typical investors are VC funds, but angel investors invest in this stage too

### Series B - description

* In this round, you are usually taking the business to the next level, past the development stage
* To reach this stage, you usually need a substantial user base and evidence that there is potential for success on a larger scale

### Series B - planned use of funds

Expanding the business and reaching new markets

### Series B - who invests in this round?

Typically, the same investors that invested in Series A are also participating in Series B. Additionally, you often get other VC funds or VC funds that specialize in later-stage investments

### Series C - description

* Businesses that raise a Series C funding are already successful
* Series C funding is usually used for scaling up the business and preparing for a successful exit through an acquisition or IPO
* Often a company ends its external equity funding with Series C

### Series C - planned use of funds

Funding for further growth: For example, expansion into new markets or products, and acquisitions of other companies

### Series C - who invests in this round?

Previous investors are often accompanied by PE funds, growth equity funds, and other institutional investors

### Series D and later

* Companies that continue with Series D funding (or E, F, G…) tend to either:
* Seek capital for a final push before an IPO or exit
* Seek additional funding because they didn’t reach the goals set in Series C

### What VC funds do

* Venture capital funds are PE funds that invest in startups and early-stage businesses
* VC funds don’t just provide capital - they also mentor and assist the management team
* VC investors often have board seats in early-stage businesses, and they are involved in key corporate decisions

### Only a fraction of VC investments are profitable

* Most VC investments lose money
* Studies indicate that on average
* 7/10 portfolio companies will not return even the money invested in those startups
* 2/10 are expected to return enough to cover all the losses
* 1/10 generate the 20-30% IRR that investors anticipate

### Home runs are important

* Even though most VC investments fail, the few successful ones can provide amazing returns. These are referred to as home runs
* Home run potential is one of the key aspects VCs are looking for
* Everyone wants to find the next Amazon or Google

### Due diligence for a startup investment

* Typical things VCs evaluate before an investment
* Financial and ownership information
* Validation of user/product data
* Quality of founders’ projections and forecasts
* Quality of the founding team

### VC portfolios

* The number of portfolio companies varies from a dozen to over a hundred
* Smaller funds invest in fewer companies
* Funds that invest in later-stage startups invest in fewer companies
* It is common to reserve 40-60% of the capital for follow-on investments
* This money is reserved for additional investments in successful portfolio companies

### Why follow-on matters

* Famous VC firm Andreessen Horowitz invested in Instagram at seed stage and earned an impression 31,100% return
* Unfortunately, they didn’t make any follow-on investments because they also supported a competing firm
* They sold their stake for $78m, which is microscopic compared to their portfolio size

### Keys to successful VC portfolio management

* Focus on finding the potential home runs
* Follow-on investments are important: double down on the few winners
* Limit losses in unsuccessful investments where you can
* Don’t throw good money after bad - exit unsuccessful investments early

### Pros of VC funding

* Can provide crucial capital for growing the business
* Unlike with bank loans, you don’t need cash flow or collateral to secure funding
* VCs provide mentoring and expertise
* VCs have valuable connections

### Cons of VC funding

* VCs usually want a significant ownership share
* VCs want growth and returns fast, which is not what all founders want
* VCs will be involved in decision-making
* VCs may pressure a company to an early exit

### Evaluating a start-up investment

* What kind of things do VCs focus on when evaluating a startup investment?
* Quality of the product
* Business model (“how will you make money with the product”)
* Scalability and potential for growth
* How big is the market?
* What’s the competition?
* Quality and commitment of the management team
* Potential exit strategies
* Current ownership and funding situation