If you’re running a start-up, the last source of money you should seek is venture capitalists. Before that you should consider using your own money, funds from friends and family, cash from angel investors, and money from suppliers and customers.
The reason you should try all these sources of capital before talking to a VC is that they will probably give you the cash you need to develop a business model without interfering with how you run the company.
And if you can use that money to develop a business with paying customers, you may reach a point where you can keep running a cash flow positive business without getting a big check from a VC.
But you also see an opportunity to grow the start-up, the capturing of which will require more money than you can raise from those other sources.
Here are three tips that you can use to boost the odds that you get the right VCs to invest on reasonable terms.
1. Find VCs who wish they had invested in start-ups like yours. Before dealing with VCs, you need to understand how they work. VCs get most of the money they invest from limited partners who are often insurance companies, pension funds, and university endowments. The limited partners pay a 2 percent management fee and 20 percent of the profits that the VCs’ general partners generate from making and harvesting investments.
Those investment returns have plummeted for the average VC. Back in the late 1990s, the average VC fund generated an 83 percent internal rate of return while the comparable figure for 2013 is about 6 percent. This means that the average VC is earning lower returns than an investor could make by buying an S&P 500 index fund.
Therefore, VCs are under enormous pressure to make winning bets. They tend to specialize in investing in specific market segments and stages of a venture’s development. You need to find VCs who specialize in your market and your venture’s stage of development.
However, if the VC has already invested in one of your competitors, you must be very careful what information you divulge. Because the VC is more likely to be pumping you for information so he can share it with his portfolio company with whom you are competing.
VCs are not likely to lie to you directly. But before you share all of your information with them, have a preliminary conversation. Ask them to convince you why they are a good fit for you; what companies in your category they recently invested in; which they are talking with; how much they are willing to invest in this round; and to provide you examples including amounts raised and valuation.
Your best shot to get an investment from a VC who understands your business is to find one who has recently missed out on an opportunity. That is, one of their competitors made a big return by investing in one of your competitors.
If you can present your company as a way for them to get in on the industry, you are potentially in a strong position to get that VC to participate in a bidding process to invest in your company.
2. Create a well-timed bidding process. By the way, you should never try to raise capital when you are about to run out of it. You should do so when you have just completed a strong quarter and make sure that the funding round closes within six weeks of completing that quarter so that the VCs can’t delay the closing as they wait to see how your company does in the following quarter.
To do that, you have to get the VCs to bid for a chance to invest in your start-up.
How so? In the first week after the quarter closes, set up meeting with four to six VCs that pass the test I described above. After you meet with them, disappear for a week or two so they can conduct due diligence on your company.
In week three or four, meet with the VCs and tell them how much you want to raise. But do not mention the amount that your start-up will be worth. Instead tell the VC, “the market will determine the valuation.”
If you have done your job well, you will get at least one term sheet - that include how much they want to invest, what share of the company they will take, and other details.
Once you have that, let other investors know you have a term sheet - but do not provide details of the terms. You should also let the other investors know what you want from
For example, you can tell the VC that if it gives your start-up a valuation of, say, $100 million and invests $30 million, you will guarantee the VC a lead position in the deal. Or if another VC gives a lower valuation and invests the same amount, you will give it the right to bid last.
3. Set the valuation of your company based on the amount you raise. The valuation you ultimately agree on is greatly influenced and mainly determined by how much you raise, and not on what the company is hypothetically worth. To understand this, you must the widely used term “pre-money valuation” - it refers to the value placed on your start-up before the VC invests.
If a VC generally likes to own 50 percent of the company after a Series A round. This means that if you intend to raise $10 million, then the pre-money valuation will be $10 million. The VC will end up with 50 percent after the deal closes-- calculated by dividing the amount of the VC invests by the pre-money valuation plus the amount that the VC invests ($10 million / ($10 million + $10 million) =50 percent).
These three tips will help you raise the capital you need to expand your start-up.