How investment timing affects risk, return, and liquidity
When venture capitalists manage their startup portfolio and thesis, they will typically tailor them to specific verticals, geographies, or business stages. That last point is significant for portfolio management, as the business stage can determine many things about a fund’s financial structure, capital allocation, risk tolerance, and return expectations. This post will highlight why startups need funding, why investments occur in various rounds, and how those rounds affect a VC fund’s management.
Why do startups need funding in the first place?
For a technology startup to scale their business, they need capital investments to create the cash on hand necessary to allocate to specific business projects. Many startups are unprofitable, and therefore do not generate capital on their own. This fact is the entire reason the venture capital industry exists in the first place. VCs invest their money in a startup for an equity stake that grows in value as the business grows in size. The goal is to lead a startup to an exit or a liquidity event. An exit is achieved through a merger or acquisition (M&A) or listing on the public market through an IPO, Direct Listing, or SPAC.
Why do startups need funding “rounds”?
A startup does not typically receive all of the money necessary to achieve scalable growth upfront. When VCs invest institutional capital in a business, they do so at different stages during the company lifecycle. There are three main reasons why this is the case:
- Startups use VC investment to help a company achieve specific milestones. These goals are essential for both the startup and the investor. By having specific targets to hit, a startup knows how to put their capital to work effectively. By hitting those targets, the startup proves to investors that they are worthy of receiving future investments because they have successfully used the money to continue to grow the business.
- By hitting those business milestones, startups can accurately measure performance with more and improved data. They have a better understanding of their product, customers, sales, and expenses. This knowledge means they can more accurately forecast future scenarios and what it will take to achieve their objectives. This milestone performance feedback loop makes investment less risky for a VC as the business grows.
- Assuming a business is successfully hitting milestones and continuing to grow revenue, the business’s valuation will also increase. The valuation is probably the single most crucial part of investing in a startup. We want to know what value we are getting for the money we put into a startup. As the valuation grows, so does our equity stake in the business, determining our eventual return on investment.
In short, startups receive cash to hit milestones. Those milestones provide data to confirm a startup’s valuation and better forecast growth. Those forecasts become more accurate and less risky over time as we can better predict business growth. These risk factors will become significant when considering how a VC approaches their investment strategy and manage their portfolio.
Funding Stages of a Business
There are many gray areas for venture funding, as the valuations at different rounds can vary significantly and have changed over time.
To keep things as simple as possible, we will focus on five stages of business development: idea, development, early growth, and later-stage startups. I will include risk levels in this, but since 80% of startups fail, all of these ventures have some inherent risk.
Some quick notes before we start: Series A used to refer to the first round of institutional funding. Over time, these rounds have gotten larger, and venture capitalists have moved into later business funding stages. This movement in the private markets has created an opportunity for the rise of earlier funding, and investors such as accelerators, angels, and micro-VCs. This funding gap has also introduced Seed and Pre-Seed funding rounds. Quite frankly, the naming is relatively arbitrary but still used to gauge roughly where a business is.
In terms of timing, a best practice is to raise 12-18 months of runway (cash on hand) in each round. Fundraising takes on average six months for a founder to complete, so this gives the business enough time to achieve milestones that will increase its valuation for the next funding round.
An idea-stage startup is one that is in the beginning phases of becoming a business. Activities in this phase include developing a business idea, forming a founding team, and doing the initial legal process of setting up a business. There is typically no institutional capital in this phase, and money is either provided by the founders (bootstrapping) or from friends and family.
- Risk Level: Extremely High
In the development-stage, a company has likely created an MVP (minimum viable product) or prototype and has a small team. The company also probably has some notable mentors or advisors. They may or may not have a small group of customers and revenue. They likely have at least a sense that there is a product-market fit, which puts them in the right place for initial funding. In this stage, startups receive capital from angel investors, crowdfunding campaigns, accelerators, or pre-seed VCs. Round size is $250K-1M at a $3-5M valuation.
- Risk Level: Extremely High
Early-stage startups have product-market fit, a small customer base, and early revenue. The early-stage is very broad across funding, composed of Seed and Series A rounds of financing. In the Seed stage, a startup will likely $20-100K MRR and raise $1-3M at a $4-12M valuation. At Series A, you can expect $100K+ MRR and to raise $3-10M at a $10-30M valuation. Although these investments’ risk is still very high, there is enough traction to determine how revenues will grow and set specific goals.
- Risk Level: High
A growth-stage company will be raising their Series B and C rounds. In this stage, a company knows its product, its customers, and is rapidly expanding its business to different markets. Much of the focus in this stage comes down to capital efficiency and balancing growth with accounting. Growth-Stage VCs and Venture Debt are popular in these rounds. Also, Private Equity firms will get involved in this stage, as well. A typical Series B company will have $3M ARR and raise $10-25M at a $25-100M valuation. Series C companies will have $10M+ in ARR and raise $25M+ at a $75M+ valuation.
- Risk Level: Medium
Late-Stage companies are the least risky of them all. In these scenarios, a company will be a well-established industry player and ready to exit. KPIs will be easy to forecast, and growth will be less explosive but still steady. Due to players like Softbank and Tiger Global injecting money into late-stage companies, exits have been pushed off over time as companies have stayed private longer. There are many implications to this that I won’t discuss here, but it’s essential to know as a trend.
- Risk Level: Lower
Risk, Returns, and Liquidity
So how does this all translate into portfolio management? When putting together a fund and thesis, investors will have to determine their risk tolerance. Businesses in the early-stage will have less traction and significantly higher risk. With that risk comes a lower valuation and a higher return potential, and a longer window (10+ years in many cases) to an exit and liquidity.
Early-stage investors have to consider liquidity timing when making their investments. They also have to allocate follow-on investments for companies in their portfolio that raise future funding. As more investors will inject capital into a business over time at a higher valuation, the initial early-stage investments will dilute equity ownership. Follow-on investments solve this problem. In recent years, the development of a “secondary market” has allowed early investors to sell their shares before an official exit. This market has allowed investors to get some liquidity early on their investment and reduce founders’ dilution by creating fewer overall shares.
Growth and Later-stage investors see less capital risk in their portfolio because their companies are well-established and have predictable revenue. They also typically don’t have to account for as many follow-on investments and have a shorter window to a liquidity event. This reality means they also generate smaller returns on each investment opportunity.
Although a few years old, this article helps show fund return expectations.
This story is from Sutton Capital contributor Zeb Hastings. For more information on Zeb’s work, please visit his website.