Venture capital, often referred to as VC, plays a crucial role in supporting innovative start-ups and turning ideas into reality.
Let’s take a trip back in time to the late fifteenth century when Queen Isabella of Spain financed a daring and risky business venture. You might be surprised to know that she was one of the world’s first venture capitalists! The venture involved Christopher Columbus, who aimed to discover a shorter route to India, revolutionizing trade. Back then, the risk of failure was immense, and although today’s ventures aren’t life-or-death on the high seas, they still face significant risks. In fact, approximately 90 percent of start-ups fail.
Enter the modern-day venture capitalists, the heroes of our story. These individuals or firms provide funding, or capital, to promising founders with innovative ideas. In exchange for their support, VCs gain ownership stakes in the companies they back. But their role goes beyond just providing financial backing; VCs also offer invaluable guidance and advice to founders, helping them make informed decisions and achieve their strategic goals.
While venture capital is a vital force driving the start-up world, it can be a bit mysterious to many.
How Venture Capital is Changing
Over the past few decades, venture capital, which is the money invested in new and risky businesses, has gone through significant changes. Back in the early 1970s, Silicon Valley saw the rise of venture capital firms, but only a handful of these companies controlled most of the money available for startups. This gave them considerable influence over which entrepreneurs could get funding for their business ideas.
However, things started to shift in the early 2000s due to two important factors. First, technology advancements made it cheaper to start a new business. The cost of essential components like servers and networking decreased, and with the introduction of cloud computing, startups didn’t need physical office space for data storage, saving on expenses. This made it easier for entrepreneurs to launch ventures without relying heavily on venture capital.
The second game-changer was the establishment of Y Combinator (YC) in 2005. YC is a school that teaches aspiring entrepreneurs how to create and fund their companies with venture capital. By bringing together a scattered entrepreneurial community, YC enabled the sharing of knowledge and leveled the playing field between venture capital firms and entrepreneurs.
Around this time, Marc Andreessen and Ben Horowitz founded Andreessen Horowitz, a venture capital firm that recognized the shifting landscape in Silicon Valley. They realized that providing money alone was not enough; entrepreneurs needed additional support in areas like recruiting, marketing, and sales.
This is where venture capitalists like Scott Kupor came into the picture. As part of Andreessen Horowitz, his role is to advise CEOs, offering guidance in building networks and relationships with people and institutions. With this approach, Andreessen Horowitz has successfully supported the growth of several major companies like Pinterest, Slack, and GitHub.
Venture capital has evolved over the years, and recent changes in technology and the rise of educational platforms like Y Combinator have given entrepreneurs more independence while prompting venture capital firms to offer valuable support beyond just financial investment.
What VC firms look for in early-stage startups
Venture capital (VC) firms, which invest in early-stage companies, focus on three key factors when deciding where to put their money.
Firstly, they pay great attention to the people behind the company. Instead of having a fully developed product, founders often approach VC firms with just an idea. So, VCs have to rely on qualitative analysis to assess the potential of the founders. They look into the founders’ backgrounds and seek evidence that they can effectively bring their idea to the market. VC firms are also interested in what sets these founders apart from others who may have similar ideas. They want to find a strong “founder-market fit,” where the founders have unique experiences that provide them with valuable insights into the product they are trying to build.
An example of this is Airbnb. Its founders had a brilliant idea because they had experienced the struggle of finding accommodation during busy conventions. Their solution was to rent out affordable places in their apartments to conference attendees, which eventually turned into the successful Airbnb business.
Secondly, VC firms analyze the product being offered. To stand out in the market and attract customers, the product needs to be revolutionary and offer significant improvements over existing alternatives. Incremental improvements may not be enough to gain momentum and succeed.
Finally, VC firms consider the market size. Since many early-stage ventures fail, it is crucial for successful startups to have a large market to continuously expand into. However, predicting the size of potential markets can be challenging, especially for innovative ideas that haven’t been explored before.
For instance, when Airbnb first started, they saw themselves catering to a small market of conference attendees. But Andreessen Horowitz, a VC firm, recognized the broader potential of Airbnb, extending beyond conferences into the hotel market and beyond. This foresight proved to be accurate, as Airbnb went on to achieve tremendous success.
Overall, VC firms invest in early-stage companies based on the founders’ capabilities, the revolutionary nature of the product, and the potential market size for growth. These factors are crucial for determining which startups are worth backing and have the potential to become successful businesses.
Mastering the art of pitching
Mastering the art of pitching a business idea to venture capitalists requires finding the right balance between flexibility and determination. If you’ve ever been in a position to pitch your entrepreneurial dreams to investors, you know it can be quite nerve-wracking, especially if your future success hinges on the outcome.
Thankfully, the author, with years of experience at Andreessen Horowitz, has witnessed numerous pitches and can tell the difference between good and bad ones. To understand a good pitch, it helps to consider what makes a bad pitch.
Sometimes, founders make the mistake of focusing on potential buyers for their company once it’s successful. However, venture capitalists are more interested in hearing about the founders’ ambitious strategy to conquer the world with their idea, even if success isn’t guaranteed. The key is to paint a compelling picture of how the world will change once their idea takes hold.
During the pitch, investors will challenge founders through a process called the “idea maze.” This involves questioning the origin of the idea, why it would make a good product, and the market insights that were considered during its development. The purpose is not to determine if the product will succeed 100%, but rather to understand the depth of the founder’s understanding and thought process.
It’s important to note that many founders end up making changes to their product, known as a pivot, based on the feedback received. However, making significant changes during the pitch itself is not advisable. Investors want to see a commitment to the conquer-the-world strategy, and sudden shifts may indicate a lack of conviction.
Nevertheless, founders should be open to valuable advice and be willing to adjust their pitches accordingly. Being receptive to feedback and adapting appropriately can strengthen the pitch and improve the chances of securing investment.
To sum it up, a successful pitch involves demonstrating a bold conquer-the-world strategy, navigating the idea maze with confidence, and being open to constructive feedback while staying committed to the core vision.
Understanding term sheets
Term sheets are important documents that outline the rules and processes for a business deal between a founder and a VC firm. They can be quite complex and confusing, especially for founders who are not familiar with them. However, we can simplify term sheets into two main parts to make them easier to understand and level the playing field between founders and VCs.
The first part focuses on the economic side of the agreement, dealing with things like the investment amount, who gets control of shares, and the order of payout if the company is sold.
The second part is about governance, which has long-term consequences. It involves how the company’s board of directors operates and who gets to be on the board. Negotiating this part is crucial because the board plays a major role in running the company, appointing the CEO, and making important decisions about its future.
In typical term sheets for successful founders, the board of directors consists of three people. One is a representative from the VC firm, another is the company’s CEO (usually the founder), and the third is an independent outsider with no conflicts of interest.
As the company grows and goes through additional financing rounds with different VC firms, the board will likely expand. To maintain a balanced board, it’s essential to negotiate that for each new VC on the board, there should also be another representative from the company.
Term sheets are important agreements for founders and VCs. They have two main parts: one dealing with the financial aspects and the other focusing on governance and the composition of the company’s board. It’s crucial for founders to understand and negotiate these terms to ensure the best outcomes for their businesses in the long run.
Building a strong CEO-board relationship
Having a good relationship between the CEO and the board of directors is crucial for the success of a company that has received funding from venture capitalists (VCs).
Once the CEO has a fair agreement (term sheet) with the VCs, her main focus should be on running the company with the newly acquired funds. This involves leading the team and taking care of both daily operations and long-term vision, especially if she is the company’s founder. However, the CEO’s relationship with the board can sometimes be complicated, so it’s essential to ensure a healthy connection between both parties.
This is especially true when dealing with VC representatives on the board. While many boards allow CEOs to make their own decisions, some VCs, who may have been CEOs themselves in the past, might be tempted to get involved in the company’s day-to-day affairs. However, it’s crucial to remember that VCs should not be overly involved in those details. The CEO is the one who should be in charge of managing the company’s daily operations.
Nevertheless, it’s still important for the CEO to maintain open communication and exchange feedback with VCs and other board members. VCs often have experience serving on other boards and can provide valuable insights based on mistakes they’ve seen other CEOs make. For first-time CEOs, this input can be especially valuable, as they might be facing challenges they haven’t encountered before.
Even though VC firms provide the funding, the CEO is responsible for running the entire company, including the board. From the beginning, the CEO should establish clear feedback channels with the board, like having regular meetings to seek advice and share company updates. In cases where there are multiple VCs involved, the CEO might not have time to meet individually with each one. In such situations, it can be more efficient for the VCs to come together and consolidate their feedback before presenting it to the CEO.
In summary, maintaining a healthy CEO-board relationship is essential for the success of any company backed by venture capital. The CEO should lead the company while keeping an open channel of communication with the board, valuing their valuable input while ensuring they do not interfere with day-to-day operations. Ultimately, the CEO is responsible for running the company, and clear communication with the board is key to achieving success.
Choices for successful startups after VC funding
After successfully navigating the venture capital (VC) process, companies have two main options for their future. If your company is among the 10 percent of startups that succeeded and are financially stable, congratulations! Now, as the CEO of a profitable business, you may receive offers from larger companies interested in acquiring your company. In fact, 80 percent of successful VC-backed startups end up being acquired.
If acquisition is on the table, there are important considerations. One major issue is deciding which employees will stay with the company after the acquisition. Many key employees who have been with you for years deserve recognition for their hard work, so negotiating fair equity deals for them is crucial.
Another option for your company’s future is to go public through an Initial Public Offering (IPO). This means selling shares on the stock exchange, allowing the public to invest in your company. Setting the right share price is critical. An overpriced IPO, like what happened with Facebook in 2012, can lead to negative perceptions of your company. Seeking advice from experienced investment bankers can help you determine the best initial share price.
Regardless of whether your company is acquired or goes public, the VC firms that initially invested in your company will be looking for their rewards. They took a risk by funding your company, and now they want to cash in. However, if they sell their shares too quickly, it could harm your company’s value due to a perceived mass sell-off. It’s often better for VCs to gradually withdraw their stock over time.
As the CEO, your journey is entering a new phase, whether through acquisition or IPO. The initial idea you pitched to VCs is now evolving, and you might have to answer to a larger company’s CEO or public shareholders. Nevertheless, you should be proud of reaching this stage, as you are part of the minority of startups that successfully pass the VC stage.
As the tech industry exploded with new startups in the early 2000s, the way venture capitalists (VCs) and entrepreneurs interacted underwent significant changes. Today, when VCs assess companies, they seek founders who have a special understanding of the problem their product aims to solve. To win over VCs, mastering the art of the pitch is crucial. This means being open to adapting your approach while staying fully committed to your idea’s value.
Once you secure funding from VCs, the next challenge is maintaining positive relationships with them. A well-structured term sheet can be beneficial in this regard. And if you manage to reach an IPO or acquisition, you’ll become part of the exclusive group of successful founders. So, keep pushing forward with your unique insights, and who knows, you might just join the ranks of the accomplished entrepreneurs!
Inspired by a book “Secrets of Sand Hill Road”; Scott Kupor