3 Questions: Demystifying Venture Capital with John McDonald
This is the first installment in our “3 Questions” series contributed by subject matter experts throughout the tech community in Indiana. This series takes complex tech topics and explains them in easy-to-understand ways without the dense jargon so every reader can learn a little bit more about our industry.
Everything else flows from success in raising capital. It allows you to hire the people and partners you need to build the company and keep them aboard, which is the secret to any successful business.
What types of capital sources are available to startups?
What is the difference between the types of capital?
What are the keys to unlocking capital?
There are primarily four types, and they align very nicely to the four stages of the development process of a new technology startup employed by venture studios everywhere like Central Indiana’s High Alpha and my own venture NEXT Studios.
The first stage is ideation.
This is where you create new ideas for startups, and “pressure test” those ideas by studying things like your target buyer and market and what problem you are solving for them. Typically, the venture capital employed at this stage is called “pre-seed funding,” which is often sourced from your friends and family. These people are investing in your company largely because of you—who you are to them and what they believe you can do with their investment when given a chance. Often, your closest friend and initial investor is yourself—this is called “bootstrapping” and is simply using your own money to start up your own company. An extremely limited number of “pre seed” organized funds also make initial investments at this stage, many of which are tied to local economic development or industry initiatives. In Indiana, you can sometimes start a company with as little as $25,000 in pre-seed capital (though $100,000 is more typical), especially if there is a physical device as part of the product idea.
The second stage is productization.
This is where you take your initial idea, which has been vetted in the ideation stage, and turn it into a “minimum viable product” or MVP. This is the first complete release of your offering, and while it may not have every feature you will ever want, it’s enough to get it in the hands of some pilot users and gather their feedback. You’ll use that feedback to improve the product and build your “go-to-market” strategy to engage and win customers, which you’ll use in the next phase. Typically, the venture capital employed at this stage is called “seed funding”, and often comes what are called “angel investors.” Angels are high-net worth individuals who deploy some of their wealth at this stage for many reasons, the most likely of which is that they are also successful entrepreneurs who want to help new startups take flight. These investments are high risk, and in some ways are like organized gambling, where they bet they are placing is on you and your idea. In Indiana, I’ve seen angel-backed seed funding rounds as small as $200,000, but more typically these are between $500,000 and $1 million, depending on how complicated the MVP is to build and test.
The third stage is launch.
This is where you take the go-to-market strategy you developed in stage two, coupled with the improvements you’ve made to your product through your pilot users, and launch a full-scale plan to attract, win and keep customers. This is where you start to grow your team substantially for the first time, largely by hiring business development representatives, inside sellers, outside sales representatives, marketers and customer success reps, depending on the talent needs of your go-to-market strategy. Typically, the venture capital employed at this stage is called your “A-round,” or the first of what may be many future rounds of venture capital, and it’s often sourced from organized venture funds.
Venture funds are a unique type of investment vehicle. Unlike angel investors, where individuals make the decisions about what startups to invest in with their own money, venture funds are made up of “limited partners” or LPs who sign over money to the care of a group of “managing partners” who are employed by the fund to scour opportunities, make investments, and manage those investments for the LPs. They are paid management fees for this, and usually a “carry,” which is a share of the profits if any of those investments result in a successful return. Venture capital funds will have a stated focus for their investments, a range for the amount of investment they will make (called a “check size”) and some process for reviewing and scoring potential deals (called a “thesis”). These parameters are typically unwavering, as they are what was used to attract limited partners to invest in the fund, and therefore cannot be changed easily. Sometimes VCs will insist on “leading” a round, which is to say they are responsible for building and executing the deal on behalf of themselves and other investors, and in a deep review of the company’s structure, finances and team, called “due diligence.”
In Indiana we have a unique organization called Elevate Ventures, which is funded in part by the State of Indiana to make equity investments in startup companies. They are a venture fund, but often work with angel investors and other funds to co-invest in companies at this stage to help them succeed and pull together smaller sources of funding who may not be in position to lead the round. Because of Elevate, “A-Round” investments can often be as small as $500,000 and be made up of multiple smaller investments, but typical launch-stage investments are in the $1 million to $3 million range.
The final stage is the scale stage.
This is when you’ve proven your go-to-market strategy works, and you’re seeking funds to scale up the company’s operations to grow its market share and continue to improve the product. This is the primary domain of most later-stage venture capital firms, who like to see success in the marketplace (called “traction”) and financial stability and sales growth that suggest that the company might be able to make a profit (called a “pathway to breakeven”). Each venture capital round at this stage will be labeled the “B-Round,” the “C-Round” and so on, and can grow in size from $2 million to $10 million or more, until the company has reached a scale where venture capital is no longer required to fuel growth initiatives.
Venture capital in all its forms is the oxygen that makes technology businesses live. Success in raising venture capital is largely tied to clear objectives as to how the money will be used to advance the company to the next stage. It’s a necessary part of growing a company faster than normal business cycles would, because technology rapidly becomes obsolete. It’s effectively a “growth hormone” and like any medicine, it should be taken as directed by an educated patient.
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