Every startup needs capital to convert an idea into a business. However, many companies incur large expenses before they even generate their first dollar of revenue. Unless your founding team can satisfy the initial cash requirements from personal funds, external financing will have to be considered. This includes a variety of options such as generous family and friends, bank loans, and crowdfunding. However, your company’s ability to scale may become limited by the smaller source of cash flow that these avenues provide. This is where venture capital enters the picture.
In a nutshell, venture capital (VC) is the funding provided by investors to startups. Venture capital firms have access to large funds and, depending on the size, the firms can invest significantly more capital. During 2017, CAD$3.5B worth of venture capital was invested in over 592 deals in Canada, with the vast majority of these deals taking place in Toronto and Montreal. Well-known Canadian venture capital firms include Real Ventures, BDC Capital, Golden Ventures, OMERS Ventures, iNovia Capital, and more. Likewise, there are also angel investors who are wealthy individuals looking to grow their personal net worth. In Canada, there are many angel investor groups such as York Angel Investors, iGan Partners, Maple Leaf Angels, and more. While similar in the functions that they provide, angel investors and venture capital firms have significant differences. The roles and typical structure within a VC firm will be elaborated upon in a future blog post.
In exchange for their capital, VC investors want equity in the company. Equity represents ownership of the business, which is divided into shares. In other words, if your startup could be represented as a pie, a share would be a slice of that pie. As a company grows in size and value, the value of each share also increases.
Purchasing shares can be an entirely different process depending on the type of company. A public company sells its shares on a stock exchange which can be bought by the general public, whereas a private company, such as a startup, typically sells its shares to individuals that can add value to the startup. In addition, private investors will often want a seat on the Board of Directors, where they vote on key business decisions and influence the company’s direction.
One of the most fundamental aspects of investing is the concept of ‘risk vs. return’. Investing in a well-established public company such as Apple has lower risk due to its size, stability, and market dominance. Therefore, investors cannot expect to generate a large return from their investment since the risks of losing their investment is much lower. On the contrary, the success of a startup is often unpredictable, with less than 10% of startups succeeding. This results in investors losing the majority or all of the capital they invested. Therefore, in order for investors to take on higher risk, they demand larger returns. For this reason, venture capitalists are always on the lookout for the next big startup that they can acquire portions of equity in early on, and receive massive returns when the startup is able to successfully scale. As a result, most VCs are interested in startups with the potential for high scalability.
Due to the riskiness of investing in startups, VCs are subjected to the ‘Babe Ruth Effect’; great VCs will often strike out, but their grand slams are what people typically remember. In other words, they may lose capital on many of their investments, but by being able to invest in a winner early on, it can outperform to the point where it compensates for all the losers.
The Fundraising Process
A startup goes through multiple stages of growth, from the initial idea, to a product, to a rapidly growing company. During each phase, a startup will need additional funding to hit their milestones. As such, startups go through multiple funding ’rounds’ throughout the life of the company, each round holding a different valuation and investment terms. Most VC firms define themselves by the stage of financing they invest in. The fundraising process will be elaborated upon in a future blog post.
VCs will almost always ask entrepreneurs about their exit plan. In other words, how can they liquidate their equity? Liquidity refers to how easily you can convert an asset (something with economic value) into cash. Equity in an early stage startup is considered non-liquid as it is difficult for investors to sell their ownership to others. Instead, they make a profit off their investment during an exit/liquidity event. This can occur in one of two ways: a new equity raise or by acquisition.
An equity raise occurs when the company decides to raise further capital via private or public markets. Typically, the ultimate goal for many startups is to “go public” also known an initial public offering (IPO). An IPO occurs when a private company decides to sell its shares to the public. This means the firm’s shares can be sold on the stock exchange where anyone can purchase equity in the company. On the other hand, anyone with equity in the startup can sell their shares for cash. One of the advantages of an IPO is its flexibility – investors can choose to sell all, a portion, or none of their shares.
In contrast, an acquisition occurs when a larger company decides to purchase a startup. Firms will do this to either get rid of a competitor before they become a significant threat, gain access to new technology and markets, or to employ the startup team.
As a founder, it is important to target the right investors for your company. VCs offer more than just capital – they bring to the table their expertise, alongside a wide network of powerful and experienced individuals. With the amount of risk that the VCs undertake, they become equally as invested in the success of the startup. When the startup faces hardships, VCs can offer advice and guidance providing the startup with a higher chance to succeed.
Stay tuned for the next blog post as enLIGHT will be diving deeper into the world of venture capital.