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
Founding rounds

 

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
  • Planned use of funds:
    • Early-stage product development
  • Who invests in this round?
    • Typically founders, friends, family, angel investors, and accelerators
  • Some companies go directly the seed stage
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
  • Planned use of funds:
    • Typically financing for product development, market research, and the first steps of the business
  • Who invests in this round?
    • Angel investors, specialized in seed funds, and VCs who invest in early-stage ventures
  • Fewer than 10% of seed-funded companies will go on to raise Series A funds
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
  • Planned use of funds:
    • The funding is often used to get the actual business fully started
  • 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
  • Planned use of funds:
    • Expanding the business and reaching new markets
  • 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
  • Planned use of funds:
    • Funding for further growth: For example, expansion into new markets or products, and acquisitions of other companies
  • Who invests in this round?
    • Previous investors are often accompanied by PE funds, growth equity funds, and other institutional investors
  • Often a company ends its external equity funding with Series C
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
How VC funds help businesses
  • VCs can help businesses in many ways by providing
    • expertise through their business knowledge and industry knowledge
    • connections with suppliers and distributors
    • help with developing marketing, PR, legal, and HR functions
    • assistance in financial modeling
    • connections to other investors in future funding rounds
    • plans and guidance with exits (IPO or getting bought)
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 and cons of VC funding
  • Pros
    • 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
    • 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