How To Raise Venture Capital Funding in 7 Steps
By Deniz Taşdemir, İrem Akpınar
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“Venture capital (VC) is a form of private equity and financing that investors provide to start-up companies and small businesses that are believed to have long-term growth potential. Venture capital generally comes from well-off investors, investment banks, and other financial institutions.
Venture capitalists generally expect a share of the future profits or a sizeable stake in the business in return for their investment. This can mean that a successful business start-up if it develops into a large company, will always have some control exercised over it by the original venture capitalist.”
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I. Determine Business Valuation
Your business valuation and the size of your venture round are interlinked. Venture capitalists prefer to take a set percentage of a company in exchange for funding. Therefore, the higher your valuation, the more money you could raise. The precise manner of determining what a business is worth varies by business and by industry.
If you’re already an established business with sales and revenue, estimating a valuation is possible using traditional methods. The three most common methods of determining business valuation are:
Net asset valuation: This method involves adding up the value of all assets on your balance sheet and subtracting any long-term debt. This is usually not an excellent method for venture capital since investors are more interested in the future cash flows of your business.
Profit multiples: Assuming your company is profitable, you could use a multiple of your annual profit. The usual metric is earnings before interest, depreciation, and amortization (EBITDA). However, the multiple is affected mainly by the future growth of EBITDA, which can be highly speculative.
Discounted cash flow: Discounted cash flow uses your projections for future cash flow and discounts them using interest rates to create a value. This method can be complicated due to the highly speculative nature of forecasted cash flows.
For most venture deals, traditional valuation methods aren’t effective. Every business is different, which makes it challenging to come up with a general valuation formula. Valuation is often a combination of how much a company needs, how much equity in your company you’re willing to give up, and how much the venture capitalists are willing to pay for that equity stake.
Ultimately, your company’s real value is whatever the market will pay for it. If you decide that venture capital (VC) funding is a good fit for your small business, you’ll first need to determine the value of your business, decide the amount of funding you need, and Prepare your pitch to investors. Once you have the details of your presentation worked out, you will need to locate potential investors and present your pitch.
II. Determine Funding Need
The amount of money you should try to raise is determined by several factors, including:
- How much capital you need for your business;
- The current stage of your business;
- Valuation and dilution preference.
Dilution is how much ownership in your business you will give up to new investors. The less you raise, the less you need to give up. For instance, if you want to raise $2 million but don’t want to sell more than 20% of your company, you’ll need a valuation of at least $10 million. For initial rounds of venture capital, it’s not uncommon for VCs to want to purchase at least 20% ownership of your company.
Enterprise Valuation
Knowing and maximizing the valuation of your business is essential in maintaining a collaborative shareholding structure as well as in obtaining the most favourable outcome in M&A and other financing transactions.
Overview of our services:
- Constant monitoring and review implementation of the business plan;
- Identifying and evaluating value changing factors such as changes in macroeconomic data;
- Comparison of different valuation models and choosing the most appropriate model(s);
- Preparation of the valuation report.
III. Put Your Pitch Together
Every business is slightly different regarding what’s needed to prepare for a venture capital round. Most companies will need to prepare a business plan and pitch deck. Additional- ly, you may be asked to provide detailed product documen- tation and references to your potential investors.
Pitch Deck
Your pitch deck is part of the introduction to the potential investors who will get to your business and should be tailored to the specific investors you’re presenting. A well-put-together and professional-looking pitch deck can be crucial to securing venture capital funding. The average pitch deck is roughly 19 pages or slides covering numerous details about your business proposal.
A comprehensive pitch deck should elaborate on what problem your product or service solves, how your product or service is the solution, what the market looks like, what your product is, how your product or service is performing and traction for further growth, who is on your team, your competition, projected financials, amount of funds needed
Business Plan
A robust and detailed business plan is an excellent asset to your business, whether you’re seeking venture capital or another source of financing.
Here are the core components of a successful business plan for funding:
- An Executive Summary;
- Your Business Opportunity;
- Your Company’s Current Financials;
- Your Current (and Future) Loan Requirements;
- A Description of How You’ll Use the Funds;
- Your Current (or Future) Loan Repayment Plans;
- A Brief Description of Your Team.
IV. Target Venture Capital Investors
Once you have all the pertinent information about your business assembled, it’s time to begin searching out potenti- al investors. You’ll begin by making a list of potential inves- tors and prioritizing the list. Having identified those you feel are most likely to invest in your business, you can begin making the necessary connections to enable you to present your pitch.
Make a List of Potential Venture Capitalists
Most venture capital firms invest in a specific business segment. These segments are often defined by the current business stage, the type of business or industry, or the geographic location of the business. Venture capital segments typically include:
- Investment stage;
- Location;
- Industry;
- Prioritize the List.
After identifying a list of nearby investors with the right stage and industry focus, you should prioritize the ones that appear to best fit your business. In all likelihood, you’ll eventually reach out to everyone on the list.
However, initially, you should begin with the most likely to invest in your company based on their past funding history.
Network Your Way Into Meetings
Starting at the top of your prioritized, targeted investor list, you need to network your way to them. Cold emailing or calling venture capitalists is neither an effective nor a good use of your time. Very few venture capitalists will source a deal that way. Many see it as a red flag if a CEO can’t network their way to them. Some ways to network your way into meeting venture capital investors include:
- Introductions;
- Competitions or accelerators;
- Public relations;
V. Negotiate
Once you have found a potential VC to partner with, negotiations take place. Term sheets are preliminary legal agreements wherein the significant terms of a venture capital investment are agreed to before signing an actual share purchase or equity agreement.
There are important tips for your negotiation of the term sheet with the venture capitalists:
You should openly communicate with the venture capita- lists about your negotiation process and request the term sheet after meeting a few times. Instead of verbally negotiating the terms, even if the terms do not align with your interests, show your interest in working with them and request the term sheet to get closer to finishing the deal.
Once you get a term sheet from a firm, inform other firms that you received a term sheet from a firm showing interest in investing in your start-up. This will cause firms to act and send you the term sheet due to competition in the venture capital market.
As venture capitalists are more experienced than founders in the negotiation of the term sheet, you should negotiate in writing in the process of making a deal.
Requesting a price increase when the terms sheet is received from the venture capitalists is not an effective strategy. Instead, you should specifically negotiate your terms, which include the amount of funding you aim to obtain at once.
Written negotiations are more effective and time-efficient compared to verbal negotiations. It will give you the opportunity to negotiate the whole deal and signal what is significant to you at once, which will also allow you and your investors to quickly agree on the key deal terms and enable you to consult your mentors and lawyers.
To negotiate effectively, explicitly express that you have a deal and show that you are ready to act. You may respond to the term sheet with an email indicating your excitement for working together and that you are going to accept the deal as you red-lined.
Taking into account that this is a process of business negotiation and focusing on controlling emotions, such as the tiredness and frustration of selling equity in your business, is important for the negotiation. Hence, a negotiation in writing with venture capitalists is more logical as it might allow you to conceal possible emotions that might arise.
VI. Proceed Through Due Diligence
Upon agreeing to a term sheet, a lengthy process of due diligence on the part of investors starts. While actual due diligence questions will vary depending on the type of business you have, these matters should be discussed:
- The market and competition;
- Your team and your company’s business culture;
- Your finance and human resources (HR) systems;
- Your current and potential customers;
- Product development plans;
- Sales and marketing plans;
- Any legal contracts your business has entered into.
Venture capitalists evaluate potential risks associated with the investment and aim to get a full understanding of the business beforehand to minimize losses with due diligence. It is a rigorous process that determines whether or not the venture capital fund will invest in your company. Investors will want to review your company’s financial statements and legal documents while conducting the due diligence. The process of due diligence can be divided between exploratory due diligence and confirmatory due diligence. Firstly, exploratory due diligence is the process carried out at the beginning of the investment process. Generally, investors do market research and industry analysis to get a better understanding of the startup’s competitors and growth plan to evaluate risk before investing. Secondly, confirmatory due diligence is conducted after the term sheet has been signed. It is a more detailed examination based on verifying information acquired during exploratory due diligence. Thus, confirmatory due diligence is used to ensure the accuracy of any prior findings.
It’s, a project of trust, a project where participants are encouraged to learn and to share their knowledge, a project where having fun and sharing great moments.
VII. Close to Deal
At the end of the negotiations, there will be some final legal and financial documents required to close the deal:
Term sheet: Lays out the terms under which the GP agrees to invest.
Stock purchase agreement (SPA): Dictates the specific terms related to the sale of stock to investors.
Disclosure schedule for SPA: Provides exceptions or explanations to representations and warranties agreed upon in the SPA.
Voting agreement: Sets forth requirements for how certain shareholders must vote their shares in certain instances.
Investor rights agreement (IRA): Breaks down the rights and privileges afforded to shareholders.
Right of first refusal / co-sale agreement: Provides the company the first opportunity to purchase the shares of an investor who wishes to sell them.
Certificate of incorporation: Lays out the privileges and rights that come with owning preferred stock.
