We read all the time about startups that raise equity. There is a tech startup culture being nursed that equity fundraising is a sign of success. The annoying part: It can be but most often it’s not.
The venture capital industry, the office co-location industry, the entrepreneur event industry and the media industry all nurse the idea that it’s an entrepreneur success story to raise equity. And it is for those that truly need the funding and can deliver on steep and challenging milestone requirements. Everyone else shall not get distracted by the message to raise equity but focus on building and growing their business.
Venture capital is an industry that are dependent on a steady flow of businesses wanting to raise equity. Their business model is to find, invest and exit promising early-stage businesses. Their goal is to make a financial return to their own investors.
Venture capital is not objective
Venture capital managers, the VC’s or partner’s that you meet, invest on behalf of those that has invested into the venture capital fund, the General Partners. The venture capital managers role is to find investment objects and to make their money on an annual 1.5 – 2.5% management fee. The management fee is paid by the fund to cover annual VC operating costs. The fund also pays a return-sharing fee if the fund makes more than 20% ROI.
Here comes the industry challenge: Operating a VC business is expensive. Intelligent people have high expectations on annual compensation, share of the wealth, trendy offices and extensive travel and entertaining costs. Hence the venture capital fund/-s needs to be large to be able finance the VC-managers. At the same time each individual investment is relatively small since targeted businesses are early-stage startups. A successful VC fund therefore needs to invest in 100+ new businesses per fund.
A small VC firm with a couple of partners and a handful of analysts easily cost $2 – 3 million in annual operating cost. Often more than that not counting VC partners wealth that is built from the 20%+ return-sharing. The venture capital fund needs to be at least $125 mn in size to cover that annual cost with the 2% annual management fee. With an average VC investment of $1 million each fund needs to make 100+ investments.
There are circa 100 investments scanned and reviewed for every investment that is made. Most of the reviewed investments does not meet basic investment criteria. To raise equity is tough and the venture capital industry needs a huge flow of new businesses that pitch for them to fill the investment funds. That is why there is so much noise about success for those that make it to raise equity.
When shall I raise equity?
There are a few situations when it’s great to equity:
- You’re in a truly miss-fortune situation and can’t, for some reason, start your venture as a side -hustle on your spare time, with your own savings or with the support from family and friends. Think twice, however. You will gradually lose control if you succeed to raise equity from angel investors or venture capital already on this early stage of your business.
- You have come to a stage where you can truly scale your revenue to the next level, but cash flow is not yet there for the necessary investment. This can be a valid reason to raise equity from investors to propel your business to the next level.
- You start to look for an exit have concluded that a gradual departure is your best exit option. This can be a great reason to raise equity from investors that share you exit planning. You can read more about the best exit options here.
When shall I not raise equity?
There are also a few situations when it’s less ideal of a situation to try to raise equity to your business:
- You’re in the wrong business. This is from the point of view of investors and you don’t want to waste your time preparing and chasing investors that do not exist. Unless we are talking about friends and family investors, professional investors like venture capital, private equity, investment companies and most family offices all look for truly scalable businesses. If you operate a typical mom and pop business, look to family and friend to raise equity. If you operate a local or regional business in construction, trade or hospitality, look at family and friends.
- You have been stuck for a while and have challenges to grow your revenue. Cash flow and cash at account is drying up because of operating expenses. This is not an ideal situation to raise equity if the reason is to buy time. You may succeed to attract equity investors buy you give away control and institute new milestone expectations and reporting while you should really focus on your offering and sales process. A half-step backward may buy you time and serve you better than to raise equity.
- You consider to partially cash out but to remain long-term in the business. This can be a situation to raise equity, but you need to consider what exit options your investors will have. The odd exception can be if you operate an asset intense long-term infrastructure business and target long-term infrastructure investors.
Being an entrepreneur is about solving problems and learning as you go. Growing your business is a proof of success. To raise equity can be a tool to support your growth. To raise equity is in it selves not the proof of success.