Today, venture financing is glamorized by the media. Financing announcements on Techcrunch, movies like The Social Network, and HBO’s hit show Silicon Valley have led many founders to believe that venture capital is the natural next step for any budding startups. It’s true that venture capital can be a great way to finance growth and that the right investors can add a stamp of legitimacy to your business and provide valuable connections to further your business. But venture capital isn’t right for every founder or every company.
Taking on venture capital will have a substantial impact on the course of your company. Many founders rush into seeking venture capital financing without fully understanding what they are getting themselves into.
Here are the six six questions that every founder should ask before they begin raising capital.
1. Are you a venture-backable business?
First things first. Not all businesses are attractive to venture capital investors. Before you set out on the fundraising trail, make sure you have a business that is venture-backable.
Because investing in startups is risky (nine out of 10 startups fail), venture capitalists are looking for outsized returns on each of their investments. For early stage VCs, every investment needs to have the potential to return the entire portfolio—a desired return of approximately 10x. In order to provide those returns, your business must have the potential to scale exponentially.
In addition to looking for large returns, your investors will want to see those returns on a relatively short timeline of five to 10 years. Most VC funds are setup to have a 10-year life span—the first three years are spent investing the fund, and the final seven years are spent harvesting returns to provide the funds investors. The point in a fund’s lifecycle at which you received investment will determine how soon the fund will expect to see a return.
In order to attract investment, you also need to have already proven yourself by building an initial product and by showing proven customer demand. Early product development is cheaper and faster than ever before. Even early prototypes for hardware products can be created with little outside capital. Having an initial product is now a minimum requirement for most investors.
2. Do you have any alternatives?
Venture capital is dilutive. The average equity round of financing results in founder's giving up 10% to 30% ownership. Less equity means a smaller piece of the pie in the event of an exit. Before deciding to take on venture capital, you should consider your non-dilutive alternatives. Crowdfunding, commercial loans, government grants and tax incentives, and bootstrapping can be a great ways to fund growth without giving away any equity.
Every form of financing, dilutive or not, has its pros and cons. Crowdfunding can be time consuming and often doesn’t cover more than the cost of producing the product. Commercial loans have to be repaid. The government grant applications processes can be long and tedious. Tax incentive programs may cause you to jump through hoops and distract you from your company's true purpose. And bootstrapping generally results in slower growth, with less cash on hand to invest in growth. Be sure to weigh each of your alternatives carefully and pick the financing structure that makes the most sense for you.
3. Do you know how much you need to raise?
Are you raising $1 million because that seems to be how much other companies are raising, or are you raising it because it is the right amount of money for your company?
Most successful venture-backed companies go on to raise more than one round of financing. In order to successfully raise your next round of financing, you need to show significant progress between rounds. You need to reach your company’s next milestone. Between your Seed and Series A round, that usually means proving that not only do customers want your product, but you have found a reliable way to scale the business. The greater of 18 months of cash or enough money to take you past the next major milestone is usually seen as the right amount to raise.
Raising too little could mean you reach the end of your runway and aren’t able to attract any investment at all, or could result in a down round, where money is raised at a lower valuation than your last round. Down rounds are incredibly dilutive and demotivating for all shareholders.
4. Are you comfortable with the risks venture capital poses to you and your business?
By taking on venture capital, you are making a commitment to strive for exponential growth. You won’t have the luxury a year from now to decide that you’re making enough money to take home a good salary and choose to take your foot off the gas. You are expected to push for growth, to get your investors their 10x return. Failing to do that could result in you getting replaced.
And when it come to exits, you will be limited to opportunities that result in a strong return for your investors, who will often have blocking rights on a sale. This means that many exit opportunities that would have been perfectly acceptable to you as the founder could get rejected, forcing you to hold out for much larger—and much harder to get—exit opportunities that are in the interest of your investors.
Furthermore, as we discussed earlier, your VC investors will want you to exit within five to 10 years. This urgency to produce an exit could mean that your are pushed by your investors to take a half-baked exit. This could force an acquisition before you’re ready—one that either financially or structurally you wouldn’t have taken otherwise.
5. How much time are you willing to put toward a raise?
Raising venture capital can become a full-time job. A common rule of thumb is that it can take six months to raise a round, with most rounds taking at least a couple months to close. Before you set out to raise money, ask yourself if you are willing to put months toward a raise. Can your business survive you taking your attention away from it for that period of time? Do you have the stamina to spend that much time courting investors? Giving up before you cross the finish line means wasted time and might not leave enough time for you to pivot to alternative funding strategies.
6. Are you ready to take direction from others?
Many entrepreneurs start their businesses because they want freedom. They don’t want a boss; they want to be able to chart their own course. But the second you take on outside capital, that changes. You will have shareholders to report to and likely a more formal board of directors than you had pre-financing.
CEOs running venture-backed businesses need to be able to manage the interests of multiple stakeholders. Unlike banks, equity investors tend to provide more than just capital. They provide guidance and connections, and will often have an active interest in your operations. Investors want to work with “coachable” CEOs, people who are willing to take outside input.