QTMA advisors Tim Tham and Julien Lin introduce the basics of venture capital. Additional case studies and examples are included in their recorded workshop (bottom of the page).
I. Venture Capital 101
Theory Behind Startup Financing
- A company funds its growth with either debt or equity
- Debt: Amount of money borrowed by the company, typically from a bank. The company must repay this money, as well as the interest that accrues
- Equity: The value of the shares of a company. A company can issue shares (units of ownership of a company) in exchange for cash
- Retained earnings: Profits generated by the company. This profit can be re-invested in the company to continue its growth
- Startups have significant growth, causing them to have substantial cash-burn. Many startups will not have a positive cash flow until later in its life.
- Startups, therefore, tend to finance heavily with equity for the following three reasons:
- Financing using retained earnings is unfeasible due to high cash-burn. Startups don’t have enough cash to fund their operations alone.
- Financing through debt requires large debt repayments, which startups may not be able to fulfill.
- Financing through equity dilutes ownership due to share issues, but comes with no recurring financial burden
What is Venture Capital?
- Venture capital is a form of private equity
- Private equity describes equity investments ($$ invested in a company by buying its shares) done in private markets
- These equity investments are executed by venture capitalists
- Venture capitalists are unique as they have a higher risk profile than traditional investment funds
- Most of venture capitalists' returns are generated by a small portion of the high risk/high reward companies in which they invested
Venture Capital Fund - Structure & Profit Generation
- Venture capital fund: manage the pooled funds that venture capitalists invest in a startup
- Funds typically have a commitment period of 3-5 years, but the investment period can last up to 10 years
- Roles within a fund include…
- General partners: responsible for fund investment decisions
- Venture partners: source deals and are compensated on deals closed
- Principals: coordinate members of the investment team (associates/analysts)
- Associates/analysts: responsible for the analytical component of a due diligence: working with management, calls with experts, memo building
- Advisors: provide input in the due diligence process and investment committee meetings, advisors come from many backgrounds
- Venture capital fund managers earn money through…
- Management fees (1.5-2.5% of the capital committed to the fund)
- Carried interest (managers keep any returns that exceed the return expectation)
How do Venture Capitalists Invest?
- Venture capital: raising capital through the sale of shares, most common
- Venture debt: medium-term loan that does not require collateral, but requires the startup to issues warrants to compensate for the lack of collateral
- Revenue-based financing: upfront exchange of capital for a percentage of the startup’s recurring revenues
- Simple Agreement for Future Equity (SAFE): exchange of capital for future equity
- Series funding: stages of growing a startup through outside investments
- Series categorization should be taken with a grain of salt as they start to lose their meaning in later series
Early Stage Characteristics
- Series A/B funding
- In a startup’s early stages, investors are taking a large bet on a company
- Investors look for the company’s founder-focused qualifications and product-market-fit
Mid Stage Characteristics
- Series B/C funding
- Less risk, higher focus on the company’s traction and scalability
- Series C+ funding
- Company has higher expectations of recurring revenues and profitability
- More types of investors coming in
- Opportunities for either IPO or acquisition should be present
Venture Due Diligence
- Due diligences (DDs): mechanism for venture capitalists to assess an investment and the characteristics of the startup that make it attractive. The findings are distributed to the investment committee through an investment memo
- Memo touches on three fundamental areas…
- Problem: what need does the product solve?
- Deal characteristics: what are the terms of the deal?
- Recommendation: is it currently an attractive investment (is it the right time to invest)?
- Venture capitalists evaluate a startup using the following dimensions to determine if their investment will generate returns…
- Team: Is there evidence that the team can execute?
- Product: Does their product have a unique value proposition?
- T.A.M (total addressable market): Is the industry market large and actionable?
- Business Model: Does the startup have attractive and defensible economics?
- Competitive Landscape: How concentrated/competitive is the market space?
- Financial Health: Is the company on the right track for sustained profitability?
- Valuation and Exit: How much is the company worth?
- Risks and Mitigations: What are the risks and how can they be minimized?
Defining the Opportunity
- Clear Purpose Statement
- Definable, Unsolved, and Widespread Problem
- Solution (competitive landscape and why the company has a competitive advantage must be mentioned)
Actioning the Opportunity
- Product Roadmap (how development plans will be reached)
- Sales, Distribution, and Marketing
- Team (team’s academic/professional background)
- Deal terms (proposed terms of the deal)
- Valuation: process of determining a company’s value
- Both quantitative analysis and negotiation (between the founders and the fund) are used to determine a company’s value
- Pre-money valuation: value of a business prior to the investment of an investor
- Pre-money value = post-money value - venture capital investment
- Post-money valuation: value of a business plus the additional capital provided by an investor
- Post-money valuation = investment ($) / fund ownership
- Exit: event through which investors in a company can cash out their ownership
Student-Friendly Sources of Funding
- Front Row Ventures: provides funding through the SAFE model
- QICSI: 16-week program with the chance to win funding
- Creative Destruction Labs: international program providing mentorship, business development support, opportunities to raise capital
- TheNext36: 7-month program with funding opportunities up to $50,000
1. Problem Statement
- First thing that investors see
- Problem statement is crucial to a pitch because the rest of the presentation seeks to solve the problem
- If the problem statement isn’t solid, the solution will not be worthwhile
- Problem statement should be short, sweet, and relatable
- A good problem statement will not necessarily make a good solution
There is no effective, trusted way for professionals to find and transact with each other online - Linkedin's Problem Statement
2. Competitive Advantages
- Aspects of a product/service that allows it to outperform its competitors
- Common competitive advantages include…
- Network effect: the more people using the service, the more value it gains, (ex. Facebook, Uber)
- Intellectual property: legal filing that ensures that competitors cannot copy some aspect of a company (patents, trademarks), (ex. Google search engine)
- Economies of scale: cost advantages of a company due to the large scale of their operations, (ex. Spotify)
- Although first-movers advantage is beneficial, it does not inherently mean that the company will be successful
- Two crucial questions to answer when pitching a product/service include…
- Will consumers give up habit to try your product/service?
- What’s stopping another company from doing this, but better?
- Competitive advantages must be maintained in the long-run, even when new competitors enter the market
3. Key Numbers
- MAU/DAU: monthly/daily active users, shows popularity and activity of the platform (strength of network effect)
- MRR: monthly recurring revenue, shows stability of the company’s revenues
- Take rate: how much the company charges per transaction, shows pricing power (how much more a company can charge without losing customers)
- Churn: how many people are leaving the platform, shows popularity and stability of the platform
- LTV/CAC: lifetime value/customer acquisition cost, shows profitability per customer (should be between 5-10%)
- Burn rate: how fast the company is using cash when growing
- Place less focus on specific projected revenue numbers, focus instead on potential outcomes and how to tell when these outcomes are reached
- Develop plans to ensure that there is a backup plan for any scenario (plans for best/worst case scenarios)