Why and when to take VC funding for an early-stage startup?
5 min read
May 10, 2022
VC fundraising should not be a default entry on every startup’s roadmap. With bootstrapping, business angels, crowdfunding, bank debt as potential ways for a startup to scale, resorting to venture capital firms is suited for a very specific kind of company.
This article is written by
Alexandre Lalaus & Marie-Anne Moreau
, VC, and Principal at Alven, gave some valuable insight as to why Venture Capital funds need high-potential startups in their portfolio and what characteristics VCs look for when trying to spot future home runs for their fund.
Why aren’t all startups VC-backable?
Venture capital firms have a business model that requires them to invest in startups with a scalable business model and global ambitions. The job of a VC fund is first to get money from investors (public entities, banks, pension funds, etc.) and invest it in promising startups to generate returns on investment.
Statistically, roughly half of VC investments are lost due to the startup’s premature ending. A small part of the portfolio generates a more significant return on investment, and the rest of the portfolio outperforms and generates profits for the fund. Therefore, VC firms are looking to invest in startups they think will reach high valuations and make the firm profitable.
This goes to show that not all startups, as innovative as they may be, are meant to be funded by VCs. That being said, what are some key aspects that make a startup VC-backable? Let’s dive in.
What makes a startup VC-backable?
Venture Capitalists send money back to their investors —called Limited Partners — by selling their shares of their portfolio startups. This liquidity event is called Exit and it hinges on the following formula:
Exit value = revenue at exit x multiple revenue
To maximize this value, what the fund will look at is:
- What level of income the startup can achieve over the investment horizon (5–10 years)?
- What multiple of revenues investors will be willing to pay to acquire the startup?
Regarding income, VCs are going to look at which market the company addresses by analyzing its size and its dynamics. VCs will also construe the type of income (recurring or punctual for instance). Finally, the ambition and experience of the team will also have a real impact on the (potential) income.
Regarding the multiple, it is determined by various elements. In particular, it relies on the VCs’ perception of the evolution of the income (stable or increasing). The startup’s position must be defensible against other competitors.
Some business models are currently in vogue among VCs (e.g.: SaaS, marketplace) but new business models can potentially generate tremendous revenues. Another key point is growth. Typically, an acquirer will be willing to pay “dearly in multiples” for a startup that grows very quickly — because that means that the income for year n+1 will be significantly higher than the income for year n. Finally, there is the aspect of market strategy: if a company creates or defines a category, it gets a “leader bonus” deriving from its first-mover advantage.
To sum up, there are 4 elements that will create for VCs a definition of what a VC-backable startup is.
- A unique and differentiated offer. This means that the startup creates a differentiated category or redefines a category in its own way. Being either unique or differentiated allows the startup to stand out from the competition.
- The potential for a “healthy” business model which spits out a lot of margins — will be better valued.
- A growing market. This means that stuff is happening, it is dynamic, and people are interested in it.
- A credible path to create a category. This brings together elements such as the team, the product, the positioning in the value chain, the network effect which is starting to be put in place, and so on.
Once a startup ticks these boxes, it is not yet ready to start its roadshow*. Founders need to make sure that the timing for VC funding is right for their startup. If it is not, bootstrapping may be an option for them to grow their business.
What is the difference between bootstrapping and pre-seeding?
In the life cycle of a company, bootstrapping and pre-seed both take place during the ideation phase — that is when the founders further refine the problem they want to solve and still research the angle from which they want to address it.
This phase is not always intended to be financed by VC funds, especially since entrepreneurs and funds do not yet know whether the project will lead to a highly-valued company.
This explains why many entrepreneurs choose to bootstrap: to fend with their own resources and the capital flows generated by their business to finance their launch and development. Since this phase is often considered as “the founders’ time”, it remains important for them to take time to think it over. Indeed, entrepreneurs may be more agile without other partners in their capitalization table.
For some projects, it may be more interesting to raise in pre-seed. It can be useful for entrepreneurs to buy key human resources or launch strategic R&D programs. Pre-seed funding rounds can accelerate the trajectory of the project through a quick decision. At this stage, it may also be strategic to raise with funds that have the experience to move startups from 0 to the next stages (seed or Series A).
Lithuanian digital health and wellness startup Kilo Health bootstrapped for 8 years before raising an €800K Seed round in July 2021. On the other hand, the deep-tech startup Silina, developing curved sensors for the imaging industry, raised a €90K pre-seed round within its first year of existence to finance R&D and prototypes. At G. Ventures, the first student VC fund in France, we finance pre-seed-stage startups launched by student entrepreneurs. We will be careful to target startups that fit our investment thesis and that are in the right timing to receive VC funding.
Roadshow: series of presentations in order to raise a financing round from investors
If you are looking for funding for your startup and you fit our investment thesis, you can check our website: https://www.gventures.co/