Second in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital. We expect the series to run for a year after which we will collate the posts into a book. You can find the rationale behind the series here, and the list of questions here. We welcome your comments on any and every aspect of what we are doing.
All too often entrepreneurs with very young companies start thinking about raising money almost before anything else, and then they write a business plan designed to please investors, and before they know it the cart has got in front of the horse and they have a strategy which has been dictated by their perception of what the investor community is looking for. Anyone who has found themselves building a financial model which justifies more money than they think they need because ‘investors won’t be interested in anything smaller’ has fallen foul of this problem.
The reality is that venture capital isn’t right for every company and the better approach is to write a business plan for what the business needs first and then look at financing options second. Venture capital is only right for a very small percentage of businesses and approaching the problem this way round will let you see if your company is likely to be one of those, whereas writing a business plan designed to appeal to VCs is likely to result in a long haul trying to raise money, and then if you are successful you have a higher chance of hitting problems down the road.
As I see it there are three factors that determine the suitability of a business for venture capital:
- there is potential to build a substantial company
- an appropriate amount of cash can make a genuine difference to the chances of success, and,
- the founders want to build towards a big exit over 3-5 years.
First, the potential of the business – as I wrote in the first post of this series the venture capital model is predicated on investing in a small number of big winners, hence for a business to be suitable for venture capital it must have the potential to become a company of substantial value.
Second, the money – venture capital funds are good for helping the small proportion of companies for whom a cash injection of £3-30m will materially increase their growth rate and chances of success. Smart entrepreneurs will evaluate whether the increased chance of success is worth taking the dilution and the other restrictions that come with raising venture capital – Ben Holmes of Index Ventures has described this as ‘the entrepreneur’s equation’.
The £3-30m capital requirement is important because if your need for cash is below that range your opportunity will likely be too small to interest most venture capital funds, and if it is too much above then you will start to become too big. The problem with small investments is that even if they are successful and return 10x they aren’t significant in the terms of the overall fund size, or in common parlance ‘they don’t move the needle’. The problem with companies that require an awful lot of money, from a VC perspective, is that funds can end up with too much exposure to an individual business, and if it then fails their other smaller investments will struggle to make up for it, and their whole fund will be in trouble. In order to avoid having too much exposure to any one business VCs often club together in ‘syndicates’ – this works well up to a point, but if there are too many parties in the syndicate decision making can get slow and agendas can diverge, causing big problems for the investee company.
Caveat: the £3-30m range is only intended as a rule of thumb and there are many examples of companies successfully raising venture capital with plans that show requirements below £3m and above £30m. My point here is that as you get outside that range fewer and fewer funds will want to take a serious look.
Finally, and probably most importantly, venture capital is only right for your company if your goal is to exit the business over the next three to five years, and you are happy to embrace the discipline and rigour that goes with that objective. VCs raise funds on the promise of investing in businesses with these characteristics and we will test for them during due diligence, time and time again. Nor is it wise to try and fake it, tempting as it might be, because if you succeed in pulling the wool over the eyes of the investor during due diligence the truth will inevitably come out as you work together post investment (how can it not?), and conflict will follow.