It is important to know the entire value chain of investment and investor types, because the later stages of the chain have an effect all the way down to your early raises.
Angels will invest in you because they think a Venture Capital Fund will also do so later on, and they in turn think the same about a Private Equity Fund, who in turn thinks either a large company in your sector will buy you, or you might list on the public markets one day. So changes to the public listing market, or the number of large players in your sector, will affect whether anyone is willing to give you the £100k you wanted to prototype.
When to Take Investment and How Much
It is worth reading the article on Valuation before continuing…
Think of the future of your company as a series of milestones, in product development, customer uptake, and other aspects. Time- calendars and seconds and years- only really features in that future through employee wages, office rents, competition, and the annualisation of investor return ratios.
This means that you are raising money to reach a milestone, not to survive for an amount of time. Of course, people want to know roughly how long in time that milestone will take, not least because of the associations mentioned above. But you are providing time measurements in support of your primary piece of information, which is the milestone you are aiming for.
The reason you work forwards in milestones is that they change your valuation. June becoming July doesn’t change anything, but revenue becoming profitable does.
As noted in the Valuation article, you de-risk your company each time you reach a milestone, and thus increase the valuation. To that end, the more money you raise now (I.E., the more milestones you want to be able to reach with the current raise), the more equity you will have to give up, due to the worse valuation.
On the other hand, there is a huge cost associated with constantly raising money in small increments. A new raise will take 2-3 weeks to get a meeting with an investor, 4 weeks at the very least for an investment decision, and then another 4-6 weeks for legal. That’s a lot of time for a young company to be without the focus of its CEO. There’s also the risk that you miss one milestone- it happens- and then have to do a raise at a valuation below your last raise, which might make people think you are failing and prevent you ever raising again.
There is no rule on how to play this balance. It will be very case-specific and the variation is enormous. What might be considered the “mean” raising profile would be:
- A raise to build a prototype
- Then one to cover some trials of the prototype, and adjustments based on the market feedback, until there is a final product with possibly first revenue
- Then one to really grow the sales of the final product, and reach profitability
- Then one to stabilise internal operations and reduce costs, and begin international expansion
Spread about a year to 18 months apart each, that means about 4-5 years until the fourth raise, but again this is a very flexible area.
Investment Stages
Pre-Seed Round
- Amount: £0-150k
- Investor: Family and friends, self-funded, accelerator, incubator, crowdfunding, angel
- Aim: Build a prototype
- Requirements: A basic business plan, financials covering the cost of building the prototype and financials for the future 5 years if it works, proof of some expertise
Seed Round
- Amount: £100k-£1m
- Investor: Angels, Venture Capital Fund, Family Office, crowdfunding
- Aim: Refine a prototype, build more expensive prototypes, begin sales, hire core team
- Requirements: Pitch deck, data room, financials with cash flow and income statement monthly for two years, annual for 5-10 years
Series A
- Amount: £1m-5m
- Investor: Venture Capital Fund
- Aim: Growth. Drive sales, hire sales team, possibly reach breakeven
- Requirements: As per Seed Round, but also with data on uptake, KPIs and metrics from early use and testing
Series B
- Amount: £5m+
- Investor: Venture Capital Fund, and Private Equity Fund for £15m+
- Aim: Profitability. Hire a sustainable team, lower costs, begin relationships with other large companies, keep driving growth, possibly start to internationalise
- Requirements: Full corporate documentation. Detailed financials prepared by an accountant, formal business plan, legal advice, evidence of performance and metrics
Types of Investors
Friends, Family, Angels. They are less sophisticated and so require less information on what you are doing and planning. On the other hand, they therefore provide less help for you going forwards. Be very careful about self-funding or taking money from friends and family; firstly, they may not be able to take the risk of losing their money, and secondly, if nobody outside your family thinks this is a good idea, maybe it isn’t. A big issue with angel investors is that later on, they can cause real problems when it comes to selling or raising new investment. Don’t take any investment, ever, without some form of advice from an unconnected third party.
Accelerators and Incubators. They usually take 5-15% of your equity in exchange for some money and support. Read carefully exactly what they offer- many will claim to offer lots of cash, but actually most of it comes in services in kind. They tend to be passive shareholders and let you make your own future fundraising decisions without interfering.
Venture Capital Funds. They usually have some sort of specialisation, whether by sector or by type of company or stage. These are professional teams with a fiduciary duty to their investors, which means they cannot take certain risks and need to have completed certain due diligence.
Most VCs will have a target investment range (for example, £1m-3m), and a preferred equity range they take; some want large stakes of 50% and a lot more board control, others are happy to take 15-20% and help you on your way. What you get back will obviously be different.
VCs raise a fund from investors, let’s say a £50m fund. They don’t take all that money on day one, so it is all committed capital. They take a 2% management fee each year on the committed capital, to run the office and pay wages- in this case, £1m per year. That fund has a specific mandate for investment types and company stages.
For the first three or four years, they will make a few investments per year, each time drawing down the money needed from the investors. After a few years, called the “investment period”, they might have 10 investments, each with an average value of £4.5m (remember that not all the £50m was available, due to the management fee).
They then enter the exit period, where one by one they sell the investments, and distribute the money back to their investors. By the time the money is all given back, any profit over the original £50m is returned 80% to the investors, and 20% to the fund. Hence what is called the “2 and 20” model; 2% fee per year, 20% of profit. Usually a fund life will be about 10 years, from first raise to last exit, and a VC will raise a new fund every year or two.
VC funds are measured, within the industry, by the rate of return per year they offer their investors, the IRR (internal rate of return): doubling your money in 1 year is a 100% IRR, in 4 years is 19%, and in 7 years is 10%. This is why VCs are sometimes focused on short timeframes- they want the IRR to be optimised, not the total value of the company. That misalignment is always worth discussing with a VC. Ask them what their timeframe for exit is and make sure you are comfortable with it.
In general, for every ten companies invested into, a VC will realise a profit on about two, no meaningful gain or loss on about six, and lose everything on the last two. In other words, two companies have to carry the entire fund into a profit.
In turn, this means that each company they invest into has to be a potential huge success, in case it is one of the two that will carry the fund. A company that can, with a high probability, double the money of a VC is less interesting than one that has a lower chance of making a much higher valuation in the end.
Family Offices. These are very similar to VC funds, except that the sole investor is a single (sometimes a few) rich family. This means there are a few differences.
A family office can take a longer view over investments, and even hold onto them forever if they become profitable, since they are not competing with investors based on their IRR. They are also willing to make investments into less risky products with lower returns, since their aim is to preserve family wealth.
The downside is that they may do a range of investments- property, stocks, VC- in order to diversify the family’s wealth, and so can be less focused on or less experienced in VC specifically.
Both VCs and Family Offices will usually want to sell to a PE fund.
Private Equity Funds. These work in the same way as VC funds, with external investors, IRR targets, and individual funds with portfolios of companies.
Strictly speaking, any investment in equity that is not publicly listed is an investment in private equity, so VC is a sub-category of PE. However, PE usually denotes funds that operate in the next stage of the value chain up from VC.
PE investments range from around £15m for the smallest investments, to huge deal over $30bn per company. The largest PEs raise funds of tens of billions every few years. Because of the size of the investments, this usually rules out startups. PE funds have specialist knowledge of sectors, and they buy companies from and sell to the major companies in that sector. Pharma PE funds will be dealing with GSK, for example.
The existence, size, and activity levels of the PE market in a sector is symbiotic with the VC market. VCs need PEs to sell to, and PEs need VCs to buy from (N.B. there are other PE models than merely buying successful companies from VCs).
There are three alternative end destinations for companies that grow successfully, other than being passed from PE to PE.
Trade Sale. At some point, a VC or PE fund might sell to an industry player. A lot of VCs will think about which company might buy your startup, should it succeed, to determine what kind of price tag they might get, and so whether they want to invest.
IPO. An Initial Public Offering is what happens when a company floats its shares on a stock exchange. This is an expensive, slow and difficult process, and is the rarest, but it keeps the others honest; if industry players or PE funds start offering to buy at unduly low prices, a company can threaten to IPO, thus raising the price. IPOs involve a lot of scrutiny of accounts, and so it is worth having professional accounting right from the start; precluding yourself from an IPO due to messy accounts early on will lower your valuation in a sale to PE.
Never Sell. Some companies remain successful for many years, paying off a nice dividend, and the founders and investors choose not to sell. There are one or two VC and PE funds that buy for future dividends, but generally family offices tend to be more open to this. Another option is for the management (including the founder) to use debt to buy out the VC or PE that wants to exit.
Conclusion
There is no need to learn the financing value chain in much detail. You just need to have an idea of what the person investing in you wants to invest for, and how they think. That means knowing who they are planning on selling to, so you can check you are aligned with them in the direction you want to take your company, and the speed.