I’m always looking for that game-changing entrepreneur whose idea is lightning in a bottle — the person who’s ready to make the jump from concept-in-the-garage to the founder of a market-changing company. Few entrepreneurs have the millions they need to get their product or service to market (and why not spread the risk since savvy entrepreneurs that have already made it should not double down, or should they?), and that’s where venture capital funding comes in.
Since the Volcker Rule was added to the Dodd-Frank Act in 2010 (prohibiting traditional banks from participating in VC funds), banks have been notoriously skittish about any VC investing. We can argue about regulatory overreach all day long. But for now, that investment in your startup is not likely to happen. Leaders in innovation like you have to find your capital elsewhere. That’s where the Venture Capitalist (VC) comes in — this is the person whose job it is to put money into concepts and ideas.
What Exactly Is Capital?
Capital is money. Good, old-fashioned money that’s an asset — and therefore investable. Capital’s siblings are capitalist and capitalism, both of which are optimal contributors to the finance vernacular.
Capitalism is a word much in the news these days, and, in some sectors, it’s a pejorative. In the immortal words of Ebenezer Scrooge, humbug. Capitalism is what drives our economy and creates the wealth that pays the taxes that make the country run. Whether that’s a good thing or not is a topic for another day. Anyway, here’s Merriam-Webster’s definition:
An economic system characterized by private or corporate ownership of capital goods, by investments that are determined by private decision, and by prices, production, and the distribution of goods that are determined mainly by competition in a free market.
Why does that definition matter? Venture Capitalists are the poster child for capitalism — they believe in an economy that’s always evolving, building on innovation, creating jobs, and generally providing the rosy future that we keep hearing about. Don’t be fooled by a VC’s willingness to give away lots of money, though. Behind that sunny exterior and open wallet beats the heart of someone who expects a tidy return on their investment, wants a stake in your company, and will cheerfully take a pound of flesh if you fail.
So before you approach a VC about financing your venture, educate yourself on how the funding process works. Also, study up on the jargon that the VCs and their pals (also known as lawyers) toss around with wild MBA abandon. When you work with a VC, there are many players involved in the transaction at different times. Getting most companies from being a startup to being a Wall Street darling takes several years and many millions of dollars — or euros, or yen, but you get the idea.
Friends, Family, and a Good Lawyer
Friends and family are the gold standard for early investing in your company. They believe in you, want you to succeed, and are usually good for the first bit of cash you need to get started. Maybe they’ll help cover the bills when you devote all your time to fine-tuning the next Snapchat.
Before you accept too much money from too many people, hire a good attorney. Unless you are an attorney (and you know what they say about attorneys who represent themselves), take some of that money and consult with a professional. When your mom gives you her Visa, it’s one thing. When a neighbor gives you $25,000, you need something in writing defining everyone’s expectations. Startups are a lot like playing the lottery, and everybody with a ticket wants in when you win big.
As you negotiate with prospective financiers, you’ll need your own attorney to ensure your best interests are represented. Don’t be that entrepreneur who was so carried away by the money that he didn’t realize he gave up a majority stake in his company.
Startup Money — Angel Investor or VC?
You might have a family member or some friends with the capital to invest in your company in exchange for some shares of the business. When your money comes from that sort of informal source, that’s an Angel Investor. Angels are great for startup money, typically less than $1 million. If your angel has expertise in your industry, they can be a tremendous asset. They’re then a great source for providing access to customers or distribution channels, operational expertise, and mentorship. The downside to an angel is that they may not be great at reading markets and trends — and most angels are not good for further rounds of investment as your company grows.
There are also Accredited Investors: high-net-worth individuals (HNWIs) who have been blessed by the SEC to invest individually. They may be interested in investing startup money. The SEC also accredits formal Angel Investors.
A Venture Capitalist‘s job is to sniff out potential winners. If you partner with one for your startup funding, other investors are more likely to give you serious consideration when you open up your second round of investment. That relationship with one institutional investor clears the way for others — there’s more confidence that the due diligence is done and you’re not a bad bet.
Corporate Venture Capitalists are VCs who work under the umbrella of a corporation. CVCs look for companies whose technologies provide synergy with existing business streams. Their end goal may be the acquisition of your company rather than the traditional VC’s IPO exit strategy.
Crossover Investors are the real angels. These are the guys who invest before, during, and after the IPO.
The Venture Capital Food Chain
VC firms are privately held Limited Liability Corporations (LLCs). There are a lot of moving parts in VC structures — and it’s important to know each one. The firm is led by the General Partner, or more commonly, the Managing Director. The terms are interchangeable; the GP/MD is the top of the food chain.
In the limited partnership structure, all the managing partners have some sort of management authority. The person with the GP title is the first among equals, and that state equates to greater personal liability should something go wrong. It’s really just semantics, but the lawyers really prefer the MD title as a further stopgap against liability.
Venture Partners are the investors on your radar, and you might be on theirs. They’re always on the hunt for new deals, sit on boards, and have MD-level status for their flock of startups. Principals or Associates are the youngsters just out of grad school. They’re the number crunchers and assistants to the VPs, and they’re learning the ropes of the business. Some firms let principals sit on boards and vote on deals, but that’s the exception.
Some VC firms with a laser focus on one industry might have an Entrepreneur in Residence on the letterhead. This is usually a big name to entice other startups into the fold. In some cases, it’s a legendary entrepreneur who’s the house oracle, and they’re there to pick the winners.
What Feeds the Food Chain?
Okay, fine, but where does the money come from? If all these MDs and GPs and VPs have all this money to invest, why are they still out there rustling up the next Big Thing?
Important tip — it’s OPM: Other People’s Money. Large institutional investors put a little (relatively speaking) of their portfolios into venture capital. Pension funds, foundations, endowments, banks, and insurance companies are the most generous sources of money for VC funds. Some high-net-worth families also put their money into VC funds. These investors are Limited Partners (LPs) in the firm and, as such, do not have the voting rights. They give that responsibility to the MD.
There is always one investor who puts the most money into the deal in the later rounds of financing: the Lead Investor. Since they have the biggest stake in a given round, they assist in negotiating the terms of the deal and will usually take a seat on the board. Every round of financing is a wholly separate deal. In a successful venture, there might be four or five rounds to get to the public offering.
The Makeup of Your Board
By the time you’ve gone through the seed money stage and you’re raising money for a second or third round, your board looks markedly different than it did when you were sitting in your angel investor’s study with a couple of colleagues and a copy of Robert’s Rules Of Order. For one thing, there are VC reps on the board — people you’ve only known for a few months — and they have a say over your baby. Take advantage of the expertise at the table; these guys are hand-picked to guide you and ensure that you’re the industry-changing success that they’re betting on. When you get to the final rounds, these are millions of dollars in free consulting you’re getting — and everyone has the same goal.
A Board of Directors is the group of people making strategic, long-term decisions for your company. Expect the lead investor from any given VC fund to be on your board, and a fund with a disproportionally large stake may want two or three representatives on the board. The founders should always be on the board, ideally with you as chairman (or chairperson). Wait, this phenomenon is starting to change. In Europe, it is not as common for the founder to also be the chair. In the U.S. I am starting to see this same trend. Maybe worth of its own post.
Preferred Directors are the VC’s reps on the board since they negotiated preferred equity. In some cases, part of the deal is that a Preferred Director has the ultimate veto power. The entire board could vote for something, and all it takes is their “No” vote to kill the motion. Board Observer Rights are facilitators, sort of. They listen more than they talk and are usually the VC’s second pair of eyes to take notes and support the director.
Unicorns Are Real
Unicorns are the tech startups that succeeded beyond even the entrepreneur’s wildest expectations — the little piggies that went to market with over $1 billion in capitalization.
With the right technology and partners, your company can join that most exclusive club.
Of course, the major players and how they operate aren’t the only things you need to know about VC deals. Start from the top of my series about the latest changes in VC deal terms. Read up on: