When to Raise Venture Capital

by Evangelos Simoudis, Ph.D., Senior Managing Director at Trident Capital

When it comes to funding, even with all the available information and transparency that the Internet affords us, entrepreneurs still wonder when to seek venture capital instead of pursuing other financing avenues for their startup.

The Priorities

First of all, entrepreneurs obsess, or should obsess, about:

1. Building the right solution (product or service) to solve a particular problem or address a market need

2. Identifying the right market for their solution

3. Forming the right team (and here)

4. Monetizing their solution under the best business model

5. Funding their endeavor

As an entrepreneur I used to do the same. As an investor, I always consider the first four areas (product, market, team, business model) as I try to determine whether to fund a startup.

Sources of Funding

Entrepreneurs have five broad options for financing their companies:

1. Friends and family

2. Customer contracts (bootstrapping)

3. Bank loans/Lines of Credit

4. Angel investors

5. Crowdfunding

6. Incubators and Accelerators

7. Venture capitalists, including corporate investors

 

The majority of private companies, say 80% or so, including high technology companies, are funded through the first three options. Many times, an entrepreneur identifies an idea he would like to pursue and reaches out to his friends and family for seed capital, typically a few tens of thousands of dollars. Other times, an entrepreneur not only identifies an important customer problem but also one or more customers that are willing to immediately fund the development of this problem’s solution, thus bootstrapping the company. Typically this option is available to startups addressing enterprise problems where the customer is able to provide tens or a few hundreds of thousands of dollars to solve the particular problem. It is also possible for entrepreneurs to seek bank loans, using personal property as collateral, in order to finance their nascent companies.

Angel Investors

An angel investor is an individual with sufficient disposable income to provide startups with capital, typically in the form of debt that later converts to equity (also known as convertible debt) or in the form of equity directly. Angels may organize themselves into groups, such as the Band of Angels, Angels Forum, or others, in order to pool their capital and thus be able to participate in larger investment opportunities. By joining together, they also reduce their risk exposure, benefit from each other’s expertise as they consider an investment and conduct due diligence, and better support their portfolio companies. Angels invest their own money and — by the nature of the investments they make — are willing to take very high risks. Each angel typically commits $10-100K per investment. As a result, by working with angel groups, entrepreneurs may be able to raise $500K-1M for their early stage startups. We are now seeing the emergence of Internet resources like AngelList and DataFox that aggregate listings of new companies and their products, making it easier for investors to stay abreast of the startup ecosystem.

In terms of the amount they invest in each company and the risk they take, angels fit between friends and family and VCs. In other words, it is not unreasonable for an entrepreneur to start by receiving a first round of funding from friends and family, proceed with an angel round and then move to a VC round. In the last 5 years we have seen the emergence of the super angel. In addition to their general angel investor characteristics, these individuals are defined by their professional focus on early stage company investing. That’s all they do, and they make larger investments in comparison to angels — typically $100K-1M per investment.

Crowdfunding

This is a new source of funding that has emerged because of the interest —or fascination — from private individuals wanting to participate in the high tech economy. It is differentiated from angel investing in that most of the individuals invest very small amounts, occasionally only hundreds of dollars, and such individuals take a more casual approach to startup investing. Recently we saw the emergence of crowdfunding platforms such as Kickstarter and Indygogo that facilitate the interaction between startups and investors. Companies such as Pebble represent successful examples of crowdfunding.

Incubators and Accelerators
Over the last few years, incubators such as Y Combinator and TechStars and accelerators have re-emerged as places for startups to begin their lives. In addition to the independent organizations, corporations such as Samsung, Nike, Sony, and others have created their own incubators to promote entrepreneurship as well as to gain better access to innovation. While incubators and accelerators have not traditionally been a funding source for startups, a few of the more prominent independent ones like Y Combinator have raised their own side funds to invest in the more promising of the startups they incubate. Similarly, certain corporate accelerators, such as Shell’s, provide funding to the best of the startups they work with.

Venture Capitalists

Venture capitalists (VCs) are professional money managers investing funds on behalf of their clients who may be corporate or stage pension funds, foundations, endowments or other such institutions. As such, they are organized into professional partnerships, not unlike legal or accounting firms. Some corporations such as Verizon, Singtel, Dell, American Express, and many others have also established their own venture funds.

VCs fund only about 5% of the private companies in the US, but they have financed every major technology wave in the last 50 years and are responsible for financing some of the biggest corporations. In information technology alone, VCs have funded Digital Equipment Corporation, Intel Corporation, Apple, Google and most recently Facebook and Twitter, to name just a few. VCs typically invest $500K-10M per company through a single or multiple rounds of funding.

VCs as a Broader Resource

Entrepreneurs should not approach VCs only for the money they provide. More importantly, VCs have sector and industry expertise. They know how to create structures that can benefit entrepreneurs both in attracting new investors during the startup’s lifecycle and at the time of an exit to an acquirer or to the public markets through an IPO. VCs also have networks of executives, prospective customers and potential partners they can attract to the companies they invest in. Brought together, these ingredients can place a startup at a very different trajectory than companies that are not VC-funded and result in a big financial and market success for the entrepreneur.

When to Approach VCs

Entrepreneurs should decide to approach VCs when they:

  1. Have created a solution that addresses an existing big market — typically a market that is at least $1B, or can result in the emergence of a similar size market.
  2. Have developed a disruptive business model through which to monetize this solution, or have an initial well-supported hypothesis for such a model.
  3. Need the expertise and networks that other funding sources cannot provide them.

Each venture firm is willing to take on different levels of risk. VCs focusing on early stage investing are willing to take product risk and fund even pre-product companies. Through their funding, they are trying to make sure that the startup can develop a product that first works in the lab and can then work with a few real customers. VCs that invest in later stage companies are willing to take market and management team risk. For instance, they will fund the creation of a replicable sales and marketing process and the management team that will make it possible. Later on, they may accept expansion risk — funding the company’s growth in a particular market and expansion into additional markets. Finally, when raising venture capital entrepreneurs should always remember to be deliberate and match their company’s area of focus with the venture firm’s focus — and more importantly, the expertise of the individual partner they want to work with.

Entrepreneurs have several investment options through which to finance their startups, including VCs. VCs finance a small percentage of the private companies, but they can provide enormous value since, in addition to money, they offer their expertise and networks. Before approaching a venture firm, entrepreneurs should make sure that their startup is a good match to the VC’s experience, interest, risk profile and investment focus.

Evangelos Simoudis, Ph.D. is a Senior Managing Director at Trident Capital, where he focuses on investments in Internet and software businesses. Find him at blog.tridentcap.com and on Twitter: @esimoudis.