Venture capital is arguably the most glamorous form of funding for startups. Venture capitalists invest their money in young growing companies that show high growth potential. In exchange for their capital, a VC will receive (often significant) equity in the company. An equity raise can substantially accelerate a company’s growth in conjunction with business acumen, network, and leadership. However, there are many things that you will first want to know so you can go through the process wisely, carefully, and successfully. This guide will explain to you the process of raising capital step by step from how to perfect your pitch, to how to find a quality VC, and much more.
How do I know if it’s the right time to raise equity?
VCs expect 10 times their returns in less than seven years. These aggressive investors are not interested in slow-growing or unscalable businesses. They want explosive growth and a significant return. These types of investors and quick lofty goals are not for every startup though – and VCs know this. However, for companies that do not expect a growth rate of 10x in seven years, this does not necessarily mean that they’re bad businesses. It just means that a different type of funding may be best.
If a startup misjudges its timing when accepting outside capital, it could be catastrophic. If a startup accepts outside funding before it is ready, the company could just simply burn money without properly growing or scaling. In fact, scaling too early and investing too heavily in resources is the primary reason that most startups fail.
Before taking the plunge and deciding it’s time to raise venture capital, here are a few signs that it may be the right time:
- You have a consistent business that works: A good analogy is comparing your business to a “candy machine.” If the quarter is inputted, and the candy comes out, then the machine is working. Similarly, if you have identified your customer and brand identity and found product-market fit, you are on the right track. If you’re consistently adding paid customers, then your model works like the aforementioned “candy machine.”
- You have a plan for using the funding: If you do not have a plan of how to use venture capital to properly reach milestones and scale the business, don’t even bother. Why raise capital and give up a percentage of your company if you don’t know how you’re going to use it? You need to have concrete plans for the present and defined goals and objectives for the future. You need revenue forecasts and a roadmap of milestones and goals.
- You have more demand than you can handle: If you have more customer demand than you can service, then this is an obvious sign that it is time to scale up and look for outside help, expertise, and funding.
- You understand your customers and the value you bring: Make sure you understand your customers like the back of your hand. If you are able to answer the question, “what do my customers love the most about my business” then you are already on the right track. For example, if you think the most valuable part of your business is one thing when your customer base values another thing, you will undoubtedly invest in the wrong things with additional capital.
- You are growing organically through word of mouth: If your existing customer base is referring new customers to your business, then you are growing organically and have a unique value proposition. However, it is extremely hard to scale solely through organic growth. Venture capital can help extend your reach by allowing you to invest in sales and marketing.
How Venture Capital Works
Once you’ve decided that your startup is ready to raise money, it is important to understand the different stages and milestones for fundraising. Raising money can be one of the most difficult aspects of scaling a growing business. While valuations and metrics of businesses at the same “stage” or funding round can vary, it is important to understand the variations of each round, and the common themes between each round.
In general, each round should last about 12-18 months to allow founders to focus on the actual business rather than raising capital. Startups typically aim to increase their value by 2–3x minimum during each round and significantly develop. If you have already decided that you have a viable, scalable business, likely, you have already passed through the initial pre-seed and seed rounds. The pre-seed round is the very first round a startup goes through before the business even has an existing product or customer base. A pre-seed can be funded by friends and family and/or angel investors. Seed is the next round which focuses on raising initial capital to test and develop the product before it’s fully operational. However, it is very common for some VCs to also get involved during the seed stage. Once the startup passes through these initial rounds, the subsequent rounds will be dedicated to growing and scaling.
Series A
There are several objectives for Series A. They include having a fully operational business in the market, scalable customers/users and revenue, and a well-defined strategy.
By this point, the business should have defined KPIs, and be able to demonstrate a successful track record. KPIs can include anything from user metrics to growth metrics to financial metrics.
Because companies are still very young in the Series A round, valuation can vary and be overinflated- especially if there is a bidding war between VCs and other investors. Additionally, VCs in later stages often get pushed out by larger investors and have to aggressively overbid in earlier rounds.
As of November 28, 2020, the mean Series A funding round is currently at around $15.9 million. This is significantly higher than the median of $6.7 million as of Q1 2020 and largely due to the increasing amount of “mega-rounds”- particularly in the biotech sector.
Be very mindful of not only how much equity you are giving up in this round, but also be mindful of the types of shares you are giving up. If you are a founder and you still own over 50% of the shares in the company, that does not necessarily mean that you “control” 50% of the company. Not all shares are created equally. Make sure you are mindful of voting rights and understand the privileges that different classes of stock have to offer. The very worst thing that you can do as a founder is be “held hostage.”
Series B
Series B is when the real fun starts. Businesses at this stage are looking to scale as fast as possible, serve as many clients as possible, keep revenue recurring, and raise serious amounts of capital. At this stage, businesses may be looking to take on additional investors or explore getting acquired. Acquisitions always allow startups to grow even further through addressing previously untapped markets and revenue streams. Even more so than the Series A round, there is a real range of capital raised here. Some companies will raise as little as $12 million, with others raising north of $60 million. The median amount raised in this round is usually around $23.7 million with a range between $12-$36 million.
Series C
Like Series A and B funding rounds, Series C is focused on scaling the company, and growing it as quickly and as successfully as possible. However, the major difference here is that the Series C funding round is largely initiated by businesses that are generally quite successful already. The Series C round though can also offer companies the opportunity to raise additional funding to develop new products, expand into new markets, and begin acquiring other companies. The main goal for investors in this round is to inject enough capital to receive more than double their investment back.
This round usually raises the most amount of capital. Therefore, it is not shocking that there is about a 40% chance of investor exit at this level.
The Series B round on one hand is a major milestone for a company. On the other hand, however, if you have reached this point in your company’s life cycle, there are a whole bunch of issues you need to be prepared for and mindful of.
- Make sure you do not overly concede. By the time you have hit Series B financing, there is at least one investor who has received some sort of concession from you from the prior Series A round. Series B investors will typically require at least all of the same rights from Series A- and then some. If you make overly-significant concessions in Series B, it could mean harsher concessions from you in future rounds as well.
- Account for both existing and new investors. This can always make negotiating specific Deal terms more complex. Trying to make both existing and new investors happy can be a challenge and has implications for many of the specific Series B terms- namely voting rights.
Oftentimes companies are prohibited from taking on additional investors and raising Series B capital without the consent of Series A investors. What this means for you as the business, is that even if Series A investors aren’t directly involved in the Series B talks, they or their lawyers may want to still review all the Series B terms and documentations before approving the deal.
- Make sure you are ready to raise serious capital-a down round could cause problems. If you raise less money in a Series B round than Series A round, this raises an additional set of issues and complexities- namely with the dilution of shares. Series A documents typically contain anti-dilution protection for investors. In the event that you go through a down Series B round, Series A investors may receive the economic equivalent of additional shares. This creates additional dilution for you as a founder on top of the dilution that is already occurring from Series B investments. This is truly not a good scenario for founders, and you should do whatever you can to avoid going through this.
Series D and E
The Series C round is commonly the end of external equity fundraising. However, some companies move forward with a Series D and Series E round. For the most part, companies receiving up to hundreds of millions of dollars in capital through Series C rounds are prepared to continue scaling globally, and maybe even IPO. Companies by this point may enjoy valuations of over $118 million. Raising Series D usually means that a company is either looking for another chance to accelerate before an IPO or it didn’t achieve the mandate it had planned when raising Series C.
There is a major pro and a major con to these rounds that you should be mindful of as a founder.
On the positive side, this shows that you’ve found another way for your company to expand further before going public. You’ve found a way to give your company an additional boost of capital and increase your value further before going public.
However, on the negative side, you may need these rounds because you haven’t met expectations during the Series C round, or experienced a down round. In this case, it could be disastrous for your business. If you’ve reached this round because you’ve been left no choice because of a down round, then your shares may get further diluted, while your company gets devalued.
Bridge Rounds
No company is the same, and there is no rigid transition between funding rounds. Often businesses will need to raise capital through a series of smaller funding rounds called bridge rounds. Bridge rounds can get messy and complicated but can be a useful stepping stone between one funding round to another.
More often than not, bridge rounds are structured as convertible debt. Generally speaking, these notes are structured so that upon maturity, which is theoretically the next round, the investor’s bridge note will convert into equity shares.
How long does it take to raise equity?
The entire process from deciding to raise capital, preparing a pitch, to finally receiving capital has no set length. Every company is different, and every entrepreneur is different. If the company is run by a founder who has already had a successful exit or two and has a close investor network, the fundraising process may take considerably shorter. However, most entrepreneurs do not fall into this category.
If you are an entrepreneur that does not have the track record or network, this process can certainly take anywhere from 6 to 8 months, and be emotionally taxing. Oftentimes, you will hear more “nos” than you can count on both hands- and that’s ok. While speed is certainly important, especially when trying to compete with other similar companies, it is not the most important thing. Just make sure to not get lost in the fundraising process. If you are doing things right though, it should not take you any longer than 12 months from start to finish in securing the cash you need to get going. Make sure you know your idea, plan, and data verified and defensible to keep the process from dragging on.
Next, when you speak to the VC make sure you have your pitch perfected and you stand out from the competition. Your foot is already in the door. Now you have to take the opportunity and run with it. But first, here is what NOT to do.
- Make big proclamations
- Use “patented” more than once
- Make unrealistic financial projections
- Boast about your credentials
- Be vague
A VC cares about the business, but they also care about leadership. And so, first, they want to know about your character. They want to see if you are sharp, driven and focused. They also need to see your humility and potential. They will want to know your story just as much as they will want to know about the company. Who are you and what is your leadership style? How do you work in a team? Can you take the business to the next level? Also be sure to demonstrate that you are willing to listen and learn, and ask questions.
VCs will also want to see your passion and if you truly eat, sleep, and breathe this business you’re pitching. Tell VCs how much you have invested yourself into this business- both emotionally and financially. Explain why you believe in this business, rather than how great you are and how genius the business is. Additionally, make sure that you are articulate and clear, and demonstrate a mastery of your business, the industry, and the competition. Always go into pitch meetings with the mindstate of answering this one question – “What is my business and why should this VC care?”
Outside of learning about your character, VCs need to see a detailed plan of what you will do with their investment. They need to know your exact projections, and why. You need to have a track record of success with the potential for more success. If you don’t have a track record for success just yet, they need to see some indicator that you are on the pathway there- either through a strong demo or a detailed business plan. Make sure you have milestones and deadlines as well- VCs love to see those.
Lastly, make sure you cultivate the relationship. You most likely won’t get a deal on the spot. That only usually happens in movies. Keep the fire simmering, send a weekly update on your progress, and check in continuously. This should ideally be a long-term partnership and you must treat it as such.
How to find and approach venture capital investors
Now that you know a bit more about when is the right time to seek out outside funding, as well as the rounds to go through, it is important to understand how to catch investors’ attention in the first place. If you don’t know which VCs you should approach, we have a directory of all Canadian venture capital firms to help get you started.
Remember, VCs have a pretty good eye and ear for what’s a real opportunity, and what’s not. They also hear hundreds of pitches all the time. What you need to do is get them to listen. Therefore, before even speaking to a VC, it’s best to be first introduced through someone that a VC values. Whether it is an intro from an attorney, a professor, or a founder from that VCs portfolio, being introduced to a VC from reputable sources immediately gives you and your business more credibility.
Next, when you speak to the VC make sure you have your pitch perfected and you stand out from the competition. Your foot is already in the door. Now you have to take the opportunity and run with it. But first, here is what NOT to do.
- Make big proclamations
- Use “patented” more than once
- Make unrealistic financial projections
- Boast about your credentials
- Be vague
A VC cares about the business, but they also care about leadership. And so, first, they want to know about your character. They want to see if you are sharp, driven and focused. They also need to see your humility and potential. They will want to know your story just as much as they will want to know about the company. Who are you and what is your leadership style? How do you work in a team? Can you take the business to the next level? Also be sure to demonstrate that you are willing to listen and learn, and ask questions.
VCs will also want to see your passion and if you truly eat, sleep, and breathe this business you’re pitching. Tell VCs how much you have invested yourself into this business- both emotionally and financially. Explain why you believe in this business, rather than how great you are and how genius the business is. Additionally, make sure that you are articulate and clear, and demonstrate a mastery of your business, the industry, and the competition. Always go into pitch meetings with the mindstate of answering this one question – “What is my business and why should this VC care?”
Outside of learning about your character, VCs need to see a detailed plan of what you will do with their investment. They need to know your exact projections, and why. You need to have a track record of success with the potential for more success. If you don’t have a track record for success just yet, they need to see some indicator that you are on the pathway there- either through a strong demo or a detailed business plan. Make sure you have milestones and deadlines as well- VCs love to see those.
Lastly, make sure you cultivate the relationship. You most likely won’t get a deal on the spot. That only usually happens in movies. Keep the fire simmering, send a weekly update on your progress, and check in continuously. This should ideally be a long-term partnership and you must treat it as such.
According to global venture capital firm 500 Accelerator, a common struggle that inexperienced startup founders find when pitching VCs is sticking to a step-by-step plan. Understanding the end-goals of the pitch are fairly straightforward: make yourself memorable and make the VCs understand your company’s value proposition. However, this is easier said than done. Somehow translating the end-goals of a successful pitch to an actual pitch is actually quite complex. The best pitches follow a rigorous structure that helps engage potential investors, help entrepreneurs stand-out, and prove the value of a company. More often than not, you’ll be turned down by the first investor(s) you pitch your business to. Take their notes into consideration and use their comments to tweak your pitch deck for the next investor you meet. Here is a good five-step framework of how to formulate and perfect your pitch. Deeply research the person you will be meeting with and adapt your pitch and strategy accordingly. Make sure that before you even walk into their office that you have answers to these certain questions: ○ If so, frame your company similarly…but make sure to remain humble. VCs hear numerous pitches and can sniff out a big ego. ○ This is very important. This can help you find out their priorities and address them. ○ If it’s not a partner they will not be a decision-maker. This is very important to know beforehand. Doing some simple background research can help you start tailoring your pitch. Make sure that once you know all this info that you practice the pitch over and over again until it’s flawless. Do not go right into the pitch, even if it’s instinctual. If you jump right into the pitch, without engaging in some sort of small talk first, you are wasting valuable time in refining your pitch and building the relationship. A casual opening is a good way to connect with them as people, rather than as presenter to presentee. Remember- investors aren’t just investing in your company, they’re investing in you. Make sure you break the ice first also before diving headfirst into the pitch. You can also better frame the presentation based on how some simple small talk goes. You can, for example, ask a simple question such as “what is the most important thing you want to make sure I cover?” You aren’t hard-selling them, you are getting to know them, and you are engaging them before you’ve actually begun your pitch. You will also know where to spend more time focusing your pitch as well. Make sure that once you’ve engaged them and the pitch has started, that you keep things succinct, catchy, and clear. You want investors to know what they’re looking at and why they should care. The last thing you want is for a VC to feel confused or feel as if they wasted mental energy listening to you. VC’s can tell if you are honest about your numbers. But if you have strong metrics, make sure to bring this up early and be as specific as possible. If your metrics are weak, then address it by discussing what problem you’re solving and the gap you plan on filling. Make sure your numbers have context, relevance, and seamless integration into your company’s business and the big picture. Once you’ve decided on which metrics are most relevant to your pitch and business, keep these things in mind as well: Do not waste time showing off the cool features you are developing or what you have in the pipeline. After pitching why they should care about your product, explain your product’s value with a backstory. Speak slowly and naturally as you tell investors how you, or “someone you know” experienced a real-life pain point, and how you then thought up your product to fix it. Be down to earth, be articulate, be humble, and be approachable. Remember- investors are not just investing in a company; they are investing in YOU. You’ve reeled them in with your backstory, not they want to know why your team is interesting and special. They want to see you and your team’s character, and how you’ve reacted to adverse situations. Additionally, because companies pivot all the time, they want to see that the core team has stayed consistent. Selling investors or a strong, consistent, and resilient team can go a long way.How to perfect your pitch
The due diligence process
One of the biggest misconceptions among new entrepreneurs is that you are going to connect with a VC, impress them with your pitch, they’ll agree on the spot, and cut you a big fat check. This could not be further from the truth. In fact, when a VC even offers you a term sheet, they will likely go through an arduous due diligence process. There is no set amount of time for how long this can take, but you can expect the process to take from 2 to 4 months.
VC’s will be doing a strict audit of some of these factors.
- Background check of founders- Even if you made a strong first impression and the VC likes you, he or she will want to do a deeper dive on you to make sure your story checks out. The VC will want to make sure your story is true, your professional references are accurate, and that you truly have accountability, integrity, and executive potential. They will also want to do an audit on your partners. This audit isn’t necessarily to uncover skeletons in the closet. Rather it’s just to ensure truth, transparency, and consistency.
- Industry/Market/Financial due diligence- The VC will want to verify claims made in the pitch about the industry and marketplace and do discovery interviews with people working in the field. The VC will surely want to verify revenue figures and other financials as well.
- Technical due diligence- If you are a company that uses cutting edge technology, the VC will want to verify this. He or she will also want to confirm that you know what you are talking about technologically.
- Legal/Regulatory due diligence- VCs will want to make sure that all of your legal and regulatory documents are in order, ranging from articles of incorporation to shareholder and stock documents and accounting documents.
Negotiating a term sheet
Negotiating a term sheet can be a very exciting time for a young company- however, do not, under any circumstance, get lost in the moment. This is when the hard work truly begins. When you get your first term sheet, this is just a starting point. Before moving forward and executing, you have to negotiate from a position of strength and ensure the best terms possible. Here are a few ways you can do that.
- Confirm that the VC is committed- If a VC offers you a term sheet, more likely than not, they are serious and mean business. However, sometimes you will come across a VC who is not truly committed. This is why the following point is arguably the most important factor when negotiating a term sheet.
- Get other VCs interested- This is arguably the most important strategy when negotiating your first term sheet. Avoid “no shop” clauses as much as possible in the initial term sheet. Get other VCs to show interest. This puts you in the driver’s seat and a position of strength when negotiating. If the initial VC knows you are talking to more than one other interested party, you can push for more favourable terms. In the best-case scenario, you may even create a bidding war.
- Understand basic terminology- You do not want to get eaten by a shark at the negotiating table. Brush up on fundamental market terms such as valuation, preference, anti-dilution, and board members. Even if you don’t understand the nuances, understand the basics, and use your network to gain a stronger knowledge-base.
- Especially understand dilution… – Understand how VC ownership will affect your equity and how terms will impact your dilution. Also know how much you will get diluted in subsequent funding rounds with the understanding that if the company performs well and your valuation increases, it will more than offset your dilution. However, if the valuation doesn’t increase, the impact of dilution can become more significant. This is why you need to study dilution terms inside and out.
- Valuation, Valuation, Valuation- You will need to negotiate a “pre-money” valuation with the VC at some point. This will be calculated on a “fully-diluted” basis which means that all issued stock and anything convertible into common stock will be included.
- Retain a strong attorney- While you will eventually want to take the reins and be in control, a strong attorney with VC financing expertise is critical. Especially if you are an inexperienced entrepreneur. To work through the most important points in the term sheet, a lawyer well-versed in VC is essential.
- Prioritize non-negotiables- Decide what is most important to you in advance of the term sheet negotiations. Additionally, decide on what you are more willing to be flexible on. Articulate your needs, communicate openly, and be prepared. If you come in with a hierarchy of prioritized terms, negotiations can be a lot more seamless, fruitful, and efficient.
- Limit stock exit contingencies- VCs often want founders to sign a statement agreeing to forfeit part of their stock if they exit the company early. Do whatever you can to avoid any contingencies on founder stock. If you can’t do this, then negotiate terms to keep the contingency period as short as possible, terms that a limit on shares that would be forfeited, and terms that make the buyout price as high as possible.
In addition, companies may need bridge financing while negotiating the term sheet in order to extend their cash runway until the deal is closed. A term sheet does not mean that the deal is closed. Running out of cash while negotiating a term sheet could potentially force a company to accept less favourable terms. If your runway is a concern, consider debt to strengthen your position until your funding round is closed.
What’s after a term sheet?
There is usually a two-to six-week period between the signing of the term sheet and closing known as “venture limbo.” The term sheet gives the entrepreneur and VC some sort of closure in knowing who will be working with who and what structure. However, this cannot be stressed enough- the deal is not done yet. Not even the funds have been wired yet.
Most of this “limbo” period consists of lawyers drafting and negotiating the full set of legal documents. Legal due diligence is also done in this time period.
The longer this period drags on, the higher the risk that the deal will die or fall apart entirely. Things should accelerate towards a close, not slog onwards or march steadily. If it feels like momentum is decelerating, then it is certainly a bad sign.
If everything goes well, and the “limbo” period goes as smoothly as possible, then the contract can be signed. If all parties are quickly aligned, this should be the easiest aspect of the VC funding process. Even if you are well informed and comfortable about the term sheet, before signing any contract, you should understand it well and still negotiate any term that you don’t feel fully comfortable with. This is where a lawyer has the utmost importance.
