Just follow the cash – insights on VC from an expert

by Jörg Riesmeier

When starting a company many questions arise. Is my product or service sufficiently good and wanted in the market? Where do we need to improve? Who are my potential customers and are they willing to pay for my product or service? How do I build a substantial business case around my product or service? Will all this hard work eventually pay off? All these questions are immensely important. But the question of how to finance your venture might just be the most important one of all, since founding a company without a proper financial plan would just be reckless.

The basics - How to fund a venture?

Several criteria have an impact on the right financing vehicle. This includes where the venture stands before financing and the overall goals to be achieved through the anticipated financing.

In case the goal is a solid but organic growing venture, financing through cash flow is an option. Re-investing the ventures profits counts for low risk but also little reward.

Your venture shows steady and positive cash flow? Then debt financing by banks might be the way to go. But debt always needs a corresponding collateral, which is difficult especially for younger ventures without a track record. Venture debt is a special debt form accepting the company’s intangible assets (IP) as collateral.

If you want your venture to grow fast and multiply the company’s value in a short period of time, Venture Capital (VC) or Private Equity (PE) is an option. Actually, VC is a subsegment of PE. VC invests earlier even in pre-revenue companies, whereas PE comes into play in case the venture is well established, has a track record but lacks the collateral needed for debt financing by banks.

Keep in mind, that there are several other options which are somewhere in between the above three options. Ventures could be funded through crowd funding, backer-based funding, credit card funding or funding through friends and family.

The specifics - How does Venture Capital work?

Just follow the cash: Cash always seeks opportunities to multiply. As a consequence, VC was invented in the 70th in California (Sandhill Road in Palo Alto). The management (partners) of a VC firm will set up a legal vehicle, where they bring in the management skills to act as General Partners of the fund and will raise money from pension funds, banks, individuals, etc. which will form the Limited Partners of the fund with no influence on the operations. When the targeted amount of money is raised the fund will close and start to invest in ventures. Normally, funds have a defined lifespan of about 10 years. Therefore, the fund needs to exit the portfolio within this lifespan. Exit means here either a trade sale or an IPO (Initial Public Offering) or any other liquidation event. Therefore, the primary and only goal of a VC is to increase the company value with as little cash as possible. The average fund will return 2,2x the committed capital to the Limited Partners. Obviously, some will fail to return but successful VC firms have returned 5x -10x and beyond to their Limited Partners.

  • Shareholdings, rights and duties

VCs exchange cash for equity and will become shareholders of the company. The equity portion they will receive is determined by the company valuation before investment (Pre-money) and the amount of cash invested. Thereby, existing shareholders - including the founders - will be diluted accordingly. But this dilution goes beyond the cap table to shareholder rights, decision making and voting rights. These rights are, in Germany, to a large proportion predetermined by respective laws (e.g. GmbHG). However, the shareholders can delegate certain decision-making power to an Advisory Board as set in the bylaws of the company. Thereby, rights and duties of shareholders are defined by laws, the bylaws and the individuals forming the Advisory Board.

  • What is there to consider?

Voting structures and thresholds should be chosen in a way that a single investor / founder cannot hold the company hostage by vetoing important decisions. Some of that can be arranged with drag- and tag-along rules, preferred vs common shares and delegation decision power from shareholder level to the Advisory Board.

  • What are some pros and cons of VC?

The good thing about VC is that the venture will receive cash when nobody else is willing to provide some. Also, experienced VC’s come with domain expertise and a huge network. I’d recommend making use of both! But the investors want something in return, so the founders have to share an equity portion, thereby losing some shareholding and decision-making power. How much shareholding the founders have to transfer to the investors depends heavily on how much money you have to raise at what stage of the venture journey. A pharma startup may have to raise 100M€ or more over a long time stretch, which will dilute founders into the 10 to 20 % range. Whereas a Tech startup may only need 2 to 3M€ over a short period of time, which will have a minor impact on the cap table. BUT the pharma startup may exit in the billion range, so that even a one-digit shareholding will make it an incredibly happy ending (see BioNTec).

The personal insights - Experience in the area of VC

I have been on both sides of the table and it was always fun but nerve-wrecking, too. As a VC with a full portfolio of ventures, there is always a fire you have to put out. On the other side of the table, you manage a company AND the expectations of your investors and those two things are not always going hand-in-hand. That being said, there are always ups and downs. My biggest success was most certainly investing in Pasteuria BioScience. When we met the company for the first time it had only three employees, no management but a brilliant technology to control nematodes in agriculture. We put a few millions in, hired management, got operations going, implemented a strong business development and three years later the company got acquired for 100+ millions. Nevertheless, I also experienced some mayor drawbacks during the financial crisis in 2008/09: Actually, during a three-hour flight from Boston to Orlando my world collapsed when Wall Street collapsed. Sitting on a full portfolio of ventures most of them financed by VC syndicates, a lot of key assumptions of the ventures were falling apart increasing capital need while VC’s were struggling to call capital from their limited partners. A classic double-whammy.

Looking back on that difficult time trying to learn from my mistakes, I am focusing even more on the people involved, by conducting a very thorough due diligence on the team. As if I wanted to marry them. Each and every venture will have one or more make-or-break crisis. The reason for this may come from the outside (e.g. 2008 financial crisis) or the inside (like product failure, competition, etc.). That’s the point where you need the best people, which can steer the boat through the storm. People who are able to keep multiple balls in the air not getting sidetracked or even nervous. One of my friends told once a CEO of a troubled company heading for negotiations to rescue the company: “Don’t blink!”

The plan - How can my venture be financed by VC?

The plan - How can my venture be financed by VC?

Keep in mind that VC is a people’s business. Do your research about VC funds (size, domain expertise, investment in ventures in your market space, vintage, previous investments, syndication partners, etc.) and the exit markets (trade sales and IPO’s in your market segments) To get in touch with them, networking is key. Basically, VC investors are everywhere where great business opportunists are to be expected like conferences and pitching events, but you can also reach them via personalized mails or through social media. Just don’t be shy!

The next step would be to convince the VC, that the venture has the clear potential to return the investment 5 to 10 times within 3 to 5 years. The ingredients for such a return are:

  • The “right’ management team
  • Concise business plan
  • Clear market needs
  • Competitive positioning
  • Defendable USP’s
  • Existing exit market / strong comparables

To convince the investors, you have to put all your ducks in a row and the all the eggs in a basket to have a coherent story from the day of investment until your EXIT delivering a 10x return.

Feel like an expert yet or want to learn more around the topic of financing a venture and VC? Check out our resources and knowledge base to get further information!

Comments (0)

Create comments

Jörg's Background

Comming from a biochemistry background, Jörg brings more than 25 years of experience in the field of entrepreneurship to the table. Not only is he an investor and entrepreneur himself, managing and financing companies of different backgrounds, he is also a valuable and cherished member of Chemovator mentoring our Ventures.