VCs Are Starving -- Starving! -- for Solid Investments: 5 Ways to Take Advantage
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Raising capital is no easy task. Over the past five years, I’ve had to do it multiple times -- for a management buyout, for our first accelerator fund and for the purpose of supporting more than 100 of our own startups.
Things might seem daunting in that regard. But in actuality, it’s a founders' market right now -- because major venture capital firms have plenty of money to invest early in promising companies. A report by KPMG reveals that the venture capital world collected more than $17.15 billion in capital commitments in the second quarter of 2017. So good news for businesses looking for capital: the cupboard is far from bare.
Still, that doesn’t mean you should stroll into your local VC's office and start tossing out demands.
The reason: Founders naturally have some anxiety about dealing with potential investors. They’re already putting in 80-hour work weeks to keep companies running, and picking up an entirely new financial skill set takes time. Hopeful entrepreneurs are tasked with sinking hours into mastering the bizarre lingo and politics of the financial world; and they still run smack into a wall of rejection.
Nobody likes hearing his or her baby is ugly, but that sort of kick in the teeth is common when you interact with VCs. Dealing with these stressors under tight deadlines only amplifies that anxiety.
Yet, here’s a dirty little secret of the finance realm: Investors are just as anxious and excited as you are about a potential partnership. It might feel like they don’t have a dog in the fight, but they need you just as much as you need them. So, stick with it. Here are some tips for how to do that.
A journey into the mind of a venture capitalist
Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist by Brad Feld is a great guide to the VC world. Once you have the context down, you'll find it easier to close the deal on your first round of funding.
“Venture capital firm” is a fancy name for an investment company that makes risky bets for equity in companies with hopes of a high return. These firms rarely use their own cash, and investors pay them an annual fee to put their capital to work regardless of the number of investments or returns.
General partners (fund managers) typically make money doing this two ways: a 2-ish percent annual management fee based on the fund’s capital commitments and a carried interest (i.e., profit share) of the fund’s returns at the end of its life -- usually about 10 years.
Meanwhile, limited partners (investors) only make their money when a fund is liquidated at the end of that life cycle. Limited partners (LPs) are playing the long game and tend to be hands-off with investment decisions. They pay a management fee regardless of whether their money is invested and is making returns; and they get grumpy when that money isn't put to work.
Most VC firms maintain a godlike image from entrepreneurs' perspective, but most of them are actually pretty bad businesses from that same perspective, because the average VC firm barely generates any returns for its investors. Considering this crappy performance, most LPs would be better off investing diectly in the teenagers peddling homemade slime on Instagram.
That said, though, there’s still plenty of money available for investment in the global economy. As interest rates approach zero, investors are scrambling to find vehicles for massive amounts of capital -- hell, even state retirement funds are entering the VC game.
In short, the supply (available capital) is significantly outpacing the demand (viable startups). Despite sometimes laughable returns, there is no lack of funding available to viable startups interested in going the VC route.
Related Video: What Venture Capitalists Want to See in Your Business
5 tricks to raise capital the right way
I’ve played on both sides of the fence myself, first by raising money for my company, and now by providing capital to startups through Coplex Ventures. Don't become overconfident, but you can relax when dealing with VCs if you keep these tricks in mind:
1. Be ready for action. A survey from Upfront Ventures found that LPs are at their most optimistic since the recession. They’re hungry for new opportunities, which means the VCs you’re talking with are likely being squeezed by their LPs to cut checks and make investments.
Like you, they’d like to get a deal inked fast. So, be prepared to move quickly, by getting your financials in order. Get your story straight about plans and projections, and find a polite way to request a definitive answer regarding the investment in a specific time frame.
2. Meet the minimum performance metrics. Many VCs are sitting on loads of cash. They have raised more than $130 billion in the past three years and are capable of supporting your company’s growth. Do your research on Crunchbase to learn about any particular group of venture capitalists' investment history.
Once you understand a firm’s typical round size and investment preferences, you’ll have a better understanding of "fit," as well as the valuation you can demand. Most VC firms have clear-cut performance metrics that ventures must meet before they'll consider them. A Broadway-quality pitch by itself won't be enough because many VCs have moral -- and sometimes legal -- obligations to their LPs on these numbers.
3. Don’t be intimidated. There’s no reason to be nervous around fund managers -- they have just as much to lose as you do. Cambridge Associates’ benchmark for returns in the first quarter of 2016 was 0.2 percent for its U.S. Private Equity Index and negative 3.3 percent for its U.S. Venture Capital Index. Most VCs are figuring things out as they go -- particularly if it’s their first fund (and yes, we're currently running our first fund). You can use this to your advantage when negotiating a deal.
4. Know exit horizons. VCs want exits out of their current fund before the end of its life so they can create investor liquidity. Ask questions about when the fund started and add 10 years to that date. This will give you an idea of the time frame the firm you're interested in has to create exits and uncover their deal selection motives.
If a fund has a lot of capital to deploy and is a few years in, it needs to make bets for quick (even if smaller) exits. If the fund is just starting, its VCs are going to be more open to longer exit horizons. Capitalize on this.
5. Know the boundaries. Funds are governed by private placement memorandum (PPM) and limited partnership (LPA) agreements. These provide LPs a clear “investment thesis” while creating boundaries for the types and stages of investments they are willing to make. If your company doesn’t fit a fund’s thesis, it cannot legally or ethically invest in you. You can save time -- and avoid potential rejection -- by reviewing these documents first.
Too often, entrepreneurs submit to the godlike aura of venture capitalists with their flashy cars, expensive shoes and corner offices. Instead of falling for this, remember that it’s a founders' market.
If your company has solid people, processes and products in place, you have plenty of leverage. Quantifiable data is often the biggest gating factor, as VCs use hard numbers to quickly sift through applicants. As long as you meet their metrics, you’re in a great position. The next time you walk into a fund-raising meeting, remember: You’re the one holding the cards.