Nothing Ventured – How VCs Work

The process of venture capital is worth understanding for any start-up. There are courses run by the British Venture Capital Association (BVCA) and business schools as well as a plethora of books on the subject. 

The principles of venture capital apply to all of the equity fundraising options, but the core principle is that a VC offers one or two rounds of funding, typically after friends and family and either crowdfunding, an angel, an SEIS fund or an incubator. The VC looks to break the model down into rounds which include objectives that will increase the value of the business to allow the next round to be carried out at a higher valuation to ensure that the risk in each round is correctly rewarded.

Here are some key questions for start-ups looking to understand the VC process.

What is the VC looking for in an investment? The VC is looking for high-growth companies that use capital efficiently. They need this rapid extension because they know they will invest in some break-even businesses and some complete failures – they need your business to deliver 10-20 times growth or at least have the potential to, so that the successes pay for the losses and still deliver the high rate of return that investors are looking for. A founder should understand that the investors in a VC fund, typically pension funds and other institutions, are looking for a premium for putting their money in a higher risk investment sector. That premium means they will be looking for a return of around 5% per annum above what they would receive by investing in publicly quoted stocks. The growth also has to cover the share of profit and costs that the VC partners will charge their investors. When looking at their own economics the VC needs its winners to deliver a return of 8-10 times investment.

What sort of business model can achieve those returns? The VC is looking for businesses that can disrupt an industry and create sustainable ‘market power’. Betfair is a classic example in our industry – the market power comes from being first and creating the largest pool of betting liquidity and it was certainly disruptive for the bookmaking industry. A company that is disruptive but can easily be copied or has a low barrier to entry is unlikely to appeal to a VC. The founder’s task in presenting to a VC is to convince them that the size of the (new) market is big enough to deliver a 10 times return and that the management team and product are good enough to take that leading market position.

What milestones is a VC likely to be looking for? For a B2C gambling company breaking a business model into milestones is likely to involve some rounds similar to these:
• Round 1: Build a prototype carry out user research.
• Round 2: Launch a minimum viable product, recruit key personnel, acquire 500 customers, and test different versions of the product on the customers.
• Round 3: Launch a full product, establish viable Cost of Acquisition and Life Time Value KPIs. This is the key to any gambling business. If the founder can prove that they can recruit customers for £100 and they are worth £200 to the business then they have increased the value of the business significantly and created a strong case for the final and normally largest round of investment.
• Round 4: A marketing push to acquire enough customers to move the business into profit and obtain the number one position in a new sector of the market.

What does a VC expect the money to be spent on? VC’s like the investments made by a start-up to be highly productive. They don’t want the money spent on machinery, hardware or stock because it doesn’t generate a high return. That is why VCs like software and internet companies that don’t have stock, huge capital requirements or need big buildings. VC’s prefer the money to be spent on product development and marketing.

Why Invest in rounds? The VC does not want to invest all of the money a start-up needs in its first round. There are some financial reasons for this, such as the way the fund is measured by its investors which encourages it not to tie up money in an unproductive way. However, the key reason is that it keeps pressure on the start-up to deliver and allows greater flexibility. If the objectives of a funding round aren’t delivered, don’t expect a VC to keep putting money in without changes ─ this can often include replacing the company’s hierarchy.

Lean start up: At GamCrowd we have been supporters of the Lean Start-up methodology. It works well with the funding rounds we describe in this paper and the disciplines it imposes will increase both the long-term chances of a successful business and the chances of raising funds. The methodology is described in the book The Lean Start-up: How Today’s Entrepreneurs Use Continuous Innovation to Create Radically Successful Businesses by Eric Ries and it has created a worldwide movement. It focuses on launching minimum viable products, obtaining real customer data and failing fast before too much investor’s money is spent. These are exactly the same steps a VC will look to break a business plan into. GamCrowd would recommend the book to any start-up.

How do I get in touch with a VC firm? Most VC’s publish their investment criteria online and the British Private Equity and Venture Capital Association lists them all on their site at www.Bvca.co.uk. Alternatively you could be introduced by an SEIS fund, an angel or an incubator to a suitable VC as a natural progression of that relationship.

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