How can I finance my startup?
Venture Capital (VC) is a finance niche dedicated to investing in early-stage, innovative companies with high potential. It serves a critical function, providing promising startups with funding when traditional funders are hesitant and less willing to take the risk. However, whilst venture capital is highly coveted by startups, it isn't the only path for startups. In this article, we cover the inner workings of venture capital and highlight the other forms of finance that can be useful to startups.
How does VC work?
Venture funds almost always follow a process before investing in a startup. Let’s take the VC's perspective and divide the process accordingly. Note that some of the following steps can vary depending on the fund. It’s always wise to ask a VC what their specific process looks like.
A fund’s thesis & why it matters
Before investing, venture capitalists (VCs) raise funds from their own set of investors, called “Limited Partners.” The VC will pitch high-net-worth individuals, family offices, superannuation funds, and other institutions for investment. They then use this pool of funds to invest in a portfolio of startups over several years. When the startups are acquired or have an ‘exit’ event, the VCs will distribute the profits to the fund's Limited Partners and the management team.
It's important to remember that VCs are not all the same and invest at different stages and in different types of companies. Their internal fund ‘thesis’ and mandate govern this, which is the fundamental investment strategy they offer to their Limited Partners and guides a VC fund. It may surprise you that only 3% of Australia’s VC funding flows into Western Australia, yet our state represents nearly 11% of the Australian population and has the fastest growth rate.
This opportunity is the foundation for the thesis and mandate of Fund WA I, which is to invest in this gap by finding exceptional, innovative companies in Western Australia that are often overlooked on the national stage.
As a Perth-based expertise-backed VC fund that exclusively invests in promising startups in Western Australia, we believe that a local venture fund is best suited to serving the early commercialisation period of a WA company’s lifetime. Other funds may be national or even international in nature and invest exclusively in a particular vertical sector, such as medical technologies or B2B software.
Understanding your stage and what you want to achieve by the next round is important when reaching out to a particular VC and crafting your pitch.
Sure, but how does a VC actually work?
Venture capital is a risky business. Nearly half of the funds fail to return the invested capital to their investors, and another large proportion fails to deliver the returns necessary to satisfy their investors. That makes venture funds a quirky model in which to invest. Capital is locked up for 5 to 7 years before the fund starts to exit its positions in startups. Because money is locked up for so long, investors demand a high rate of return to make it worthwhile. Generally, this is about 20% per annum or three times the return on the money they invested.
Funds are also investing in risky companies, especially those in the early seed stage to pre-Series A stage. At a young age, startups have little track record or proof that they’ll be successful, and sadly, many aren’t. The vast majority of startups fail for a variety of reasons. Often it is for reasons outside of the founders’ control. Macroeconomic or geopolitical factors can affect a startup overnight. It’s not hard to understand how, for example, the COVID-19 pandemic forced many companies to go bankrupt in the event and travel sectors.
Yet the truth about venture capital is that investing in startups is still an exciting and very rewarding cause. Venture funds typically diversify across 20 to 30 companies at the seed stage. Of these companies, only a few will work out. But when they do, they can be truly exceptional companies. This is called the power law, which governs how venture funds plan their portfolios.
The power law tells us that the vast majority of profits in the venture capital industry come from a small cohort of amazingly successful startups every year. It takes these outlier companies to deliver on venture capitalists' promises to their investors.
VC funds consider every startup they invest in through this lens: Could this be big enough to return our whole portfolio multiple times over?
This is why VCs seek out high-risk, high-reward companies: The potential payoff can be immense if they are successful.
Sourcing
Sourcing is the earliest stage in the investment process, where VCs create ‘deal flow’ or, simply put, a pipeline of startups to review for investment. You’ll find VCs networking, attending innovation events, and reading industry publications and startup news. VCs will often reach out to startups that appear interesting, but many are equally receptive to emails from startups that reach out through email. While not necessarily the most efficient avenue to connect with a fund, many will read and respond to cold emails. However, be mindful that your email is just as likely to be buried amongst the hundreds of other pitches a VC will receive. So, a warm introduction or connecting in person at an event will usually prove far more effective.
Selection
Selection is when a VC fund decides whether a startup presents a viable investment opportunity worth looking into in greater detail. An informal meeting over a coffee is often the first place to start with a founder. They’ll want to discuss the business and ask many questions. You may find that there are several of these meetings over a period of time.
VCs take a ‘red flag’ approach in these initial meetings to filter large volumes of startup pitches quickly. This means they’ll be scanning your business for any critical weaknesses, risks, or potential deal-breakers that might make investing unattractive. Broadly, a red flag makes a company not ‘venture-backable.’ This could include:
If you’ve passed their initial checks, you (and your team) will be invited to present a more formal pitch to the VC team. This will be an opportunity for deeper, more probing questions and answers. Be prepared with good data and information!
Due Diligence
If you have passed the selection phase, you will be invited to move on to the due diligence phase (DD). Due diligence is a rigorous phase where the venture fund thoroughly examines a startup before making an investment decision. In practical terms, it is a deep dive into your company's financials, legal and regulatory environment, management team, market opportunity, technology, and competitive landscape.
Be prepared by creating a comprehensive data room before you engage with a VC, but don’t stress if you don’t have all the data upfront. Most VCs will ask you for specific data or information as they progress the DD. It may take some back-and-forth to ensure all the correct documents are available, so factor this into your timeline. Many VCs also want to talk to a startup’s customers, suppliers, or partners for insights into the company's operations and market perception as part of the DD.
Acknowledging that due diligence is time-consuming for both founders and the VC, progressing to DD is a great sign that the venture fund is interested in your startup. However, it never guarantees a final investment!
Only after a thorough investigation can a VC make an informed decision about whether to invest in a startup and at what valuation.
Investment Committees
Finally, should you pass due diligence, the fund will take the opportunity to their investment committee (IC), who will make the final decision about investment and the proposed terms. This group typically comprises experienced professionals, including partners, senior associates, and industry experts. Often, founders will be asked to pitch to the IC once again. In essence, the IC ensures that the VC invests in high-quality startups with the potential for significant returns.
Remember that the IC process can produce various outcomes, including:
If successful, you’ll receive a term sheet summarising the outcome and offer.
Remember this is all part of the investment process, and as a founder, you always reserve the right to negotiate, reject, or accept the terms on offer.
Value-Add
Beyond investment, many VCs look to add value to their portfolio companies through strategic guidance, advice, network access, introductions, mentoring, and coaching support.
It's wise to ask early how a venture fund supports its portfolio companies and undertake your reference checks as a founder with some of the funds’ existing portfolio companies. It’s important to dig into how the venture fund supported founders in the good times and especially the bad times. Calibrate expectations early to avoid unpleasant surprises down the track. A founder's journey can be incredibly stressful and lonely at times (while also exciting and rewarding), so having strategic partners on hand will prove invaluable in the long run.
Having an idea of what you want out of a VC relationship can help you navigate if they are a good fit for you.
Rejection
No one likes to be rejected! Fundraising is hard, and getting a ‘no’ from a VC is always an unpleasant experience. The fact is that venture capitalists only invest in about 3% of the startups that they see. To put it into perspective, across Australia in 2023, there were only 413 deals in total (Australian Startup Funding). So being rejected by a VC doesn’t always mean that your company is critically flawed; it may simply not be a good match, or there may be other more promising deals on the table for a VC.
When it comes to fundraising, it truly is a numbers game. Sometimes, it can take a hundred rejections before you find a fund or investor who believes in your vision for the future and offers a term sheet.
When facing rejection, consider whether you need to tweak your business or your pitch or perhaps do nothing at all. A VC may have rejected your startup because the opportunity isn’t well communicated. In such a case, perhaps you didn’t describe your grand vision for the business over time and need to include your exciting roadmap.
Alternatively, you may feel the feedback was more genuinely targeted at an aspect of the business that needs bolstering. This is a great opportunity to address this concern and then demonstrate to the investor that you’ve actioned their feedback.
Sometimes, the feedback you receive might not align with your vision. In such cases, appreciate the investor's input and move on. Remember, while their advice might be valuable, you're ultimately the expert on your business.
Continue fundraising until the money is in your bank account. Even if you are deep into the late stages of an investment process, deals can fall through for various reasons, so maintain your fundraising efforts.
Timing for fundraising
The average time taken to close a full funding round can vary significantly, depending on the size of the round, market conditions, and the startup’s stage of development. As a general guideline, it can take six months or longer. It is common for an investment process with any given VC fund to take several months before a final commitment is made or the money hits your bank account. To demonstrate that the company has a solid financial foundation and can weather this process (and any unexpected setbacks), start your fundraising process with at least six months of capital in the bank. Ideally, you want to be able to demonstrate a 12-month runway.
Calculating and closely monitoring your ‘burn rate’ is extremely important for startups when assessing fundraising.
What’s the deal with NDAs?
A Non-Disclosure Agreement (NDA) is a document that ensures confidentiality between the startup and the venture fund when discussing the more commercially sensitive aspects of the business, such as intellectual property or business strategy. As a rule, venture capitalists do not typically sign NDAs. This isn’t because they are trying to take advantage of you but because it puts a VC at risk. For instance, if a venture capitalist were to sign an NDA with a startup they don’t invest in, they are potentially at risk of a lawsuit if they invest in a company’s competitor at some future time. A good middle ground is to discuss an NDA once the investment conversations have matured and your company is deeper in the process.
When is VC the right fit?
While venture capital can be a valuable tool, it's not suitable for all startups. VCs are seeking companies with the potential to disrupt industries and achieve rapid international growth. Before launching into fundraising from VCs, ask yourself whether you have the appetite for:
If your venture is unlikely to reach an outsized valuation or this is simply not the level you are aiming at, this does not mean that you are starting or running a ‘bad’ business. In fact, it can be a great opportunity for the founders. Owning 50% of a $10M exit is a life-changing experience, but it will never be a fit for VC.
Talking to other founders about their experiences raising venture capital might help you understand whether it is right for you.
Exploring alternative funding options
Funding generally occurs in multiple stages, each designed to support a company at different points in its growth journey:
Sometimes, the best alternative is to raise no capital at all. Bootstrapping is the norm and is extremely common at the very early stages of a company’s life. Bootstrapping is where founders invest their personal capital into the startup and focus on profitability from day one. The profits are reinvested into the growth of the business.
Bootstrapping isn’t a fit for all business models but is a viable pathway. It allows founders to grow at their own pace and with significantly larger ownership and control over the company. A lesser-considered upside is that bootstrapping forces founders to get closer to the customer and focus on building products that are commercially valuable to scale, which builds early revenue.
Many great companies have never raised a single dollar from investors. Mailchimp sold to Intuit for $12B USD, the world’s largest bootstrapped exit. The Mailchimp journey was extraordinary, but there are likely many smaller stories of bootstrapping to be told.
Given that 3 of 100 startups raise venture capital, bootstrapping is well and truly the norm.
Startups at the pre-seed and seed stages often use angel investors and family offices for funding. Angel investors and family offices are all unique from each other and should be treated as such. They can be motivated to back young companies for purely financial or philanthropic reasons.
Western Australia is a very wealthy state with many family offices and potential angel investors (McCrindle). The difficulty is that much of the wealth has been generated in resources and property, meaning that understanding early-stage technologies is not ubiquitous. As a founder, you should consider investors who can add value beyond the money they provide. For example, an angel investor who is an executive in a market you are interested in could provide capital and valuable advice. An additional benefit is that high net worths and family offices who have generated wealth in your industry are more likely to invest as they deeply understand the problem you are targeting.
Use a ‘snowball’ strategy: Ask committed angels or family offices for introductions to their network of fellow investors.
Leveraging and taking advantage of grant funding streams is a great way to offset the capital you need to raise from other sources, reducing the dilution you may need to absorb and allowing you to do more. However, writing grants is time-consuming and, although a great source of undiluted funding, should only be considered “icing on the cake” rather than counting on it as a certainty.
Debt comes in two flavours - venture debt and traditional debt. Traditional debt is extremely difficult to come by for a founder of an early-stage company, as startups simply don’t tend to have the assets to use as collateral. This represents a very risky proposition to a lender.
Venture debt is becoming a viable option for founders at the Series-A stage and beyond. It is typically only applicable to companies that have recurring or high-volume revenue streams, as repayment is more assured. This can be used to reduce the amount of cash a founder needs to raise from investors who will dilute the cap table.
Venture debt is relatively new, but there are several providers in Australia. Ask for references and case studies about how it has worked for other founders.
Crowdfunding is an exciting way to raise capital from a large audience of smaller investors. In 2023, $71M was raised through crowdfunding platforms across 82 companies (Fintech Australia). About a third of these companies were in the food and beverage industry.
Crowdfunding tends to suit B2C companies the best, as the platform uniquely allows them to market and raise from their most passionate customers. Customers with an equity stake in a business make excellent brand ambassadors, spreading the word about your products to their friends and family.
Crowdfunding can be extremely fast when offerings open, but it still requires you to put in the effort to create a high-quality listing and promotional campaign.
Venture capital is a subset of private equity, but private equity funds differ. Private equity funds are more variable in what they look to invest in than venture funds. Generally, however, they look to invest in companies with some revenue or earnings. The investments they make tend to be lower risk and come with lower return expectations.
What do VCs look for?
When evaluating a startup investment, VCs look for key indicators that suggest the potential for success. These indicators can vary depending on the investor’s strategy, but three critical factors typically stand out:
Venture capitalists look for ‘venture-backable’ companies that meet their unique mandate. We’ve already discussed fund mandates, so let’s look into some other qualities VCs tend to delve into.
Founders
The founders are one of the most important factors in early-stage investments. Ultimately, a VC invests in the people, not the company. Venture investors must trust the management team to make the best decisions and not require micromanagement. A VC invests in your business. They should not be running your business!
There is no one-size-fits-all definition of an investable founder. While every founder is unique, recurring characteristics often attract investors:
Spending time with a founder allows a VC to scratch at the surface to discover the depth of a founder's quality. They may even ask questions about a founder’s past and upbringing to find evidence of success in hard times. Traction is also a telling metric. The best founders tend to demonstrate excellent or very high-quality traction for their stage. For example, they may have identified and persuaded top-tier talent to join their fledgling startup or struck a large commercial partnership at an early stage.
No two founders are alike, and there is no one model for success. Be your authentic self but remain open to being coached and mentored.
Market
Markets are high on VCs' wish lists when it comes to investments. Large market potential is absolutely critical to a VC fund's economics. Funds require big outcomes to justify their existence, and this simply can’t be done without a large market.
The market must provide the startup with a competitive advantage. Markets that are either big and diversified by lumbering businesses or small and rapidly growing markets are interesting. Monopolistic or even oligopolies are difficult to attack because the incumbent companies have incredible market power.
Some markets require creation. This is tough work but can be incredibly lucrative and almost always positions your brand as synonymous with that market.
For example, deep tech ventures often have the advantage of creating something entirely new, which can offset market development challenges.
Advantage and Competition
Startups need a strong and durable advantage over their competitors. For deep tech, this is almost always in the form of intellectual property and patents. Software needs to focus on generating a moat to defend itself from the competition, such as the classical network effects, switching costs, platform effects, etc. From a VC perspective, founders often do not consider the ‘business as usual’ case as a formidable competitor and, as a result, do not spend time considering how to change ingrained consumer behaviour. Humans are habitual creatures and would rather follow the path of least resistance. Having deep insights into how to disrupt the ‘business as usual’ is highly advantageous.
Never underestimate the competition! Find out as much information as you can about your primary competitors. They are often as driven and innovative as you are.
Traction
Traction focuses on the startup's progress around customer acquisition, revenue generation, and market validation. Traction is best thought of in terms of how many core parts of the business have been de-risked. The important part to remember is traction varies based on different industries and products. Deep tech will focus on prototypes and research, whereas in software, revenue is prioritised. Strong traction signals demand for the product or service and that the business model is viable. VCs use traction as evidence that the startup can grow and achieve significant returns on investment. Traction is also a reflection of the founders. The best founders will have exceptional traction for their stage, whether that be quality or quantity, of course with allowances for bumps in the road.
Venture capital is more competitive than you may think. Knowing and matching your cohort’s level of traction makes your company a competitive opportunity.
The Bottom Line
Deciding if VC funding is right for your startup depends on your company's growth potential, capital needs, comfort with VC involvement, and alignment with VC firms. Carefully consider these factors to make an informed decision and importantly, allow yourself sufficient time and runway to explore your options.
Watch out for our next blog post, where we’ll explore the art of building your pitch deck and how to present your data for maximum impact. Pitch decks are a core part of your business's communication strategy and have more gravity than many founders may realise.
Fund WA OPEN DOOR: Fund WA is a Western Australian venture capital fund that supports early-stage businesses at the commercialisation stage across all industry sectors. Their Open Door initiative is an opportunity for founders to join a 45-minute call with a member of the FundWA team to pitch and talk about fundraising for your startup. Be sure to read their Cheat Sheet before applying. Learn more at www.fundwa.com.au
R&D Tax Adviser, Innovation Facilitator & Educator
9moFundWA Don't forget the most important and common funding mechanism for Startups, the R&D Tax Incentive. The DD process should also cover the R&D Tax claim history.