Startup Fundraising, Part 2: What is VC (and is it for me?)

February 17, 2023

Fundraising is undoubtedly one of the most important stages of the startup life cycle. And yet, especially for early-career entrepreneurs, fundraising remains a major stumbling block. With this in mind, we asked 2022 Future Founders Fellow Chris Cherian, founder and CEO of Gatherly.io and self-proclaimed fundraising nerd, to help us create a comprehensive guide designed to demystify the startup fundraising process for founders who are just beginning. Today, we’re diving into one common source of startup funding: venture capital!

Part 1: Fundraising 101

Part 2: What is Venture Capital (and is it for me)?

Part 3: So VC isn’t for me. What about bootstrapping?

Part 4: How do I start raising?

Part 5: What will my raise look like?

Part 6: So I’ve raised. Now what?

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Part 2: What is VC (and is it for me?)

Why does a startup need to fundraise in the first place?

As we’ve said, if you yourself are not a billionaire, it’s likely that you’ll need more capital than you have at first to get your business off the ground. Especially in their early stages, most startups aren’t able to secure more traditional forms of investment like bank loans (which must be paid back along a particular timeline that may not be realistic for a fledgling business). What’s more, most banks are too risk-averse to invest in startups before they have at least 2 or 3 years of consistent revenue growth in the books.  In this case, many founders turn to venture capital as a means of financing their initial growth. But make note: the venture capital route is one of several options you have as a founder to fund your business. We will explore some of the alternatives (angel investment and bootstrapping, for example) in subsequent articles.

VC = Venture Capital

Venture Capital firms (VCs) are private investors—or, more commonly, institutions that pool and manage the resources of many private entities (typically high net worth individuals or organizations, collectively known as Limited Partners) in a single fund—that invest in scalable startups. 

VCs look to invest in startups with the most potential for significant (or significantly fast) growth—with the understanding that they may not make their money back right away, or even at all. VCs usually operate under the calculation that they will lose money on many investments, but that the gains they make from what few businesses actually succeed (for example, get acquired or go public at some point in the future) will more than offset those losses.  

As we described in the previous article, VCs invest capital in startups in exchange for an equity stake in the company. In other words, when a VC finances your company, they do so in exchange for a percentage of company ownership—and a proportional share of the dividends should your company become profitable. Some VCs also require a seat on the company’s board of directors, giving them a voice and influence over company decision-making and direction.

Introducing equity into the conversation can make venture capital especially intimidating, especially for new and early-stage founders. With that in mind, we asked Chris to answer some of our founders’ most pressing questions about VC fundraising.

Are there different kinds of venture capital?

Venture capital funds typically vary by focus or thesis. A thesis is typically the guideline (or set of guidelines) by which a fund invests—in other words, the philosophy or criteria for how a VC chooses which startups to fund. The most common investing theses include some mix of stage, geography, and industry.

• Stage: Startups typically raise in stages starting with Pre-Seed and Seed investments, which then lead into Series A, Series B, and so on alphabetically until exit (typically acquisition or IPO, an initial public offering of shares on the stock market). Almost all VCs have a ‘sweet spot’ when it comes to the stage of the businesses they fund most often. The only real exception here would be the “Tier 1” VCs, big name players such as Andreessen Horowitz, Sequoia, and Accel, to name a few, who fund businesses across a wide range of stages. Most other investors will often have a specialty for one to two stages (for example, pre-seed and seed investments), with the flexibility to extend slightly earlier or slightly later for the right business. If all that feels like a lot to keep straight, don’t worry! We’ll dive deeper into the different stages of fundraising in later installments of the Think Like a Founder: Startup Fundraising series.

• Geography: Some investors prefer to invest locally or regionally, although this kind of thesis is becoming less common with the rise in virtual pitching and global deal flow access. More often than not it is smaller market funds that prefer a geographic approach to funding.

• Industry: Many funds focus on a particular set or category of industries as well. The most broad category may be SaaS (Software-as-a-Service), which itself can technically fit into any industry. Other funds may have a focus on Healthcare, Social Impact, or Hardware, in order to develop a niche and a competitive edge in advising and access to deals.

An investing thesis typically includes multiple imperatives—often some combination of the above. For example, a small climate-oriented fund in Boulder, Colorado might be interested in investing in “young talent building early stage businesses in the Rocky Mountain region that reduce the impact of climate change on our planet,” while another fund based out of New York City might focus on seed funding for EdTech startups that address educational inequality in American public schools.

Some funds may have multiple theses if they have a broader focus. An example of this might be a large-scale venture firm looking to invest in EITHER:

1. Early-stage Tech startups outside Silicon Valley

OR

2. Series A & B tech startups looking to build out their operations and scale nationally.

What makes a business VC-fundable?

The most important principle of venture capital can best be described with a baseball metaphor: VCs aren’t looking for singles, doubles, or even triples. They’re looking for home runs. 

Put in concrete terms, venture capitalists are looking for a business that can grow quickly and return their whole investment (and, hopefully, then some). 

Consider this scenario:

A seed-stage fund (whose thesis guides it to invest primarily in seed-stage businesses) raises $10 million from Limited Partners (LPs), and then makes a $500,000 investment in a startup—let’s call it Startup A—for 10% equity in the company. 

In order for the VC to recoup that original $10 million, Startup A must grow to be worth at least $100 million (in other words, reach a $100 million valuation)–such that the VC’s 10% equity stake is worth at least the LPs’ total original contribution to the fund.

Startup A has to grow to at least a $100 million valuation for the VC’s 10% ownership to be worth $10 million. 

Reality check: that may never happen. Investing in startups, especially pre-seed and seed-stage startups, is a highly risky proposition. According to a 2019 report by Startup Genome, 90% of startups—11 out of every 12—will fail, and three quarters of those will do so in their first year of business.

Venture capitalists plan for this. To hedge their bets, venture funds invest the capital they raise in many high-potential startups across their portfolio with the understanding that, while most will fail, if at least one venture succeeds, the fund’s return on investment will recoup or, ideally, exceed the LPs’ initial contributions. In other words, VCs divide their investment (in this example, $10 million) across enough companies with enough potential to take off such that the success of even one guarantees a huge payoff. 

When choosing which startups to back, investors typically look for a few key factors:

• Large Total Addressable Market (TAM)

A business’s potential is capped by the market it serves. Large addressable markets make it possible for businesses to capture a small percentage of the market while still growing to a large valuation.

• Scalability

A scalable startup experiences economies of scale; in other words, as it grows in size and value, its expenses do not grow proportionally. This means that, as the business acquires additional revenue, fewer and fewer resources are required to maintain operations.

For example, a school requires additional teachers in direct proportion to the number of students it enrolls—we wouldn’t consider that scalable. By contrast, educational software such as Codecademy does not require a proportional number of developers for each additional learner that joins their platform, allowing the company to increase revenue significantly without increasing expenses by the same factor.

• Low Customer Acquisition Costs (CAC)

If a business has to spend thousands of dollars to acquire a customer who pays hundreds of dollars, it is inherently unsustainable. On the other hand, businesses that grow exponentially have a low CAC, typically driven by word of mouth (WoM), referrals, organic/earned press, and other factors—and therefore represent a more promising bet for investors.

• Potential for Product Market Fit (PMF)

Product Market Fit is the single most important thing for a startup to get right. It is nearly impossible to scale a business without it. With it, businesses have a much higher threshold for errors. 

• • Big Picture: As a founder, Product Market Fit is the intersection of finding a good problem to solve, being the right person to solve it, and having a strong understanding of the customer for whom you’re solving it.

• • Zooming in: To achieve PMF, a company must have created reliable sales channels and proven revenue streams. It must have a good idea of what levers (internally and externally) it can pull to improve profitability, increase sales, and reduce churn.

• • When your company has a strong PMF, according to Marc Andreeson,

The customers are buying the product just as fast as you can make it—or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling because they’ve heard about your hot new thing and they want to talk to you about it (Andreesen, 2007).

Note that investors have many other criteria that they examine before making the decision to invest. The above four are just a quick heuristic to determine if the underlying business may be venture-fundable.

Case Study (non-VC fundable)

If a startup’s TAM is too small—or if any of the other criteria above raises a red flag—a VC might pass on investing. In the following example, our startup is building a calendar management tool specifically to serve high school students in the US—which means that their market size could be a bit too small to attract venture capital.

Consider this scenario: Fictional Startup B has built the Mercedes of high school student calendar applications and can charge $10/mo for their software. Estimates show that there are about 15 million high school students in the US. This gives us a total addressable market or ($10/month)*(12 months)*(15 millions) students, or $2.25 billion.

While that number may seem eye-popping at first glance, this is too small of a market for a few reasons:

• High school students are notoriously cash strapped. Even if some elite class of students can afford $10/mo for a calendar product, it’s likely that most students won’t be able to afford our product.

• Competitors with free, high quality solutions (i.e. Google Calendar, etc.) exist.

• Considering these factors, it’s highly unlikely that our startup will capture and own anywhere near 10% of this market, which reduces our available market to just over $225 million.

With our estimate of only $225 million really available for capture, this business might not be a great candidate for venture backing. 

It can still be a phenomenal bootstrapped business (more on this in our next installment) that can exit via acquisition to a larger player in the market, but it is unlikely that venture capitalists will want to fund this.

Case Study: Bevel (VC-Fundable)

By contrast, the rise, raise, and ultimate acquisition of Bevel epitomizes the potential of a VC-fundable business. When it was first founded by entrepreneur Tristan Walker in 2013, Bevel marketed itself as “the first and only head-to-toe grooming brand” crafted for Black people and other people of color with coarse, curly hair not well-served by the existing personal care market (Walker & Company Brands, 2023). 

As Walker tells it, it was his own lived experience struggling to find shaving products that didn’t leave him with bumps and irritation that first inspired the brand. By 2018, Bevel had raised more than $24 million in venture capital, launched products in Wal-mart and Target stores around the country, and was ultimately acquired by CPG giant Procter & Gamble for an undisclosed amount reportedly between $20 and $40 million (Del Ray, 2018).

What made Bevel so attractive to venture capitalists? Spoiler alert: it’s Product Market Fit.

Large TAM + Right Problem + Right Founder = PMF 

• Large TAM

Walker knew he wasn’t alone in feeling underserved by the personal care industry. His own ongoing frustrations with razor bumps yielded a revelation: there was a gaping hole in the market for a business that could directly service the “40-plus million Black folks [in the US alone] that potentially have to deal with this issue,” as well as an estimated 30% of people of other races. (Thau, 2022; Walker & Company Brands, 2023). A huge subset of the population was actively not being served—and therefore almost entirely available for capture.

• Right Problem (Right Product)

As Walker saw it, there simply was not a razor on the market specifically designed for people like him. The problem—that existing shaving products leave a large majority of Black shavers with significant skin irritation because they aren’t designed with coarser-textured hair in mind—was not being addressed by anyone in the industry. Walker created Bevel to fill that niche.

• Right Founder

Walker understood the needs of the Bevel customer because they were his needs, too. His own experience and genuine ability to identify with his consumer allowed him to build the brand intentionally and responsively—and thereby maximize its market potential. As he remarked in an April 2022 interview, 

One thing that was really important to me was to do something that I felt uniquely positioned to do, where my own lived experience could help inform what I was hoping to create. Entrepreneurship is hard enough. The way to make it less difficult is to do something that comes from an authentic place. (Thau, 2022)

Bevel’s superb PMF and high potential for growth made it a VC darling and catapulted it to a major acquisition after only a few years in business.