A big question founders often ask themselves is when should their startup raise venture capital. In the 20 years since we began investing the cost of starting an Internet driven business has fallen dramatically, but entrepreneurs usually need to finance their growth with outside money at some point. But before we address the when, it’s important to address the why. There are many alternative sources of capital, with different use cases, aspirations, and value to add, so the first question is: which is right for you?
Self-financing. Serial entrepreneurs may have made money before and prefer to fund their own companies, at least until the time is right to bring investment partners alongside them.
Customers / bootstrapping. Some startups can bootstrap their way to early proof points or even to profitability. This is a traditional approach to company building that can be an effective way to achieve early product/market fit. Crowdfunding via Kickstarter or Indiegogo is an innovation that also allows startups to get direct market feedback that can fund early product development.
Friends and family money is useful for first time entrepreneurs, with limited savings, who are getting their startup off the ground and want to recruit their first hires. Trust is everything: supporters close to the founder are expressing their faith in the entrepreneur. Initial funding for the vast majority of startups comes from this source. Our counsel: try not to give up too much ownership here.
Angel investors can be more commercial or savvy than friends and family, and therefore more helpful. If you are raising from multiple angels, we recommend to find one lead who ‘speaks’ for the group, and who ideally knows your market well. (The lead of an AngelList syndicate often demonstrates their relevance this way.)
Serial angels who have previously raised venture capital can also help you navigate the next phase of fundraising, so it’s worth understanding which sources of follow-on capital the lead angel believes could be a good fit, and the quality of relationships in their rolodex. Validate investors’ relevance, areas of expertise, and evidence of how they help solve the important problems. Again, try not to give up too much ownership in an angel round.
Accelerators such as Y Combinator and TechStars have emerged in the past years as important parts of the ecosystem. They are less important as sources of capital for the startups, as investment amounts available to them ahead of participating in the accelerators are usually small. (Both YC and Techstars have raised funds that give them the capacity to follow on in later investment rounds.) The best accelerators provide intensive mentoring to teams, often focused on taking the first steps to build out a large business. (YC focuses on early traction.) And, like the best seed funds, they act as a strong signal that an investor - usually a seed investor, but in a healthy minority of cases a series A investor - should at least meet with the company.
Equity crowdfunding (for example in the UK raised on Crowdcube or Seedrs) could also be an alternative source of early stage capital, especially in progressive jurisdictions such as the UK and Israel. The terms tend to be looser than those required by institutional investors. And they could be interesting for consumer focused startups that could benefit from a core of strong supporters. However, we are still cautious about them, given that these platforms are still evolving. In particular, we don’t know how they (and their underlying investors) may weather a downturn.
Seed funds provide the first $0.5-1.5m of institutional capital for founders that are setting out to build companies that often go on to raise further institutional venture capital. Their funding allows founders to experiment with product and clarify their focus. Their ownership is typically 5-15%.
Leading seed investors (for example in Europe, Point Nine Capital, Connect Ventures, and Local Globe) filter startups to appropriate VCs, and a solid proportion of their portfolio will go on to raise venture funding successfully.
It is common for seed funds to include value-added angels in their syndicates so they can surround the founding team with complementary expertise and experience.
Early stage venture capital funds, such as Mosaic Ventures, typically invest once there are some initial compelling proof points and the core of a team. In our case, we usually invest at Series A. We typically invest $1-6m initially (with “reserves” for following on in later rounds), and hope to own something like 15-20% of a company. We invest behind a compelling vision and plan that builds on the progress to date, and that could be the basis for a very large business or strategic asset. We expect our successful investments to grow for many, many years. And if things go well, for our stake to be capable of returning the whole fund.
We know swinging for the fences comes with significant risk. In fact, the most successful VCs often have higher loss ratios. It’s a subtle point but different early stage venture firms have different appetites for risk and sometimes different time horizons, so it’s important to understand which fund is the right fit for a given entrepreneur or startup. For example, some funds aim to minimize losses and may look to exit with a 3-5x multiple that is returned relatively quickly to their investors.
Focused early stage VC funds rarely lead later stage rounds, and thus ‘leave room’ for more funds to join in later financings. In fact, strong Series A investors will have trusted relationships that can open doors to the best funds to lead the Series B or C rounds. (Furthermore they should be capable of punching above their weight, for example in helping startups attract the best talent, or important customers and partners.)
$500M+ multi-stage venture funds, such as Index Ventures, Accel Europe, and the larger US venture firms now active in Europe. These funds can invest at all stages of a company’s life cycle, but the weight of their dollars is invested at, or after, series B. When they invest at Series A & B they often aim for ownership stakes of 20-25% or more, given the maths of “making a dent” in their funds. Medium sized outcomes are all well and good, but ultimately are not material to a large fund.
Such funds’ brands are a positive signal, and they sometimes write larger cheques at an early stage than the company needs in order to achieve ownership. (Sizing investments is a long topic for another day.) That will suit some entrepreneurs in some situations, but can come at a cost: for example, as they seek to maximize ownership, it can be a challenge to accommodate other investors.
Corporate venture funds, for example at Cisco, Qualcomm and Google, have been significantly more active in recent years - according to CB Insights, corporates participated in over a quarter of venture financings globally in Q4 2015. Assessing the trade-offs around how much strategic value corporate investors provide is for another blogpost, as there are often unforeseen costs/issues. Three high level points. First, whilst early stage, a startup may not be ready to commit to a specific strategic path. Second, strategic investors often have mixed (not purely financial) mandates and so are less credible as price-setters for other investors. Third, it is not always clear that investment helps deliver the promised strategic value. For all these reasons corporate venture funds are occasionally a fit to “follow” at Series A, but may be better considered later in a company’s evolution.
Understanding your business and what you need will determine which (if any) of these approaches is right for you.
Simon & Mike