Startups: the investment landscape, VCs demystified

There has been significant growth and development in the South African entrepreneurship and venture capital ecosystem over the past five years as evidenced by numerous new investment funds and government initiatives as well as high-caliber incubators and accelerators emerging on the scene. All are committed to furthering the growth prospects of commercially viable entrepreneurial ventures in South Africa. Notwithstanding the challenges that still exist for entrepreneurs and SMEs, this is an exciting period for the industry and progress is being made to increase funding opportunities.

In order for entrepreneurs to be best prepared for the investment journey, it is important that the investment landscape is well understood and that the most compatible investment partner is approached at the right time with a compelling and well-articulated business plan. Appreciating the investor’s perspective and context can assist with successfully communicating the investment value proposition and negotiating balanced and mutually acceptable funding terms and conditions thereby improving the chances of securing an investment. Entrepreneurs should also consider whether the investor’s investment criteria and culture are aligned with their vision and strategy for the business to ensure a rewarding reciprocal investment relationship.

1. Investment Landscape

The initial step for Entrepreneurs is to understand where various funders fit on the “Stage of Business Continuum” and to ensure that this matches their business development. The overall lifecycle of businesses tend to go through four stages and given the cash flow characteristics and requirements of each phase, they attract different types of investments and investors as depicted below:

The Start-Up Stage can be further broken down into different phases of development. It is important for Entrepreneurs to be able to identify which phase their business is in and consequently select the investment sources aligned with this phase as depicted below:

Entrepreneurs can benefit from plotting their businesses on the scale and focusing on the milestones required to get to the next stage as this will open additional sources of funding.

2. Venture Capital

As depicted in the table above, Venture Capital (“VC”) is usually related to businesses that have proven market validation and some traction in terms of revenue i.e. not start-ups in the Ideation or Conception phases. Prior to these milestones being met, grant and seed capital plus bootstrapping and investments from family and friends are the most appropriate forms of funding given the risk profile.

VC can be defined as follows:

• Money provided by investors to start-up firms and SMEs with perceived long-term growth potential usually in the form of an equity investment
• Source of funding for start-ups with limited operating history that do not readily have access to other capital markets and/or debt funding
• Entails high risk for the investor, with the potential for above-average returns
• To compensate for the risk and stage of business, VC’s usually get a say into business decisions (e.g. Board representation)
• Includes managerial and technical expertise

VC funds are typically raised from pools of capital provided by:

• High net worth individuals
• Financial Institutions (“FIs”)
• Development Finance Institutions (“DFIs”)

The overriding mandate of a VC fund will be largely prescribed by the capital providers, therefore it is worthwhile for Entrepreneurs to appreciate who are the capital providers and what are the main mandate criteria when evaluating the suitability of various VC funds.

3. Investor Perspective and Context

Early stage investors, including VCs, are investing in an environment with the following notable statistics:

• 70-80% of businesses that fail in their first year
• 1% of VC applicants that receive funding
• 70% of successful VC applicants that fail

As these figures indicate, there is a significantly high degree of failure in the start- up phase and therefore it has a very elevated risk profile. These factors influence the VC investors’ perspective and consequently they are targeting investments in exceptional candidates only; ones that can clearly articulate:

• A differentiated value proposition;
• A scalable business model;
• An attractive specific addressable market in terms of size and growth;
• Strong team credentials and industry experience; and
• Evidence to back up and validate forecast assumptions

The odds of raising capital are low hence the ability to comprehensively address these areas of investor interest in the most compelling and substantiated manner can be a critical success factor for securing funding.

Showing traction

Traction is an important component in discussions with VC investors due to the inverse relationship between traction and risk profile.

Traction can be illustrated in various forms such as:

The greater the evidence of traction, the easier it is for VC investors to believe in the growth prospects of the addressable market and the business as well as the financial forecasts which, are the main valuation drivers.

Investors to provide value proposition to Entrepreneurs

Investors equally need to participate in bridging the communication gap between the two parties and to provide a value proposition for entrepreneurs by understanding opportunities in the relevant markets, having the correct resources to evaluate the industry and to assist

with valuable industry networks and market access opportunities. A fundamental part of raising finance from VC investors, is to receive technical expertise and managerial support to assist with scaling the business and value creation.

4. Venture Capital Investment Process

Often entrepreneurs underestimate the time that it takes to raise capital from VC investors, which can put a fledgeling business under cash flow pressure. Allowing adequate timing for the process given the current cash burn rate will assist in getting optimal funding terms and conditions.

It takes on average 3-6 months from VC origination/introduction to final close. Timings are often impacted by protracted term sheet negotiations and a lengthy Due Diligence (“DD”) process.

• Term sheet negotiations can be testing as main terms and conditions are agreed. The terms and conditions should aim for a balanced outcome whereby entrepreneurs receive sufficient funding at a valuation level which allows VC investors to generate an appropriate risk-adjusted return. The expertise and network that the VC investor is able to bring to the company ought to adequately compensate for the entrepreneur’s reduced level of control.
• The DD process can seem overly onerous on the entrepreneur especially when the focus needs to be on the business but the thorough process of reviewing historical documents (legal and financial) as well as externally validating forecast assumption is to provide VC investors with the comfort that they are actually buying what they thought they were buying.

It is worth noting that the VC investor’s principal goal is to facilitate growth and value creation for its eventual exit which is best achieved through clear alignment of interest between entrepreneur and VC investor over its investment time horizon. It is beneficial for both parties to consider possible exit strategies upfront to enable these to inform strategic business decisions over the period.

Conclusion

Investment readiness is a crucial consideration for entrepreneurs requiring funding, either currently or in the future. Incorporating some of the aforementioned guidelines and ensuring that the potential communication gap between entrepreneur and investors is bridged effectively can certainly contribute to a mutually beneficial relationship for both parties and further develop the South African entrepreneurial ecosystem.

---

This article is based on a presentation given at the Investment Readiness Insights Event co-hosted in Cape Town on 21 June 2016 by the Vumela Fund, Outsourced CFO, Caveat Legal and Bandwidth Barn.

Feature image by Ken Teegardin via Flickr.