startup funding - venture capital

I have spoken to a lot of entrepreneurs who are passionate about what they are doing and are looking to raise money from Venture Capital (VC) firms. Once I listen to their pitches, I usually know if they will be able to raise the money from a VC or not. This is not saying that the business is terrible, I am only saying that VCs typically don’t back such businesses; hence, the founder should better look for alternative sources of capital, rather than move from one VC to another.

The idea behind this post is to try to educate Nigerians, and to a large extent, African entrepreneurs about how VCs will typically appraise an investment and why they won’t touch some other investments. This is also not cast in stone as VCs at different stages will look out for different things, depending on the size of their funds.

Fund Dynamics

Now that I have mentioned the fund size, I need to make something clear; within the VC or Private Equity space, investors are looking for businesses that will “return their funds”. This means that they are looking to invest in companies that will make them money equal to the size of their funds at exit. I will use 3 funds to illustrate this point: Mega Fund, Midi Fund and Mini Fund. Imagine that these funds have Asset Under Management of $500 million, $100 million and $50 million respectively. Mega Fund is looking to invest in businesses that will make it $500m at exit, while Mini Fund just wants businesses that it can sell and make $50 million back. This then informs the sizes of deals they will do.

So, Mega Fund will set a minimum investment threshold of say $30 – $50 million. This means that they can’t invest less than $30 – $50 million in any deal. For them to commit such capital, it also means that they expect their $50 million investment to yield 10x at exit. This means that the value of their stake at exit should be $500 million.

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Mini Fund, on the other hand, will set an investment threshold of $200k to $2 million. This means that they expect their $2 million investment to yield 25x at exit to return their fund.

Now, with this understanding, if you are a startup raising $2 million dollars series A from this Mini Fund, how much stake will you be willing to offer? Let’s say 20%. This implies that your startup is valued at $10 million post money. For the Mini Fund to return its funds, it means that its 20% stake in your startup should be worth $50 million in 7 – 10 years or at exit. For that to happen (assuming you did not raise Series B or C), it means that the business should be valued at a whopping $250 million at exit.

The next question, then, is what must you do to be able to achieve that sort of valuation? How much must you make to justify that valuation? If your business cannot do that, then we might need to re-examine the venture backability of that startup.

Let’s assume a 2x revenue multiple at exit; this means that your startup should have the capacity to generate as much as $125 million (or NGN45 billion) in revenue to achieve a $250 million valuation.

Having done this analysis, most VCs will need to be convinced that your business and the industry it operates in can deliver such value to the VC.

The point here is that your target market should be large enough to generate revenues in tens and hundreds of millions of dollars.

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How large do you want to be?

I have seen a number of technology businesses that don’t seem to give room for expansion. I will explain. If you named your business www.laptops.com because you started out selling laptops online, you have to convince me as a VC investor that the laptop market is large enough to build your startup on. I personally prefer names that don’t necessarily have direct correlation to the business you are doing, or names broad enough to capture expansion plans, thus giving you flexibility for additional services as you scale. So, rather than name your business www.laptops.com, you can address the electronics market by finding a broader name. Slot can decide to start selling rice if phones are no longer selling.

Revenue Source and Dependencies

I have spoken with technology business owners whose major revenues are from executing contracts with governments. Trust me, that can be a large market because governments have a lot of problems and they have money to pay. However, the business is not scalable and repeatable. In fact, it might have some ethical connotations around it, since it might not be possible to hold down the government without some corrupt practices involved.

Irrespective of how large that business can be, VCs will most likely not touch it even with a long stick. The revenue is not constant, governments change regularly, and you fall in and out of favour. As a VC, I will not back such startups, since all it takes for the business to crumble is a change of government.

I will want a business that will have a diverse customer base, so that I am not exposed to a single entity. In fact, I might not back a consulting practice, since the entrepreneur will have to activate every transaction manually. I want businesses that are repeatable. Even if you have to activate a lead, I want the lead to return on its own without me activating again.

Imagine a salary-based lender, the entrepreneur will more often than not activate a corporate organization manually. However, once that activation is made, the staff of the organization can just use the technology platform for borrowing, while the entrepreneur digitally manages these customers. This is different from a project implementation startup that has to pitch every time to get a deal to execute.

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The Team

This should not be underestimated. Most VCs invest first in the people before the idea. Are you a world class team? Do you have a technical co-founder? Do you have domain expertise? Or you just want to replicate that thing you saw in New York the last time you travelled? What unique insight do you have about your industry and/or your customers? Ideas can be stolen, but execution is dependent on the team. I want a team that can execute.

I will continue with this series in subsequent posts.

Happy entrepreneuring

@AremoFisayo

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