For Startups, It Pays to Partner With a High-Quality VC, Even If You Give Up Some Equity
My research shows that the best VCs take more equity, but can nearly double the value of the companies they invest in.
The number of venture capital (VC) funds has exploded in recent years, giving entrepreneurs more options than ever to finance their startups. There are now close to 2,000 VC firms in the U.S. alone, with over $54 billion invested in early-stage startups each year. Finding the right VC to partner with can be make or break for a young company, determining how much money it raises and the advice, networking and resources it gains access to. How can entrepreneurs identify the best VC for their company and avoid becoming one of the vast majority of startups that don’t make it?
When fundraising, entrepreneurs sometimes have their vision muddied by the desire to keep as much equity as possible, hoping to maintain greater control and the possibility of a bigger payoff down the line. However, my research as a professor at the University of Southern California’s Marshall School of Business shows that VC quality is much more important than equity share or other contract terms. In a recent study, my colleagues and I found that the highest-caliber VCs offer founders a smaller slice of a bigger pie, taking more equity but nearly doubling the value of their companies compared to lower-quality VCs.
Related: 5 Unconventional Ways to Attract VCs
Founders can be rewarded for giving up some equity if they pick the right VC
It’s true that VC investors take a substantial stake of the companies they fund. Our analysis of first-round funding for more than 2,500 startups over the course of a decade showed that VCs typically took more equity and stronger contract terms than were optimal for maximizing a company’s future value. An effective investor stake of 28% (including equity and other preferential contract terms) led to the highest company value, but the average deal gave VC investors a stake of nearly 50%.
This finding might seem to confirm founders’ fears about giving up equity. However, our research also showed that the impact of VC quality — a holistic measure combining many different factors in our model — more than makes up for the tendency of the best VCs to take more equity. Startups that received investment from the highest-quality VCs were valued 89% higher than those that received investment from the lowest-quality VCs. As a result, the founders’ share was worth 33% more than if they had partnered with a low-grade investor. Painful as it may be at the time, founders can be rewarded for giving up some equity if they pick the right VC.
The difference VC quality makes reflects the many things these investors do for a young company. VCs are typically very hands-on and help with connections, recruitment and strategic advice, especially if they receive a board seat as part of their investment. Research has repeatedly shown that companies funded by high-caliber VCs are more successful at reaching an IPO or acquisition than their peers. In addition, partnering with a well-known VC can be a reputation boost: Companies with a prominent VC backing them exit faster and at higher valuations.
Even the best VCs don’t demand overly lopsided terms these days. The sheer number of VCs, along with the growth of other early-stage funding options like angel networks and crowdfunding, has led to greater competition to invest in promising startups. VCs also know that they can hamper a startup’s future growth and their own profits by taking too much equity.
Founders should network early and often
It’s clear from our research that identifying a high-quality VC is critical to a young startup’s success, but defining “quality” is more of an art than a science. To begin, founders should consider a VC’s reputation and track record and get input from other entrepreneurs who have worked with that investor in the past. Finding the right fit is extremely important since an investor will typically be a partner in the company — and potentially a board member — for years to come. The better a VC understands and supports the founders’ vision, the more they will be able to contribute to the startup’s development.
Founders should network early and often and talk to as many VCs as possible, evaluating what each can bring to the table and whether that justifies giving them a higher stake. Having multiple offers gives founders more bargaining power when it comes time to negotiate contract terms. In addition, founders should ask potential partners about how their fund is structured and what money will be available for follow-on rounds. Throughout the process, founders should focus mostly on the lead investor since they will negotiate the terms, receive the lion’s share of equity and be the most involved in helping the company grow.
Raising the first round of VC funding is a defining moment in the life of a startup. As the number of VC firms and other fundraising options has grown, finding the right partner has become more daunting. My research shows that choosing a superior VC can nearly double the total value of a startup and lead to a better payoff for both VCs and founders. Given the important role VC quality plays, founders should look beyond equity stakes and contract terms and consider what an investor can do to help them grow their company — even if it means giving up a bit more equity in the process.
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