When you follow the logic behind the VC deal you will find that there are a lot of variations of the elementary deal structure of VC fundraising style. This logic is applicable to all styles and does not change irrespective of the funding specifics. The primary reasons for such logic to remain the same throughout are:
- It provides the investors in the venture capital fund with adequate downside protection and
- It offers then a favorable position to make additional investments in the future in case the company proves too good enough and a prospective winner.
The Venture Capital industry works primarily on the four main players involved in the deal. These are:
- The business needing funds
- The investors wanting high returns
- The investment bankers needing companies to sell and finally
- The venture capitalists that generate money for them by creating a market for the other three abovementioned players.
Ideally, VC firms need protection from investment risks. This is because this is a specific organizational structure wherein there is a co-investing effort between the leading and the follower investors. You will hardly find a VC firm that solely funds an individual company entirely.
This is a common practice followed by the VC firms to have at least two to three groups involved in all stages of the funding process. There are several reasons for it such as:
- This act as a medium for diversification for the leading VC firm to invest in more deals with the same amount of cash.
- It also reduces the workloads of the partners and distributes the risks amongst them at the same time, especially during the due diligence period.
- This helps in managing the overall VC deal in a better way.
Another positive effect of following such practice is that the credibility of the funding itself goes up along with the company.
The expectation of higher returns
In a VC deal, there is always an expectation of high returns which is about ten times of the capital. They prefer it over financing a startup company for a couple of years because this is very high-cost capital which is combined with the preferred positions. Ideally, a loan that carries about 58% annual compound interest rate is very hard to repay of not impossible but such a high-cost investment should at least deliver 20% as an average fund return. That is why these funds are strategically structured to guarantee the VC partners a comfortable and steady flow of income.
To ensure such steady returns, the VC firms choose companies where the ROI will be tremendous. They consider companies that have the ability to play by the market demand and meet it without any shortage in supply.
Things to consider
If you do not want to have any traditional loans taken out for funding your business from a bank or any other lender such as liberty lending and feel more comfortable raising VC funding, there are however a few things that you should consider as a startup founder. Ideally, these are a few questions that you should ask yourself to make sure that you have chosen the right path.
- The current size: You must ask the current size of the organization as your first step. This will help you to analyze the future growth of your company and also come up with more realistic projections for the following years and decide whether to go ahead with VC funding or not.
- Considering venture debt: You must also know whether or not you should consider venture debt which is actually an assortment of debt financing products. These are provided to companies that want backing from the VC firms. Usually handed out by dedicated Venture debt funds or banks, these act as a complement to equity financing. You will need far fewer sources in this way. That means you will be able to fund your business with minor dilution than equity. The most significant advantage is that you will not need any valuation to be set for your business, give up board seats or have restricted and fewer governance. However, you will need to pay back a venture debt along with interest just like any other loans.
- The time to raise venture debt: You must also know the right time to raise venture debt. To know the right time, you will have to customize your approach and consider different situations to know the appropriate time for acquiring funding. These situations and requirements include replenishing cash reserves to reach to the next major milestone, funding significant capital expenses that are unavoidably larger such as for acquisition and creating reserve funds that will act as a buffer if it takes a long time to reach the next organizational milestone.
- Avoiding venture debt: There are specific times when you should avoid venture debt funding. These specific situations include unrealistic debt repayment, when the conditions levied are tedious or too cumbersome, the size of the venture debt is unaffordable, uncertain time period of the loan, the cost of the loan is too high, the financial and non-financial covenants are unclear and the timing of the amortization is not well defined.
The best way to follow
With so many factors to follow and considerations to make, funding your business by raising venture capital is really a serious matter. Therefore, you will need to know the best way to follow to run a venture debt fundraising process. For this, you will need to contact different banks and interact with different lenders as well. This will help you to analyze the venture debt funds and weigh it with different factor such as the existing capital of your business.
Lastly and most importantly, it is also suggested that you hire the services of a qualified and reputable venture lawyer who knows a lot about venture debt deals. Having years of experience of working with such deals, such a lawyer will be able to provide you with strong and useful advice on how you can get such funding in the best possible terms.