Typically, start-ups turn to venture capital firms when their business start to show signs of growth. As opposed to angel investing, VCs can provide funding in higher amount which is desirable to start-ups during the expansion stage. Because investing in start-ups is characterized with higher amount of risk for capital providers than an already established firm, VCs require higher returns for the higher risk assumed.
- The Right Fit
Before approaching the VCs, one must have the full understanding of the market and the impact the business idea might have on the current structure of the market. Even if the entrepreneur believes that his/her idea is visionary or trend setting for a particular industry or market, it is not necessary that VCs will embrace that idea with the same enthusiasm. Even though different businesses have almost one same goal in mind that is to grow or to maximize their profit, the potential to grow however differs significantly, depending upon the feasibility of their idea and/or the growth potential of the industry or the market their idea appeals to.
Venture Capital primarily focuses on the size and/or growth potential of the market in which the firm operates. If they don’t believe that the market is big enough or has the potential to exhibit high growth in order to generate required return for them, it is highly likely that they will reject the idea at the “get-go”. Moreover, venture capital funding, even though sounds desirable to all start-ups, is not an appropriate way to get funds for every business. For e.g., a small start-up business such as a restaurant is better off applying for a bank loan than for venture capital funding.
- Introduction; Know Them Better
VCs spend a considerable amount of time in getting to know the founders, and watch their moves as how efficiently and effectively they execute their strategies, before committing any money. Successful entrepreneurs must typically tend to look beyond the capital provided to them, and put extra efforts on building a strong and cooperative partnerships with VC.
- Understand; VC structure, Fund Size and Fund Cycle
Venture capital firms are usually organized through partnerships between General Partners (GP) and Limited Partners (LP). GPs are fund managers who actively manage the investments, whereas LPs includes institutional investors such as Pension funds and Insurance companies, wealthy individuals, and governments through Sovereign Welfare Funds (SWFs).
GPs earn money in two forms; management fees, which typically ranges from 1.5% to 2.5% of the fund size/committed capital, and Carried Interest or simply “carry” which frequently lies around 20% of the profits after management fees. Carried Interest is distributed only when the fund has returned all the capital initially invested to LPs. So, it is important to know how much capital is required in order to make a decision between approaching 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).
Moreover, sometimes when the funds deployed by VC is completely exhausted, it is possible for VC not to make any more investment in the business for a specific period. Furthermore, VCs have a specific pace at which they deploy capital in the subject business such as quarterly, semi-annually, or annually. So, it is also important to understand the size and at which pace the funding will be required in the future.
- Final Phase
A term sheet is offered to the founders by VCs as an indication to provide funding, and it outlines all the important economic and governing terms related to the investment. Term sheets are highly complicated and include a significant amount key terms. So, it is important of understanding of these key terms before the document is signed.
Once all the terms outlined in the term sheet is agreed upon and signed by the founders, the process involving due diligence of the business and drafting the actual financing documents follows the proceeding.