What does a venture capitalist do? Answer of course: invest in start-ups. But what kind of start-ups and what kind of investments?
To a venture capitalist, the right kind of start-up is not just a recently founded company. The critical attribute is potential growth: accelerating revenue, and scalable. Scalable means that at some point, for each fresh euro invested, a multiple of additional revenue is generated. The incremental investment needed to cover additional cost is negligible compared with the resulting revenue.
Many eminently feasible start-ups do not exhibit scaling behaviour, and are never intended to do so. A business may well be designed to consistently generate a steady and comfortable profit for its founders and shareholders. It may make little sense to take fresh investment or to raise debt to expand the business. Such a business is entirely valid and valuable, but it is unlikely to be of interest to a venture capitalist.
Shareholding dilution
Raising venture capital will dilute existing shareholders: part of the ownership of the start-up is sold in return for the investment. There are other ways to raise money that do not cause dilution, a loan being the most obvious. Another way is via a crowdfunding website such as Kickstarter or equivalent: typically, advance orders are paid for a new product that has yet to be fully developed.
Given loans, and crowdsourcing alternatives, then why do some start-ups still go out to raise venture capital?
One fundamental reason is that the venture capital investments can be significantly larger than other alternatives. A further critical reason is that in the event that things do not turn out as planned, then there is no residual obligation on the company promoters to repay the sum raised – unlike a debt, or money raised for advance payment of an undelivered product.
Yet a further reason is the industry contacts and experience of a credible venture capital firm. The prior experiences which other start-ups have had with a specific venture capitalist are important references, which any start-up seeking funds should explicitly verify.
Taking investment from a venture capital firm is about more than the money. It is a relationship which needs to last, potentially for several years. The personal chemistry between the board director appointed by the venture capitalist, the founders and chief executive will be critical.
Prior to any investment, the venture capital firm will explore this potential relationship: do we like the founders; what are they really like as people; what are their interests; do they like us; and, most of all, can we work together? The process is absolutely a courtship, and the respect must be mutual, honest, sincere and deep.
Potential for disagreement
However, right at the start of this new relationship, there is a potential for violent disagreement. Equally, successfully overcoming this potential fight cements an open relationship and foundation for partnership. This challenge is: how to agree a value for the start-up?
In a start-up that has yet to generate any revenue, deciding a valuation is challenging. Frequently the decision is postponed and a potential argument so avoided, at least for the time being. Instead the venture capitalist offers a loan rather than immediately buying shares. At some point in the future and once a valuation of the company has in due course been agreed, then the loan is repaid not in cash but in shares in the company at that (later) point.
Such “convertible loans” kick the can down the road,. However, the more that the venture capitalist assists the company to grow in value in the interim, the less the venture capitalist is rewarded when its loan is ultimately converted. The interests of the start-up and the venture capitalist are therefore not aligned. Many wisely prefer instead to resolve valuation early and head-on, and so remove the ambiguity.
The promoters may argue for a high valuation. The venture capitalist potentially may accept this, but counter that in consequence, its investment should have a guaranteed return when the start-up eventually is sold or otherwise exits.
Liquidation rights
In particular, the venture capitalist may demand “liquidation rights” in which its investment is repaid in full (or even multiples of this) before any remaining sum is shared among all the shareholders, including the venture capitalist. Doing the arithmetic will show that if the company is eventually sold for a very high price, then these liquidation rights in practice have only a minor impact on the other shareholders. However, the arithmetic will also show that if a more modest exit price is achieved, then the venture capitalist may be rewarded with little left over for the ordinary shareholders.
The stakes become high: an aggressively high valuation may result in aggressive liquidation multiples which will then need an aggressive exit value if everyone is to be well rewarded. A more modest valuation may instead result in a more agreeable structure for all.
Building a world class start-up is the most fulfilling achievement of a professional entrepreneur. Doing so without venture capital is really, really hard (I have the scars..). An open and honest relationship with your chosen venture capitalist changes your game.
