Raising venture capital represents a real challenge for all early stage business leaders. The exercise demands that entrepreneurs understand the world of private equity, which often means coming to terms with the venture capital process and recognizing the specific focus different private equity groups have across diverse industries.
The first challenge entrepreneurs face is understanding who or what group might be interested in investing in their specific venture. This requires conducting a study of the venture capital industry to learn who the big and small private equity players are within your specific sector.
Every stage of a businesses’ life-cycle requires capital, and clearly understanding what stage your business is currently operating within is essential to discovering appropriate sources of investment.
Within venture capital industry, the commonly understood stages of a business include; seed, early stage, growth, and mature.
Every private equity firm will have a very specific criteria for the type of business, and business stage that they invest in, so it is important be aware of what stage your business is in, and the type of investment you require to take your venture to the next stage.
To better understand the progressive stages of a business and how they correlate to different forms of capital investment offered by varying types of investors, consider the following diagram.
At each progressive stage of a business's growth, the type of possible capital investment diversifies and the type of venture investors become increasingly passive.
This means that the number of financing vehicles increases as a business matures, and that the investors who invest become less and less involved in the day-to-day operations of your business.
Practically speaking, this chart can represent a parallel to the amount of confidence in your business's ability to succeed over the long run. At the early stages fewer types of people or groups are willing to invest, and the forms of investment are limited. This is because early on people are typically less confident, have smaller pockets, and desire to be heavily involved. Which is representative of the great risk they are taking in your venture.
As a business matures, a greater variety of individual investors or groups will be willing to invest, and the possible forms of investment will increasingly diversity. As time progress, people become more confident in the business, in your execution, and desire to be less in control and involvement in the day to day operations of the company. Which is reflective of the smaller or reduced risk they are taking in your venture.
Another important exercise early stage business leaders should focus on is understanding the perspective of their or any possible investor. Too often, entrepreneurs approach the investment process from only their own perspective and fail to land deals because they lack an appropriate understanding of what investors expect, what they look for, and what their goals are.
When a venture investor decides whether or not to invest in a particular company at either the Seed Stage or Venture Capital Stage, entrepreneurs should be aware that the investor is always seeking a minimum economic return on their investment.
The Desired Multiple can vary as time progresses.
However, a Minimum Target IRR = 30 - 50 % (known as the Hurdle Rate)
The desired multiple represents how many times 2X, 3X, 4X, etc… the investor wants to make back on their initial investment.
If an entrepreneur makes a $100,000 investment expecting a 10X return in 5 years, that means they expect to earn $1,000,000 on their investment.
The Target IRR represents the minimum internal rate of return an investor expects to make every year for their investment in a business. This return on investment may never be materialized, meaning the money is transferred back to the investor. But, the IRR is a valuable indicator that the value of the investment made into a company has increased by a certain percentage during the subsequent calendar year.
If an investor makes a $100,000 dollar investment, a target IRR of 50% means that in the next year, the investor expects the business to generate $150,000 in revenue.
Typically IRR is calculated over a 5 year period.
Investors within the private equity world do not just want to help inspiring entrepreneurs develop and grow their ventures into successful businesses. In fact that is their secondary objective.
Their primary objective is to growth their own capital.
Accepting this reality is important for entrepreneurs because it can dramatically help them negotiate with investors, and make sure that the interests of each party are aligned towards a common objective.
Setting aside the economic viability of your venture and possible return in the future, investors also look for a number of qualitative characteristics about the business and it’s entrepreneurial leaders.
Generally speaking, to receive investment form venture capitalists, businesses should fulfill as many of the following criteria as possible, and their leadership should be prepared to answer the corresponding questions:
A. A Strong Management Team.
Who is leading the venture ?
Why they are the right team to transform the idea into a successful business ?
B. A Profitable Marketing Model.
How will you tell your story and reach out to people ?
Is it economically feasible ?
Will it transform people into paying customers ?
C. A Large Addressable Market (of 1 $Billion for technology ventures)
How large is your potential customer base ?
Who and where are they ?
D. A Scalable Product & Business Model.
Can your solution scale so that it provides additional benefits in the future that increase your economic returns ?
How will your business make money as it grows ?
E. A Product in Beta or Development, in other words a Prototype.
Does your solution currently exist ?
How easily can it be transformed from prototype to a marketed product ?
F. One or Two Paying Clients/Customers.
Do you have any paying customers ?
Who and where are they ?
G. Clearly Surmountable Barriers to Entry - for The Company..
What are the barriers preventing your business from being an overnight success ?
How will you overcome them ?
H. Significant Barriers to Entry - for Competitors.
What are the barrier preventing possible competitors from stealing your idea, and taking your customers ?
J. A Clearly Defined Exit Strategy.
Things don't last forever, so what is your desired event of exit from the business ?
How do you plan to get there ?
Successfully answering these points will demonstrate to investors that the entrepreneur and his/her founding group have a clear vision of the solution and business opportunity they are presenting.
Great answers also demonstrate your confidence in executing your strategy, bringing your solution to the or new markets, overcome any obstacles that exist, and eventually position the company for an exit that can provide a meaningful return on any investment made today.
The goal for any entrepreneur is to demonstrate to investors your confidence in the viability of your business opportunity as a vehicle to transform their $1 million of investment into $100 million.
For every venture, no matter the business stage, entrepreneurs must recognize that investors are making calculated decisions about the amount of risk they are willing to take for a potential economic return in the future.
When investors consider a company for investment, they weight how much risk is involved in the business from both a capital and operational point of view.
Factors they weigh include; the likelihood of company's success based on the business model, it's leadership team, the market the company operators in, and most importantly the potential economic payoff they can receive at an uncertain time, in an uncertain future.
The point here is for entrepreneurs to recognize that investors take significant risk when offering their capital to aspiring businesses, and their attitude or demeanor will reflect the risk they are taking.
To better understand the general risk appetite of investors, consider the following chart illustrating the different forms of investment and their corresponding level of risk and return.
Clearly, start-up investing is the riskiest form of venture investment. At this stage almost nothing is defined other than an idea, and a broad vision to transform it into reality.
As a business matures, the investment vehicle and corresponding risk steady decreases as more certainty is established and data collected to support the viability of the venture and value of the opportunity.
To successfully navigate the investment process, entrepreneurs should be aware of the affect risk has on the decisions investors make. It is often the case that investors will show little interest in a venture and investment opportunity at first, but will prolong negotiations in order to more clearly assess the risk involved before making an investment decision.
Moreover, when approaching investors and negotiating deals, entrepreneurs should be aware of a variety of things beyond the economics of your business and the dedicated leadership team that affect the risk appetite of investors.
These factors are beyond your control as an entrepreneur. but you can get a good idea of them throughout the negotiation process and from vetting previous investments the investor(s) made in other companies.
The factors include;
1. Investment focus (industry & business stage)
The kind of business ventures the investor(s) typically invest in.
2. A hands on or hands off approach to investing.
How much of a commitment investing in your company will represent to the investor, beyond the financing, given that they either like to be actively or passively involved.
3. Broad investment and operational philosophy.
What the investor believes in as a blueprint for success.
4. The desired type of exit.
The form of exit, and the amount of return on investment the investor(s) seek to make.
5. The available support network.
The support network available to the investor to help your business venture grow.
All of these factors meaningfully can dramatically affect the potential outcome of a deal being stuck, and are unfortunately beyond the control of the entrepreneur.
For this reason, entrepreneurs should do significant research on the investor(s) before approaching any potentially interested venture capitalists for investment.
All in all, entrepreneurs should be sponges throughout their capital raising efforts to learn as much as they possibly can. Exercise extraordinary awareness to quickly become cognizant of how investors think, how they approach their venture investments, and what they expect to see from the entrepreneurs who pitch to them.
The last factor entrepreneurs should consider is the human element.
Investors are ordinary people. Many of them have experienced the same challenges that the entrepreneurs who pitch to them are facing. Be aware that good investors will know how much of a challenge it is to develop venture, secure investment, and grow a business.
Some will undoubtably test you, and be challenging to work with. But, others will show more compassion, and even if they do not invest in your business could become great sources of insight and wisdom.
Take the extra time to develop these relationships because they will likely offer you the needed connections and resources to take your venture to the next level.
Always ask questions.
Do not fear saying; "I don't know".
But, be sure to follow it up by saying "I will or want to find out".
Demonstrating a degree of inquisitiveness and an ability to be coached, is something very much sought after from investors, and often understated by industry influencers.
Ultimately, every person enjoys offering their wisdom to others. It is among the most basic forms of demonstrating experience and of feeling valued. Investors of any kind and level want to feel wanted and needed, and entrepreneurs, particularly first timers, need wisdom and guidance to successfully navigate their business.
So, always seek out the council of investors on every topic that affects your business, and always be as highly engaged and enthusiastic about the future as possible.
Confidence and excitement is contagious!
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