Looking for VC funding? The process outlined

“We had 45 VC meetings, talking to 30 different VCs over a period of 6 months in order to successfully close the first financing round when we first founded our startup Kyto, back in 2013,” says Martin Mittermeier, MD at wattx and previously founder of Kyto. The market mechanisms have changed notably since then: “We can observe a significant shift in market power in favor of startups currently. Back in 2013, we had to invest a lot of effort into even gaining some VC attention and have them listen to our idea. Nowadays, money is relatively cheap and at the same time, there is a huge demand for new business models. But really good ideas are rare, so we see more and more VCs actively reaching out to promising startup teams, sometimes even in a hard competition amongst the VCs.”

In his career, Martin has gained insight into the VC world from different perspectives: Before founding Kyto, he worked on various initiatives at Project A, an operational VC for early-stage investments.

In the latest wattxINSIGHTS session he shared this knowledge on the mechanisms of VC financing and startup funding with his team, as well as Viessmann and Maschinenraum members. In this article, we now want to share the highlights with you. 

Why should I consider taking money from external investors?

Most entrepreneurs have to look for external investors as they simply don't have enough money to develop a completely new business into a stage with positive cash flow. Only in isolated cases - predominantly in the B2B sphere - do startups generate sufficient revenue from first customers to grow on the basis of their own resources. 

Options of Financing

Debt or Equity 

In terms of financing, a company is usually faced with two main options: debt or equity financing.

Debt financing entails getting a loan from a bank that has to be paid back over a certain period of time, including interest. Equity financing means selling shares (ownership) of a company at a certain valuation to outside investors who in return put money in the company to finance product development, growth, etc.

A startup, especially in the early phases, has no cash flow, no proven business model, or collateral to show, so banks traditionally will not finance startups with loans. Hence those entrepreneurs are usually required to sell parts of their companies (= equity) to get money in. Investors specialized in this kind of company are called venture capitalists (VC).

Especially at the beginning, without any sort of track record, it can be super hard to get investments from professional investors. Therefore, some founders approach people from their network first Those are usually referred to as ‘Friends’ (who might have rich parents), ‘Fools’ (those who can easily be convinced), and ‘Family’ (those with a close personal relationship).

 

Business Angels

Business Angels are individuals who provide capital for business startups, typically in exchange for convertible debt or ownership equity. Angels usually provide support at the initial moments, where risks of the startups failing are relatively high, and when most other investors are not willing to back them. In most cases, angels are themselves successful entrepreneurs, affluent corporate managers, or wealthy private individuals who can support the startups with their network and operational experience.

Venture Capital Funds

The typical structure of a VC
Venture Capital Funds collect money from Limited Partners (LPs), such as Institutional Investors, that can be insurances, pension funds, Family Offices, or Corporates. The General Partners are the people managing the fund and doing all the operational work (board meetings for instance). They are responsible for hiring additional personnel like Analysts, Associates, Principals, or Investment Managers, and for making investment decisions in which startups to invest according to pre-defined terms.

The Business Model

The General Partners are remunerated by the Management Fee (typically 2-3% per year) and by the Carry (of all earnings that go beyond a certain rate of return, they get up to 30%).  The timeframe of an investment into a company is typically 5-7 years. By that time, the startup is expected to return the invested money back to the LPs. This translates into the expectation that the shares can be sold after that period - either in an IPO or as a trade sale.

On the performance of their portfolio, many funds try to raise additional funds over time to increase their assets under Management (sizes from EUR 10m to EUR 1.5bn).

Venture Capital Funds are an outlier model. Here, funds rely on having 5%-10% of super valuable companies (“next Facebook”) in their portfolio that will yield very high returns. As they expect that up to 80% of their portfolio will fail, these funds need exceptional outliers, so-called ‘unicorns’, to make up for the rest.

That also means, they only invest in companies that can grow to a reasonable size. Ideally, these startups are big enough and need larger amounts of capital so the fund can deploy its liquidity. Investments in smaller companies do therefore not make sense for them, because it requires a similar amount of work for the Fund Manager, but it “doesn’t move the needle”.

Venture Capital is referred to as an Alternative Investment Class (like Private Equity Funds or Hedge Funds) so they typically are a risky asset class in a portfolio. The performance against stock market indices is usually rather poor, i.e. normally more money is returned by investing in an ETF. But the success rate is not evenly spread, some funds are extremely successful (Silicon Valley Firms, Accel, Index, Balderton) while the average fund performs rather poorly.

 

 Types of VCs and Strategy

VCs usually specialize and thereby differentiate on various levels. They might, for instance, focus their investment activities on a certain development stage of a company: Pre-Seed, Seed, Series A, or Growth. They also have a specific Limited Partner base, like independent partners or Corporate Venture Capital, and focus on a specific vertical (e.g. Micro Mobility, Food Tech, FinTech). 

 

Differentiation towards Startups
In the current economic situation (= a lot of funds available due to very low-interest rates, high investment pressure, and “asset price inflation”), capital is not enough of a differentiating factor for VCs: Some are additionally offering Operational Support with hiring, their professional freelancer network, or the like. Some advertise their strong Network, including an LP base as first customers, strong alumni, etc. Others again, claim expertise in certain areas often aligned with their investment strategy in SaaS, eCommerce, etc.

Process Overview

Founder Outreach

The classic way is for founders to reach out to VC firms, trying to get an intro in order to present their idea and business case. Various ways of doing so, many VCs just talk to people who get an intro to them because they get too many cold applications. Especially for first-time founders, it is typical to reach out to a lot of different funds.

 

VC Outreach

As the times have changed (economic environment), many funds have started so-called “active sourcing”: they reach out to a lot of companies and want to get to know the founders early on to have an “in” once they’ll be looking for investment.

 

Pitch Process and Investment Decision

The above illustration showcases the standard process that typically happens for early-stage companies. The Pitch Process can differ from stage to stage, especially in the later stages there will usually be an established relationship between company and fund.

 

The Term Sheet 

If the Investment Committee is convinced and wants to move forward, they will typically issue a term sheet which is a document briefly summarizing the deal terms.

A term sheet is not binding on a legal level, so there is no obligation for the fund to invest. But not investing after a term sheet has been issued would also contradict the regular modus operandi, hence it would mean reputational damage for the VC.

Often a term sheet includes exclusivity, meaning that a startup usually can then not move forward with other investors anymore.

Valuation

The valuation of a company is the factor that will determine how much equity the founders will have to sacrifice for their financing. There are two distinct types: pre-money and post-money valuation. Pre-money valuation entails the value before the money is injected into the startup. The post-money valuation is the value of the company after the injection (which translates to pre-money valuation plus the amount of money injected).

In later stages, the valuation is based on financial multiples such as the revenue multiple. The height of the multiple depends on factors like growth trajectory, the value of comparable companies, the addressable market, or the competitiveness of the deal. In early stages where there is no financial data yet, the determining factors encompass the team as well their previous experience), the market size, initial traction, first negotiations, the competitiveness of the deal, and whether there is a “hype” around the given topic (FOMO: Fear of missing out at the VC end).

Terms

  • Founder Vesting: The VCs want the founders to stay onboard because they often invest in the team - which is especially true for early-stage investments. Therefore founders lose their shares or parts of the company if they leave before they worked a certain time in the operative business. Typically, shares vest over four years. If a (co-)founder leaves earlier, as a so-called “good leaver”, they can keep the vested shares. In case the (co-)founder is a “bad leaver”, they lose all their shares.
  • Liquidation Preference: In the case of the startup getting sold, firstly, all VCs would get their investments back before, secondly, distributing the exit money among the remaining shareholders. 
  • Drag Along & Tag Along: “Drag along” means that if the investors want to sell a company, they can drag along other shareholders and convince them to also sell their shares. “Tag Along” is the right of other investors to participate in the sale of shares if one party decides to sell theirs.
  • Control Rights: Often, investors insist on the right to make sure a company is using the investments in the way agreed upon in the funding round(s). Therefore, they aim at making sure that the startup’s management does not make strategic changes (such as changes to the business model, or the sales of business assets), or does not burn the invested money too quickly (by e.g. hiring very costly employees, or by committing to long term obligations that cost a lot of money). Such actions require a green light from investors.
  • ESOP/VSOP: There are times where investors see the necessity to add qualified people to the startup team (such as second-line management). In those cases, the founders or existing investors are urged to create a so-called Employee Stock Ownership Program (ESOP) where a certain amount of shares is added to a pool which will then later be distributed to the new employees or advisors. In Germany, because of tax laws, this process is mainly performed through Virtual Stock Ownership Programs (VSOP).

 

Due Diligence

After signing the term sheet, the fund starts the due diligence process with the goal to find potential risks in the investment. This process highly differs, depending on the stage: In an early stage of due diligence, it is ensured that the company exists in a legal manner, that it was set up correctly, and that the claimed IP exists. This process is accomplished through, for instance, investors talking to the company’s first customers, or through checking the founders' references, and sometimes even psychological evaluations. In a later stage due diligence, deep screening of the financials and the customer relationships, an analysis of cohorts and CLV, or a vetting of second-line management is carried out. 

 

Negotiation of Investment Agreement

During that time, the final Investment Agreement is also negotiated and all participating funds as well as the company have their lawyers examine the agreement. Often, standardized agreements that have been used many times before coming into play and are only slightly adapted for the case at hand. Then, lastly, details, such as founder salaries, are negotiated. If the term sheet is well documented and clear, the investment agreement doesn’t require many changes.

 

Signing and Closing 

Finally, it comes to signing the deal. In Germany, this has to be done with a notary who will read the documentation to the parties in full, usually taking a few hours. This process is called “The Signing”. The following closing then entails the execution of the agreed terms, i.e. the shares are transferred, the money is wired, the new board members are appointed, as the board is probably set up for the first time. 

 

Post Investment 

Reporting

After the investment is made, the VCs want to understand how the company is performing. Therefore, the startup is obliged to report their KPIs, which are often agreed upon between founders and VCs. Again, the reporting is highly dependent on the stage of the company In the beginning, it will mainly revolve around qualitative descriptions. In later stages, KPIs entail excessive financial reporting, which many funds require because they are part of a corporate group (CVC), or deal with public funds (especially from the European Investment Fund).

Future Financing Rounds

After the financing round is before the next financing round: Often, founders get from 12 to 18 months of runway (i.e. the time till they run out of cash) and early on the need to plan their next financing round. For the company, it is often crucial that existing investors at least provide an amount that will help them keep their position (a so-called “pro-rata investment”) as otherwise, other external investors might perceive this as a bad sign (assuming they want to put in less money and know the inside workings of the company).

Exit

Once a startup has grown and is (hopefully) profitable, or is still growing quickly, the VCs will want to exit the company in order to gain liquidity and return the money to their investors. So the two successful forms of an exit are a trade sale (selling the company to a strategic investor or to a Private Equity Fund) and an IPO (offering the shares of the company on the public stock market). Ideally, VCs have some experience with this and can assist the company in the negotiations as well as the exit process.

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If you want to gain a deeper insight into VC Financing topics, reach out to Martin.M@wattx.io.

 

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