How VC Works - An Operating Partner's Perspective

Introduction

Over the last couple months, we’ve been meeting with early stage entrepreneurs and companies as part of the Movac Q&A Sessions held at the BizDojo Wellington and GRIDAKL.
The point of these sessions was for us to meet some interesting companies that, whilst may be too early today for Movac Fund 4, would be looking for Series A funding in the next 12-24 months.  The sessions were opportunities for entrepreneurs to ask any pressing questions about venture capital funding, what we look for when making Series A investment, and what kind of things they can be doing from now to develop the relationship with VCs and get their companies in the best position possible for an effective fundraise.
We hope these sessions were useful for those that attended, or followed along on Twitter (@movac_vc)!  Based on the questions that came from those sessions, and to cover off topics we didn’t get a chance to, we’ve asked Ed Robinson, an Operating Partner in the recently announced Movac Fund 4 to give a Silicon Valley-based perspective.  This post is the first of three where Ed discusses how VC works, what should you spend VC money on, and if, and how, you should, and can, move your company to the Valley.

How VC Works – An Operating Partner’s Perspective

As an entrepreneur, understanding how venture capital (VC) works is incredibly important, especially as you prepare to raise investment from Movac or another firm.  The purpose of this blog post is designed to give you the basics of how VC works, and is the first in a series of posts about raising capital, scaling your startup and succeeding in international markets.
How VC companies work
Before you approach a VC to raise investment, spend some time to understand how they work, and how you will work together.  VCs work by first raising a fund from institutions and private individuals, investing this fund in companies, then passing the profits back to investors after the company has a liquidity event. This is the basic mechanics of a VC firm.
When it works out; investors make money, entrepreneurs make money, and the VC firm thru management fees.  For example, Movac recently announced Fund 4, a $80-100m fund.  This will probably be deployed over 5 years, with returns in 8-10 years.
Many VCs work on ⅓ ⅓ ⅓ batting average – ⅓ companies fail completely, ⅓ break even, ⅓ are runaway successes.  VC companies like Movac work hard to increase this batting average, with general partners taking a company directorship and actively helping with strategy, connections and follow-on funding; and dedicated resources such as operating partners in offshore markets, inhouse legal counsel, and partnership with other firms. The odds of your startup succeeding are greater when an experienced, actively involved VC is onboard.
What do VCs invest in?
Picking future winners is tough.  Every VC company has their own formula for evaluating who to fund, and it usually involves three essential qualities:

1. People. Is the team experienced? Do they have energy and passion? Are they adaptable, and will they listen to advice?
2. Market. Is the market hot? Large and growing fast.  Does the team understand the market, and have a clear pathway to find customers/users?
3. Product. Is the product proven? Does it have the potential to be 10x better than the competition?

When you’re pitching to VCs these are the key things to focus on. Also remember VCs tend to invest in product companies. Successful product companies generate massive returns (develop it once, and sell it many times).  VCs tend not to invest in services companies (where you bill time), since growth is linear with billable staff.  VCs also look for companies with liquidity potential – IPO or acquisition, since ultimately they need to return money to investors.  To understand what Movac looks for in companies, see the Apply for Funding section of Movac’s website.
When to approach VCs
Most product companies require an upfront investment to get things off the ground – product and brand development, marketing and initial sales.  VCs will invest after this initial stage, when you’ve proven the product and are looking for funding for growth – scaling sales and marketing. For most startups, their funding roadmap will look something like this:

In the table above, notice the “goal” column.  Investors always look for what the purpose of the raise is.  “So we can pay ourselves” is never a good answer. Most companies raise enough capital for two year’s runway, with an understanding for what they need to achieve in order to raise more funding if they need it.
Get to know angels and VCs before you need to raise money.  Investors like to build a relationship, track your progress, and will give you an indicator of what stage they might be interested, and what company progress you’ll need to show.
Everything Changes
At the beginning of 2016, in Silicon Valley, capital markets became tighter, and it quickly became harder for companies raising VC money for the first time. “The bar has raised for everyone”.
Even in good times, by some estimates, only 0.05% of startups successfully raise VC.  Partners and Associates at VC firms meet with hundred of companies, but make only a handful of new investments each year.  For example, a large VC like Google Ventures, with US $2.4 billion to invest has only funded 300 companies over six years.
To improve your odds of raising VC money, there are several things you can do:

1. Start talking early to VCs (well before you need the money), ask them what they want to see in order for your company to be “investable”. VCs often speak at events, run Q&A, and even just attend events, which are also a great forum for getting an introduction.
2. Work on your pitch deck. Marc Phillips wrote an excellent book Inside Silicon Valley, How the Deals Get Done, with step-by-step advice for building your pitch decks
3. Listen to the advice they give you, and adapt.
4. Look for VCs who invest in your industry vertical.  These are more likely to be interested, and will have better connections.  Do some research to see the lifecycle stage of their fund (early is best).

If you’re based in New Zealand, start with Movac.  Movac is New Zealand’s most experienced venture capital company, and invest only in New Zealand early stage companies.  This experience means “smart money” with connections, advice, and support for companies as they grow internationally.
Now you’re well on your path to raising several million dollars!  The next post will tell you how to spend your VC money.

Ed Robinson was the co-founder and CEO of Aptimize, a Wellington based company acquired after two years by Riverbed Technology. Now based in San Francisco, Ed consults in product and market strategy, and is an Operating Partner in Movac Fund 4.