The world of financing often appears like a black box to startups, especially venture capital (VC).
This note is the medium we use to give them a first simplified overview in 3 posts and 10 minutes of reading (many blogs, podcasts, mooc, books to go into details and refine some simplifications).
Any comment to enrich it (while remaining simple and macro) is welcome.
1/ FINANCING YOUR COMPANY
There are four main ways to finance a start-up company.
Self-financing ('bootstrapping' in startup language) if the activity generates enough revenue to cover its investments and costs.
Subsidies, available to many activities, are (generally) only a start-up aid. They do not allow to cover several months of expenses without turnover (e.g. https://www.les-aides.fr/)
Loans, which are better suited to traditional (vs. innovative) activities or those that already have a history of profitability that reassures the banks
Finally, investors who exchange financing for shares in the company. There are two types of investors depending on the life cycle of the company:
venture capitalists (VCs): business angels, early stage VCs, growth VCs, etc., who specialize in financing innovative activities. They are also minority shareholders. They are the subject of this note.
private equity: invest in businesses with a proven business model (offering, operations, financial), often SMEs and SMIs. They often have a majority stake.
A first sip of VCs in order to introduce :
Who and why? Persona of the VCs and their expectations
What, How and How much? Business model of a VC (offer, operations, finance)
Why do they choose you? Value proposition of the startup for a VC
Making a deal? 10% on valuation, 90% on contract terms.
2/ WHO & WHY
VC persona
VCs raise money from private or professional investors ('Limited Partners / LPs').
After a predefined period of time (important point, cf. section "Different life cycle"), they return this money with a profit ('multiple') and take a commission ('carried').
The VCs are therefore in a way a startup with a fixed lifespan that raises funds to invest them... in startups with an indefinite lifespan (for better or for worse).
Depending on the life cycle of a startup, the type of VC will differ. This is a simplified summary, with the understanding that in reality the boundaries are less fixed.
Early stage: Business Angels and VC Seed
Targeted startup: has identified an important problem in a significant market, has a good team of founders and a solution (idea).
Risk & Return: very high
Investment: 10 K€ - 1-2 M€.
NB: the more upstream the project and the lower the amount sought, the more the startup will target Business Angels. That said, this is changing, especially with the syndicates of Business Angels where several are grouping together to invest amounts that are sometimes substantial.
Some startups have specialized in this approach, the most famous being AngelList (angel.co).
Growth stage: VC Series A, B
Targeted startup: has validated the product-market fit, and needs to grow strongly.
More precisely: the Series A VC invests to help the startup prove its ability to grow (in particular by setting up a sales and marketing team); the Series B VC invests to help the startup deploy this ability as widely as possible
Risk & Return: high
Investment: 2- €50M
Expansion ('late stage'): Series C, D... F
Targeted startup: ready to conquer the world, then go public within 2-3 years
Risk & Return: high
Investment: > €50M
Different life cycles
"After a predefined period of time", VCs return their investment to LPs.
This is a key point for startups to understand. Indeed, when a VC invests, he already knows when he will have to disinvest (sell his shares in the startup).
Startups are sometimes shocked by this willingness to exit a VC, but in reality, it's mostly because they have committed to their own investors.
Thus, the startup cycle is much longer than the VC investment cycle.
This must be anticipated by the startup which, depending on its financing needs, will have to welcome new VCs over time.
3/ WHAT - HOW - HOW MUCH
Like any company, the VC has his own business model: offer, operations, financial.
Some subheadings:
Offering model
LPs (cf. individual or professional investors) are indeed the customers of VCs. Startups must therefore understand that the VC's priority is to offer a return on investment to their clients, and this is all the more attractive as it is risky.
The many clauses that underpin an investment contract aim to minimize risk (see "Making a deal" section).
Operating model
The VC (also called GP for 'General Partner') often has several investment funds (in a way his 'products'). It is precisely each of these investment funds that has a certain life cycle.
Example:
A fund 1 whose investment thesis is "B2B startups in blockchain in Europe". The money raised from a first group of LPs is allocated to this fund, which has a fixed lifespan.
a fund 2 whose investment thesis is "logistics startups in Europe". Another group of LPs invests in it, with a different life cycle than fund 1.
NB: this model is just starting to evolve with the creation of Rolling funds. The investment duration becomes in a way indefinite and the entry & exit of an LP is facilitated. Still not very widespread in 2021, but to be followed.
Financial model
The VC has a lot of money to invest in startups, but relatively little to run his business model (don't shed a tear). This is financed by a percentage of management fees (1-3%) taken from the total amount invested by the LPs.
When the VC resells the shares ('exit') of all the startups in one of his funds, if the fund's valuation has increased by a minimum multiple predetermined with the LPs (the 'hurdle', e.g. investment x 1.07), he receives a commission on the sale ('carried'); the VCs are therefore directly interested in the performance of each fund, and thus of each startup.... but in a time step that differs from the startup.
4/ WHY DO THEY CHOOSE YOU?
According to the VC's profiles according to the startup's life cycle, some investment choice criteria differ. Startups should be aware of this in order to highlight the points that meet these criteria.
Criteria common to all stages :
a quality team (sine qua non)
an important market, with an important problem to solve
an offer that responds to the problem (knowing that in the seed stage this point is less important because VCs know that the startup must test its offer and adapt it over time)
and an exit potential in terms of time and amount allowing it to satisfy its own customers (the LPs)
Different criteria :
in seed phase: focus the pitch on the team, the market potential (size and problem) and the differentiation of the envisaged/prototyped/v1 solution
in the growth phase: focus on the fact that the solution corresponds to the market need ('product-market fit'), and that the investment will allow for strong growth by structuring the teams in charge of this growth (skills, processes, tools) and to continue to improve the solution
in the expansion phase: focus on the fact that the world is within reach and that the investment will allow to conquer it while structuring all the startup's departments (in particular finance, legal, HR...) in view of an IPO or acquisition.
5/ MAKE A DEAL
The Entrepreneur decides to raise funds from a VC in order to be able to recruit teams, buy equipment etc. to develop his business.
THE TERM SHEET
The Entrepreneur will have to negotiate with the VC the 'term sheet', a document prior to the shareholder agreement that will definitively act of the VC's investment in the startup.
The term sheet describes the financial and capital conditions of the operation (valuation, amount invested by the VC, share of the capital allocated to the VC), as well as the legal clauses underlying the VC's entry into the startup's capital.
Contrary to what too many entrepreneurs think, these legal clauses are extremely important.
FINANCIAL AND CAPITALISTIC CONDITIONS: the tip of the iceberg
On the basis of his business plan, the Entrepreneur's proposal to the VC is for example to invest "2" M€ for "20"% of the startup's capital, valued at "10" M€.
So much for the 10% of the iceberg, which often represents 90% of the entrepreneur's attention.
Note: there is not one but two valuations when raising funds. Before the operation, 'pre-money' valuation: the Entrepreneur announces a valuation of 10 M€ but what the investor hears (who must invest 2 M€) is that the startup has a so-called 'pre-money' valuation of 8 M€ After the signature of the shareholder agreement, 'post-money' valuation: the valuation of the startup is indeed 10 M€, i.e. pre-money + amount invested (8 + 2 = 10 M€). |
THE LEGAL CLAUSES: the submerged part, which can change everything
These clauses are numerous and some of them are relatively advanced. The purpose here is not to detail them, as many experts have done so with pedagogy (for example Jean-François Gallouin or Jimmy Guilloteau).
On the other hand, it is about illustrating how these clauses are at least as important (if not more so) as: "I'll give you 20% of the capital for 2 M€ of my startup valued at 10 M€".
Illustration with two clauses: the "Ratchet" and the "preferential liquidation".
Ex. 1 : "Ratchet" clause, protecting the VC against an overvaluation of the startup
When raising funds, the Entrepreneur proposes a pre-money valuation of his startup (e.g. 8 M€) and, depending on the investment sought (e.g. 2 M€), offers a percentage of the capital to the VC (e.g. 2/(8+2) = 20% post-money).
However, this valuation is based on a business plan whose assumptions may not come true; and this may change the pre-money valuation of the startup (e.g. new valuation at 5 M€).
In this case, the VC would have only 20% of the capital, whereas with the "new" valuation, his 2 M€ would be worth 28% post-money (2/(5+2) = 28%).
The Ratchet clause is activated at the next fund raising: if the startup is valued at a lower level than the previous one, the VC can relaunch; thus, in a simplified way, his share of the capital is adjusted to what it should have been at the previous fund raising (cf. 28% vs 20%).
Over-valuing a startup thus appears triply inappropriate:
the more the startup appears to be overvalued, the more the initial VC will tend to pile on the clauses protecting him
the chances of raising a second round of financing are considerably reduced because VCs generally do not like to invest in a downturn
if the second round of financing is successful, the shares will be reallocated according to what the initial valuation should have been.
Ex. 2: "Preferential liquidation" clause, recovering one's stake before the Entrepreneur
Let's consider two scenarios* when selling the startup ('liquidation', a faux-ami which means here that the shares of the startup become liquid):
the startup sells above the post-money valuation at which the VC invested
or below (this is where it gets tricky).
* The reality is a bit more subtle, but the point here is only to illustrate the impact of clauses.
Above" scenario
Each of the shareholders (Entrepreneur, VC) recovers his share pro rata to his participation in the capital.
Below" scenario
When the valuation of the startup's sale price (e.g. €4M) is lower than the post-money valuation where he entered the capital (e.g. €10M), the VC risks losing money (e.g. investment of €2M for 20% of the capital, on which he therefore only has 20% x 4 = €0.8M)
The "preferential liquidation" clause is then activated in three steps. In a simplified way:
A small part of the sale (approximately 15%) is distributed among the shareholders in proportion to their shares of the capital (e.g. the VC recovers 0.1 M€, the Entrepreneur 0.5 M€, and 85% x 4 M€ = 3.4 M€ remains to be distributed)
With this amount, even if it represents more than his shares of the capital, the VC gets back the difference between what he received in 1. and his investment (e.g. 2 M€ - 0.1 M€ = 1.9 M€, and there remains 3.4 M€ - 1.9 M€ = 1.5 M€ to distribute)
The remaining amount (when there is some left...) is again distributed pro rata to the capital held by the shareholders (e.g. VC 20% x 1.5 = 0.3 M€).
In this case, the Entrepreneur holding 80% of the shares initially valued at €8M (80% x €10M), only recovers €1.1M; and the VC has recovered €2.3M, slightly more than his stake (even though the startup has underperformed).
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💡Summary:
The startup needs VCs (cf. having funding to grow), and VCs need ambitious & realistic startups (cf. satisfying their LPs customers)
What type of VC corresponds to the phase of my life cycle? Do my fundraising objectives match those expected by a VC in this phase?
Raise funds when you are confident of growing your valuation
Approach the fundraising with a solid and attractive project in order to be able to negotiate the clauses as well as possible (and try to remove some of them)
The valuation of your startup is only the tip of the iceberg of a deal; the key is in the legal clauses of the term sheet
Over-valuing your startup is a bad calculation, and threefold inappropriate
If the sale value is lower than the VC's entry value, the VC will get his money back before the entrepreneur
A VC investment, especially in the seed phase, is above all a bet on a team.