With increasing competition for capital, founders must take a closer look at investor psychology
Anyone could be forgiven for thinking that we are in a golden era of VC. Every year the amount invested globally reaches new heights. Against all odds, 2020 even exceeded 2019. As private valuations soar, more and more unicorns are created and IPOs provide record returns. VC funds are awash with capital. The buzz around entrepreneurialism grows louder and more new businesses are started every year.
But something isn’t quite right.
Whilst VCs have much to celebrate, not every metric is going up and to the right for founders. The elephant in the room is that VCs are backing fewer startups. Why is this and, more importantly, how can founders increase their chances of funding success?
As the VC asset class becomes ever more sought after, fund sizes have grown. Out of necessity, average deals sizes have followed suit. Deals at every stage are just getting bigger.
But the worrying trend is the shift away from early stage towards later stage deals. In fact, first-time deal financings have been in freefall since 2014. According to Pitchbook, 2,372 first time financings were recorded in 2014 across Europe. In 2020 the number was 1,531. The result is a siren call for founders.
Investor expectations have risen alongside valuations. Series B criteria of only a few years ago feel like Series A today. Seed deals feel more like Series A deals of 2018. These are profound changes, and many founders are not appreciating this until it’s too late, until the ‘nos’ start to stack up. In a recent survey, 46% of founders said that access to capital was the biggest challenge they faced in 2020.
This dramatic shift in odds means that fundraising has become more than just an important skill. It is now a strategic competency that startup founders must master. Capital raising has historically been viewed as a ‘distraction’ to the main operational agenda of building the business. An event that just needed to be squeezed into the calendar. Now it must be interwoven into the business plan from the start and this requires a fundamentally different approach.
We can learn a great deal from serial entrepreneurs. They will be begin planning their funding journey almost from day one: The investors they will target at each stage of evolution. How those investors will evaluate the proposition - the evidence they will want to see. How their milestone plan will dovetail with the ‘natural’ funding points for the sector and business model. How they will need to be ultra-wary of premature scaling – the biggest startup killer.
First-time founders have a much harder job. There is no ‘apprenticeship model’ for learning the funding process; it’s often just ‘dive straight in, sink or swim’. This might have worked 10 years ago, but this is now a high-risk approach - one where your instincts are not necessarily going to help. You are engaging in a high stakes sales campaign where you will be dealing with very experienced ‘buyers’ who invest for a living. They determine how the game is played but the rules can often seem opaque.
The more awareness you have about the limitations of your startup fundraising experience compared to VCs and other professional investors, the more empowered you will be throughout the fundraising process and beyond. Mastery will come from leveraging the knowledge and experience of those that have trodden the path before, then putting this into practice your own way.
Fortunately, founders are incredibly resourceful and there’s no shortage of online advice on everything from pitching, to preparing for due diligence and navigating term sheets. These are important battles, but that's not where the funding war is really won or lost.
To develop a strategic competency, you must adopt a funding mindset right from the off. Learning from others that have early-stage experience is a real accelerant. Find someone who can help guide, coach and support you through the entire process. This could be a former founder, an experienced, early-stage non-executive director, or a specialist startup to scaleup advisor. Track record is everything.
The right person will help you think like a serial entrepreneur, ensuring constant alignment between the business plan and the funding plan. You will have two key stakeholders to consider as the business plan is designed and developed: Customers and Investors. As US VC Gigi Levy-Weiss says: “..understanding VCs’ mindsets is often as important as understanding the mindsets of your customers.”
As you develop the funding strategy for each phase of company development, a great tip is to think about fundraising as a strategic sales process - not dissimilar to a big-ticket enterprise sale. Whilst technically you are selling a commodity (shares in your company) you are actually selling value. This realisation will give you important insight and a sharper competitive edge.
An experienced enterprise salesperson will tell you that value selling has two key elements; business value and personal value.
The ‘business’ question is; How is my proposition going to help the investor (e.g. a VC fund) achieve their investment goals?
The ‘personal’ question is; How is the proposition going to help my internal advocate (for example, a Partner in a VC fund) achieve their personal goals?
‘Value selling’ requires you to address both. Omit one and your strategy will almost certainly fail.
Of course, for different categories of investor, the drivers of business value will vary. Whilst VC funds will be driven by investment returns, a corporate investor will likely be driven by strategic objectives, such as technology or competitive insights. A regional investment fund will be driven by job creation, and so on. But as VC is by far the biggest element of the funding pie, understanding (i) how they make money, and (ii) the psychology that is at play at Partner level, is key.
Business Value: Understanding how VC funds make money
There are 2 elements. First, the management fee: Out of any fund a VC will take around 2% per year management fee (to pay operating expenses such as salaries, rent etc.). A typical VC fund will run for 10 years.
Second, the performance fee: The VC will take around 20% of the profit on exits. These profits are referred to as carried interest (or just ‘carry’). The profit is usually the net gain after the initial investment in the fund is first returned to the investors (the ‘Limited Partners’ or LPs).
For example, consider a $200M Seed fund and assume it generates a healthy 4x return. The resultant $800M would be split as follows:
Management fee of 2% x 10 years x $200M = $40M
The Initial investment of $200M is returned to LPs, leaving a Gross Profit of:
$800M - $40M - $200M = $560M, of which 20% is taken by the VC as ‘carry’ = $112M
The balance (80%) goes to the LPs = $448M
In some cases, the LPs set a minimum return, known as the ‘hurdle rate’, which is the sum of the original investment plus a certain level of profit. So, if the returns don't reach the 4x target, the VC may end up with substantially less carry.
To hit the 4x return target, and assuming an average 15% stakeholding at exit (following some dilution of their initial stake), total returns (the sum total of all exits) would need to be $800M/15% = $5.3B
A $200M fund may expect to make around 30 investments in total but returns will vary hugely by portfolio company. A fund manager will likely expect 5 to 6 companies to have great outcomes, 12 to have modest returns, and the rest, 18, no return - they will either die or just fade away. This means that a $200M fund is going to be a unicorn hunter.
As a founder, you must be aligned with these return expectations to attract investment from a fund of this size. For example, if a VC invests a total of $10M in your startup over several rounds and holds 15% of the equity at exit, the returns could vary dramatically depending on your exit price:
Scenario 1. Exit at $67M: VC gets 15% = $10M => no profit => no carry. The VC Partners make nothing. This exit valuation would be a failure for the VC.
Scenario 2. Exit at $1B (a unicorn!): VC gets 15% = $150M => $140M profit => 20% to VC Partners = $28M. A great outcome and the VC is on the way to hitting their target ‘carry’.
Note that the VC returns are usually calculated on the aggregate of ALL investments made by the fund, so if several big investments fail, and the total returns are below the hurdle rate, the VC will make zero carry from this deal.
Given the expected valuation distribution in any portfolio, it becomes clear why VCs are passionate about driving valuation growth and having a big initial stake that can tolerate some dilution through to the point of exit. Whilst high performing funds are able to make returns of 4x and some much more, the reality is that many funds don't even return the original investment. The pressure is always on.
Personal Value: Understanding VC psychology
Time is often the biggest enemy of the capital raising CEO, but it’s the VC’s friend. The more time a VC has to evaluate an opportunity, the more they will understand the true risk and opportunity profile, which is always their aim. Contrary to popular belief, VCs are not inherently risk takers. In his recent article on how VCs think, Levi-Weiss admits: “VCs want to find a very safe deal at the (low) price of a very risky deal.”
But the closer investors take you to your cliff edge on cash the more negotiating leverage they will have. Keeping up campaign momentum is therefore critical. You must close in the fastest possible amount of time. To do this, as Levi-Weiss says, you have to understand the 2 key psychological drivers of VCs: The Fear of Missing Out (FOMO) and the Fear of Looking Stupid (FOLS).
FOMO: Given the huge number of opportunities VCs assess relative to the number of investments they make (typically less than 1%) VCs carry a certain degree of paranoia about missing something great. Every VC has their stories about the ones that got away, and the ones they ‘passed’ on that turned into big money spinners. These are the losses that VCs rarely talk about but are the ones that prey on their minds.
Despite their claims to the contrary, VCs are highly competitive. They hate the idea of another fund beating them to the punch or seeing something they missed. Bragging rights are always important! So, when a VC sees something that ticks all the boxes, they will usually move quickly to get the deal ‘off the table’.
FOLS: VCs look to carefully protect their reputations and will do everything to avoid looking stupid, especially amongst their peers. Investing in a company that looks like it’s late to market, or a company that is going up against huge incumbents, or where a competitor has been recently funded by another well-known VC fund, might end up looking like a dumb bet if things go south. Worse, it could impact their ability to raise the next fund. So, expect them to be particularly wary if your business has ANY such attributes.
That’s not to say they won’t invest, but if they have a potential risk of looking stupid this will need to be heavily offset with a strong fear of missing out. Your job as CEO is therefore to present the lowest risk proposition at every stage, with the biggest opportunity profile. If you can also create a sense of (genuine) competitive anxiety i.e., other funds taking interest, this will really help speed things along.