proceeds in the event of an exit…or liquidation.
In each financing round, entrepreneurs and existing investors give up a share of their equity in exchange for additional capital, with the percentage largely depending on the amount to be raised and the new investor’s return expectations, which take into account the company’s riskiness and its forecasted value at exit.
In the case of a successful start-up, raising capital step by step allows an entrepreneur to benefit from progressively higher valuations and give up less equity per dollar raised as the business matures.
START-UP DEVELOPMENT
VENTURE CAPITAL TARGETS
A start-up will navigate several stages of development before reaching profitability and a steady state of operation. Along the way, the company draws capital and expertise from different types of investors in the VC ecosystem. While each start-up follows a unique path, three distinct stages of development can be defined: proof-of-concept, commercialization, and scaling up. It should be noted that the vast majority of start-ups will never reach this final phase of accelerated growth.
Exhibit 2.2 highlights the type of investment required at the respective stage to successfully grow and scale a business.
Exhibit 2.2 Start-up Development and Funding
PROOF-OF-CONCEPT: Companies at this stage have little or no track record and only a concept of a product, technology or service. Small amounts of funding are required to conduct product feasibility studies, define relevant markets, formulate a business plan, and develop a prototype. Once the product or service is developed, engaging with and securing a user base to show that the idea has the potential to translate into a successful long-term business is a critical step to achieving proof-of-concept and attracting further funding; it also shows that the founding team has the ability to execute. During the proof-of-concept stage, company development is funded by seed investment often provided by the entrepreneur, friends and family, business angels or seed-stage VC investors.
COMMERCIALIZATION: After a company’s value proposition has been validated by a group of core customers the focus shifts to translating the idea into an operating business and growing the top line. Companies at this stage of development focus on refining the product or service offering, expanding the sales and marketing functions, filling out missing capabilities in the core management team, and targeting large-scale customer acquisitions. They start to generate revenue but are far from cash flow positive; building up operations naturally increases operating cost, which combined with the initial working capital and capital expenditure needed in a growing business results in a high burn rate. In many cases, funding raised from VCs to drive commercialization are the first injections of institutional capital.
SCALING UP: This stage is all about expansion and market penetration. By now, companies are typically growing exponentially and are on their way to profit or even operating cash flow breakeven. However, profits generated from operations are reinvested in the company and may need to be supplemented by additional VC funding to meet market demand. In addition to rapidly growing a start-up’s core offering, funding is needed to expand product and service offerings to differentiate the company from competitors and to balance product-specific sales fluctuations. Mid- and late-stage VC investors, along with growth equity funds, are the main investors at this stage.
Box 2.1
VENTURE CAPITAL REMAINS US FOCUSED
Geographic location is crucial for VC as an asset class, given the importance of networks when growing early-stage companies. The deepest, most “developed” VC ecosystems can be found in the United States – Silicon Valley in particular – but other geographies such as China, India, Europe and Israel have seen active clusters emerging. Successful VC communities not only have complementary funding vehicles that support early-stage growth with angel investors, crowdfunding platforms, corporate venture capital, and government funding vehicles, but provide ready access to follow-on rounds and serve as magnets to attract the talent needed to scale quickly. Exhibit 2.3 shows the total amount of venture capital invested by geography over three consecutive five-year periods starting in 2001.
Exhibit 2.3 Global VC Investment by Geography
Source: Preqin
THE VENTURE CAPITAL INVESTMENT PROCESS
UNIQUE ELEMENTS
The immaturity of companies targeted by VC funds introduces a range of unique elements into the VC investment process. Identifying future unicorns is an art, while structuring an investment to mitigate the investment risk involved is rather a science. We explore these elements in the section that follows.
DEAL SOURCING: Deal sourcing in venture is closely related to the reputation of the VC firm and the partners involved; established and well-known firms will have a regular stream of calls, pitch books and ideas flowing their way. Partners will also attend the various demo days of accelerators or industry conferences to scout for potential targets. When screening investment opportunities, VC investors’ gut-feel about a start-up and its team is a crucial component and often drives the decision to pursue a specific deal. Nevertheless, questions revolving around the entrepreneur, the team’s experience and motivation and the uniqueness, defensibility and scalability of the business model tend to feature prominently in those early discussions.
VALUATION: Determining the valuation of an early-stage investment is a highly subjective process.32 While a company’s current operations and future cash flow forecasts are a key component in establishing its value, so too are the robustness of its team, the strength of the business model and the size of the addressable market. As early-stage companies are typically unprofitable, investors employ multiples of revenue and other key performance indicators to arrive at a “post-money valuation,”33 which also determines the equity split following an investment round. The expected number of future fundraising rounds will also impact valuation, as they will lead to dilution of the equity stakes for both entrepreneurs and past VC investors.
HANDS-ON SUPPORT: Many successful entrepreneurs join VC firms to become early-stage investors themselves. The best VC funds will therefore draw on a strong bench of partners, who not only have an intimate understanding of the challenges faced by their portfolio companies, but also come with their own hard-earned experience to give credible advice. Venture partners mentor management teams, help develop the marketability of a start-up’s product or service, identify and fill holes in its team, and facilitate the development of business processes required to scale up. Venture capitalists are also a key resource for start-ups when raising new rounds of capital, both in shaping the fundraising message and identifying potential investors in their network.
SYNDICATED DEALS: While “club deals”34 are rare in growth equity and buyouts, venture rounds are quite often funded by multiple VCs. Typically, a lead investor will engage with the entrepreneur and founder, conduct due diligence, arrive at a valuation, negotiate terms and commit to funding
Subtracting invested capital from a post-money valuation establishes the “pre-money” valuation.
Club deals are PE investments made by two or three PE funds; they were particularly fashionable for large buyouts during the years leading up to the global financial crisis in 2008.
