It is important for a start-up business to create a business model before seeking investment. Why? That’s because you need to track the amount of investment you need.
Angel investors mostly write $10,000 to $100,000 checks whereas venture capitalists invest in millions.
This graph represents venture capital fundraising trends from the first quarter of 2016 to the first quarter of 2017. Comparing the quarters, we can see that Venture Capital investments are mostly higher in the mid quarters of a year and lower during the starting or ending quarters of a year.
USD 40 billion venture capital funds were raised during the first quarter of 2017. Excepting the two quarters in 2016, the reported aggregate dollar volume of acquisitions for venture-backed companies and the number of exists continue to grow on a linear trajectory.
While the trend of venture capitalism is becoming more common, it is also essential to know where to invest your money. Some small businesses may also fail not because of the lack of money but because of investing it in not-so-worthy or wrong places.
The story of Eric Edelson from Fireclay Tile is quite interesting to read in this regard. Eric believes that there are not many success stories in the tile industry. Edelson, the person accredited for remodeling the business strategy of Fireclay Tile, met Paul Burns in 2008. By 2009, the company had become financially restricted and its shutdown was already under few considerations to save the business.
Edelson and Burns together thought to reinvent the business model by investing more in marketing and branding. The result: the company revenue doubled from 2013 to 2015.
There are not many success stories in the tile industry.
Fireclay was started in 1986 and the beauty of its business lies in the uniqueness of its purely California-made products. While Edelson believes that there are not many success stories in the tile industry, Fireclay represents a success story.
In other words, there is always a margin of making it work provided you don’t give up and also you understand the six most important issues that affect venture capital funded businesses.
1. Fund and Check Size
For understanding your check size, we will first look into how venture capitalists work.
Venture capitalists work with general partners or the permanent ones and limited partners or the temporary ones. General partners are mostly the ones who manage the flow of money whereas limited partners are primarily the investors. You deal with general partners while the limited partners are mostly kept veiled. There may be more than one general partners involved in the venture capital channel.
There are basically three types of money definitions involved. The first one is basic money i.e. base amount of investment. The second one is management fee i.e. 2% of the basic money. The third one is carry (or interest) which is 20% of the basic money. The investment receiver returns 122% of 100% investment in total.
When the process starts, the general partner takes money from the limited partner and hands it over to you. When you return the total investment, it is only then the general partner can receive his/her share. The share is distributed from Carry among all general partners.
Now let’s understand the fund you need. If you are looking for a $50 million investment, you need to contact micro-venture capitalists. For investments above $50 million, go to series A $150 million fund.
1. VC-Specialty Business
Every business is worthy of investment in some way but every business is not worthy of venture-capitalist investment. In simpler terms, the type of business defines the type of investment. Venture capital investments work the best for businesses with a large market. For example, if you start a South Asian restaurant in South America in an area with very few South Asians, the restaurants may not be able to produce returns within 5 years, as contracted.
But if you start the same restaurant in a North American metropolis, it may be able to produce returns within 5 years.
A common practice among all venture capitalists is to measure the size of the market. Your business idea may seem like a successful one but it will work for them only if the business market is REALLY BIG. The chances of establishing your business in small markets are bigger but for such types of businesses, angel investments, bank loans, and micro VCs are more effective.
2. Fund Cycle and Grant
As venture capitalists need to stay in the business irrespective of the amount of money they have in backup, they keep on meeting new people and taking new orders. Investors may become very tricky when they have nothing to invest but they stretch meetings to maintain their market value. But it is also a very tricky time for you.
Most often, a venture capital fund cycle completes within less than 3 months after finding a reliable investor. To maintain the balance of work and money flow, the best way is to ask the funding organization or investor about how many investment deals they make in a year. If they make only one or two investments, they are likely to stretch your case as well.
The funding process also includes the amount of money. Venture capitalists mostly release multi-million dollar checks but they may require more meetings for $7,500,000 investment than the number of meetings they need for $250,000 investment. It also refers to scrutinizing and executing your business operations for ensuring the safety of their investment and its return.
3. Lead Partners
You are dealing with a team of investors and managers when meeting with venture capital individuals. As a fund-seeker, your job is to excite the investors to give you your desired amount of money. Here are some steps to excite the investors.
Firstly, never generalize the investors. They are individuals with different mindsets but working as a team. Some partners are interested in the tools and management industry while others are interested in the consumer industry. Read the biography of the people you are going to meet with and prepare a record of their investments. The consumer-type investor would have a record of investments in the consumer industry.
Secondly, check their trends of investments. Some venture capitalists are long term relationship builders. They want to work with the same people again and again; therefore, they make short term and low cost investments. For example, such an investor would release $5 million funding for 18 months for a soap and shampoo manufacturing company. Due to high ratio of consumerism in this industry, the company is likely to contact the investor to release another fund.
The second type of investors is of those who make big investments for long period of times. Check the history of investments to find a venture capital investor you need.
4. Term Sheet and Diligence
After completing the process and approving an investment, the investor will provide you a term sheet. It includes the economic terms and governing terms. The term sheet is compiled keeping in view the voting rights, board composition, market value of the company, venture capital funding history of the fund-seeker, investor rights, option pool and a few other things.
Term sheet describes the new infrastructure or roadmap of your business. Even if you are a repeated venture capital fund-taker, you will need a lawyer to fully understand the complicated term sheet and negotiate on the terms with board of investors.
After signing the term sheet, it will take almost 2 to 4 weeks to finance, draft, and submit documents. Many founders of start-up businesses panic at this stage. But the key is to prepare all the documents that may be required for diligence before signing the term sheet. These documents include option plans, contracts, employment agreements, and details of board members, intellectual property documents, and everything that may be required for diligence.
5. Mutual Match
There are two types of cases in venture capital investment deals. Firstly, there are successful venture capitalists with money, already aware that the fund-seeker is worried of losing the deal. Secondly, there are successful fund-seekers with a spell-bound history of investment returns. In the latter case, the investor is afraid of losing the deal.
If the venture capitalists are on the stronger side, they take advantage by executing the fund-seeker’s business operations. A majority of the fund-seekers don’t want to share the flow of their business money with third parties. In fact, nobody wants this.
A mutual match is made when both the fund-seekers and investors are strong. They make long-term investment relationship which is B-business running alongside the main business.
Apart from these 6 insightful tips, a very important step to take your business to new horizons is to always meet the investors with your lawyer. A profitable venture capital deal can make your business prosper and help you to multiply the revenue several times.