Typically, when business start-ups show signs of growth, they reach out to venture capital firms looking for funding. The fact that venture capitalists can provide a higher amount of funding compared to angel investors might be more attractive to start-ups during the expansion stage. Since there is a certain amount of risk involved in investing in a start-up rather than in an established firm, venture capitalists (VCs) would demand higher returns for the higher amount of risk they have assumed.
Is it the Right Fit?
Before seeking out Venture Capital investment, it is extremely important to have a thorough understanding of the market and likely changes that might occur in the market due to your idea.
The fact that an entrepreneur considers an idea to be visionary or trendsetting doesn’t necessarily guarantee that VCs will embrace the idea with the same enthusiasm. Even though the ultimate goal of every business is to grow and maximize their profits, depending on the feasibility of an idea and the growth potential of the market, the potential of a business to grow might vary significantly.
The size and/or growth potential of the market in which the firm operates are the factors that mainly attracts the VCs. It is highly likely for VCs to reject an idea straight away if they don’t think that a market is big enough or has the potential to be big. Small businesses might be better off applying for a bank loan than venture capital investment because of the higher returns VCs would demand.
It is beneficial to build up a strong network which would help founders to get introduced and meet VCs, rather than through cold emailing and stalking! Most VCs spent a considerable amount of time to study and watch the founders to have a good understanding of how efficient they are with their strategies, before thinking about committing any money. Most successful entrepreneurs look to partner up with VCs whose interest align with those of theirs and look beyond the amount of capital made available to them to build a strong cooperative partnership with the VC.
VC Structure, Fund Size, and Fund Cycle
It is important to consider the structure of the VC firm, the way they operate, and how they generate profit while considering to seek Venture Capital investment. Most VC firms have General Partners (GP) and Limited Partners (LP). GPs are fund managers who actively manage investments, while institutional investors such as wealthy individuals, Pension funds and Insurance companies, and governments through Sovereign Welfare Funds (SWFs) who have money invested in VC firms are considered to be LPs.
GPs generally earn management fees; which is usually around 1.5% to 2.5% of the size of the capital committed and a carried interest also known as “carry” which in a majority of the cases is around 20% of the profit after management fees when certain criteria are met. Carry is only distributed once the fund has returned all the capital invested by LPs back. So, it is important to understand the amount to capital required to decide whether to approach a micro VC (funds in the range of US$10 million to US$50 million) or a high-end VC (funds with over US$100 million).
It is possible that VCs might not make any additional investment to a business in a particular period if the funds deployed by VC are completely exhausted. Additionally, most VCs have a specific pace with which they deploy capital to business for example- annually, semi-annually, or quarterly. So, to have a comprehensive understanding of the size and pace of VC funding is extremely important.
A term sheet containing all the important economic and governing terms related to the investment is provided to the funders by VCs showing their intent to provide capital investment. It is also important to understand the key terms used in the document before signing the contract as most of these terms are highly complicated.
Once the terms documented in the term sheet is agreed upon and signed by the founders, the due diligence of the business and drafting of documents related to actual financing is done.