There are many different ways for a business to raise money. Unfortunately, seldom are any of them easy and it can be frustrating and disheartening. Understanding the broad rationale for different types of investors might save some of that effort and frustration.
Lenders are fixated on the probability that a loan will be paid back. This generally means seeing regular revenue, sufficient to cover principal and interest payments. They also seek security over some assets – either the business’s or, if they are not sufficient, through a personal guarantee from the founders. Their confidence in available revenue and the value of assets increases if there is a relationship that has bred some trust and where there is a credible financial history. Hence debt is only rarely an option for the newest businesses.
For equity investment there are very different aims and criteria. You may have family and friends, for whom the relationship will be as important as the returns and they might only have one venture investment. But for experienced angels, professional investors and venture capital firms that are investing other people’s money, the investment is likely one of many in a portfolio.
When considering a portfolio of early-stage businesses an investor will expect some of them to die. But the health of the portfolio is driven by outsized returns from a small number of investments. In very early-stage businesses, a venture capital investor may expect to lose their money 7 or 8 times out of 10. But they expect those that do well to return at least 10 times their cash, and hopefully 30 or 50 times their original investment. A venture capital investor in businesses that are still high growth but 2 or 3 years old may expect the worst of the mortality rate to be over and more like 2 or 3 in 10 businesses to fold. If they can achieve 3 to 5 times returns on the ones that make it, then the portfolio works out very well.
Directly from this maths flows the criteria for which an investor will consider a business. I deliberately write ‘consider’ as it’s not the criteria for whether they will invest or not. That will get much more rigorous – about the team, the market, the idea and the commercial model. But just to get into a conversation, there are a few basics that put a business within or out of scope.
Tips for attracting VC investment
Growth: the business proposition must be one that has potential to grow very fast. If a business is going to grow its value by five to 50 times, the proposition needs to be innovative and in a large and fragmented market, growing fast enough to allow that innovation enough space to grow. For example, a chain of barber shops is unlikely to have true innovation and certainly won’t be in a high-growth market.
Scale: supersized returns come from top-line growth but also a healthy margin, where the returns increase exponentially with scale. The VC market’s fixation on technology is driven in part by the expectation that a market is unbounded by geography and a solution can expand transcend borders, whether county, country or continent. And is able to do this with relatively little additional investment for each new territory, therefore creating economies of scale. Compare this to a sector like restaurants, for which investment in premises, decor and the right location are a big part of the formula of success and so each new location feels much like a whole new business.
Return on capital: returns are a factor of how much you get out versus how much you put in. So take two businesses with the same growth potential. Say a manufacturing company, which needs a large amount of cash to get going and another, say a direct-to-consumer eCommerce company that is building a strong brand but is not owning its own assets and therefore needs less upfront cash. The second is a more attractive investment. That is not saying that asset heavy businesses never get equity finance, but it is certainly harder for them.
Exits: achieving a return on an equity investment relies on someone buying that equity at some point. So, an investment needs confidence at the start that the founder will be motivated to sell and, generally, that the business is able to be packaged up and sold onto a trade buyer or a private equity company. Whilst any business is initially highly dependent on its founders, a business model where that is always going to be the case, or where competitive advantage is driven through human capital, will be unattractive for venture investment. So professional services firms or creative agencies for example, find it difficult to find external backers.
Tax: often a venture capital firm will have a specific tax class that they promise their investors. In the UK the government supported tax schemes — the Seed Enterprise Investment Scheme (SEIS), the Enterprise Investment Scheme (EIS) and Venture Capital Trusts (VCTs) — are designed to help investors mitigate the risks of investing in earlier stage companies. But there are conditions attached and if the company does not fit HMRC’s criteria then the VC would not be able to find a place for them in their portfolio.
For example, to qualify for SEIS a business must be trading for less than 2 years. Both SEIS & EIS have restrictions on financial services business or ones where a large part of the value of the business is property related. A business that might end up paying good dividends in the future is not as attractive under SEIS or EIS as one that can create a large exit, as under that scheme dividends will be taxable for the investor, but one-off capital gains will not be.
Therefore, venture capital investors turn down many applications that have the ingredients of a great business, that could be very successful and throw off a great income for the founders. Simply because they lack the characteristics of an attractive equity investment to add to a high risk, high growth portfolio.
Whilst it is always disappointing and frustrating to hear that someone won’t back your business, it helps to divorce the judgement of the business versus the judgement of a venture capital decision.