Why Does a Founder Raise Capital? | AWM Insights #109
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Episode Summary
Why would a founder raise money?
To turbocharge growth of the company. The company can grow faster from taking outside capital. In exchange, the founder is giving up partial ownership of the company.
What should investors be looking for?
The majority of companies in venture fail. It is wise to be skeptical and thorough. It isn’t enough to see a teaser pitch deck and start writing checks. Access to the data room and diligence in reviewing financials, management team, and legal documents leads to better outcomes.
The best venture capital investors and founders look for a win-win scenario. The VC investors get outsized returns and the founders get to build and grow their startup into a successful, sometimes dominant business. They also usually exit with millions or sometimes billions in liquidity.
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Episode Highlights
(0:55) Why is a founder raising capital? What is the money for?
(2:00) A venture company doesn’t have to raise outside capital but to grow and scale to become
(2:22) Venture capital and tech are synonymous.
(2:47) Deciding how much money to raise is a tough question for a founder. The more money a founder asks for the more ownership he or she will have to give up.
(3:15) Owners and founders try to minimize their dilution of ownership.
(3:50) Current market conditions are a big factor in to how much to raise and the valuation a company can raise money at.
(4:41) A founder and client who just raised money before the market tightened is setting strategy on how fast to use the capital. Using the capital will create more growth but will also lead to the need for another fund raising round fairly quickly.
(6:10) Example: A Web 3.0 company is trying to raise a $100 million at a $500 million valuation. For the math to work and to return a 10x, the company would need to be valued at $5 billion in the future. It is very difficult to create a company that grows to that kind of valuation.
(8:05) You must be thorough. A teaser deck is often what you see being sent around to get you interested. An investment should never be made off this incomplete information usually produced by the marketing team of the company.
(9:05) Investing directly in companies and their founder is very similar to investing in venture capital funds. The due diligence if requirements are very similar.
(9:31) A data room is created, usually hosted in the cloud, and access is granted to investors to be able to download and review.
(9:42) Financials with revenue and expenses, the formal pitch deck, legal documents, and information on founders are normally in the data room.
(10:40) Proper time and research needs to be spent reviewing this information and being skeptical can save you from making poor investments.
(11:50) Reviewing a teaser deck is not enough to decide whether to risk your money.
(12:47) If you get an opportunity to invest in an early stage company, immediately gather more information. Just asking for access to the data room will weed out a lot of the pretenders.
(13:42) Venture capital as an asset class has been very good in recent times for investors.
(15:12) Individual investors shouldn’t be making investments directly into startup companies. These direct investments take an incredible amount of time, experience, and resources to be successful. The better way to participate is through venture capital funds.
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+ Read the Transcript
Brandon Averill (00:11): Well, Justin, excited to be back, continue this venture capital discussion. We had a good time last week, obviously talking about the lay of the land, who's involved in the venture capital process, what's at a high level entail. We've also had some pretty cool experiences over the past couple weeks. One of our venture partners had their annual meeting that we attended, attended another one on Zoom back in the Bay Area, meeting with some venture capitalists yesterday. So all this is super fresh in our minds.
Brandon Averill (00:43): So all this is super fresh in our minds, something that we're paying attention to quite a bit right now, and thought it would be good to continue this discussion really and moving to, again, a little bit deeper on why as a founder, when we talk to our founders, you would actually go about raising capital and even into at each round, how much money we actually want to raise.
Brandon Averill (01:05): And then we'll get into a little bit, just let's talk a little bit about, we're on the investor side. So when a founder comes to us and they are raising capital or we're evaluating a venture capital fund, what are the materials, what are some of the things we like to see? So let's start off at the top. Justin, I'd love you just to chime in a little bit in talking with our founders, why would a venture ... or why would a founder go to market and raise venture capital?
Justin Dyer (01:33): Sure. And it's a super relevant topic right now. I mean, it's an interesting topic overall and a very critical part of this whole ecosystem and asset class. But it's really interesting right now, because the dynamics around fundraising are changing kind of by the minute almost. A lot of what you probably see going on in the public markets is trickling down to venture capital.
Justin Dyer (01:56): But, I mean, the short answer to the question is why would a founder go to raise? And it's really to turbocharge growth. A founder can start a company, go out there and start selling a product or a service and take that revenue, reinvest it in company and continue to grow that way. Or you can bring on outside capital.
Justin Dyer (02:17): Generally speaking, if you have a pretty scalable idea, tech-focused idea, tech and venture capital are generally synonymous, not exclusive, but generally synonymous with each other. And if you have that idea, you really want to take it to the next level. Well, you're going to go out to the market, the VC market and give a pitch. We'll talk a little bit about that, and prepare all sorts of other documents and try and court investors, ask people to give you money, how much, that's a pretty complicated question.
Justin Dyer (02:51): There's so many variables that go into that calculation. Obviously as a founder, you're going to want to probably maximize the amount of money you can raise, but minimize the amount of the company you have to actually give up for that money, because a venture capital investor is not just going to give you money for free, they want part of the company. And you as a founder, you don't want to give up, you want to ... it's called dilution or diluting yourself. You do not want to dilute yourself or you want to minimize the dilution, so you hold more of the company while bringing in capital.
Justin Dyer (03:24): That aspect is largely market dependent. Not exclusively. There are unique factors about the company, the founder and whatnot. But as an example right now, it's becoming more difficult for founders to raise money, almost across the stage, the maturity of the business. The seed we talked about to later stage Series E, F, et cetera, et cetera, it is becoming more and more difficult to raise money or you're giving up some sort of valuation or you're diluting yourself a little bit more.
Justin Dyer (03:59): So those are general considerations and factors that go into the overall thought process, also pretty relevant for the current environment. The amount, it's not just, hey, let's maximize the amount of money I can get. I mean, that's a big piece of it, but you need to be a little more strategic, especially in the current environment. Where six months ago, 12 months ago, you're thinking, "Hey, I'm raising and I'm going to reinvest that as fast as I can."
Justin Dyer (04:30): We were actually talking to a founder yesterday who also happens to be a client. They're thinking through this very, very similar question where they actually just raised before this whole environment really has changed drastically, and they're thinking, well, hey, do we take the money that we've raised and just continue to plow it into the business, plow it in, plow it in, continue to turbocharge that growth, deplete that capital, have to go back to the market in a shorter window, in a more difficult fundraising environment? Or do we start to stretch it out a little bit more? Do we pull back potentially our growth, or just really be super, super optimized if you will, really think through that decision of how to invest that capital in a really, really thoughtful way. It's an interesting conversation. It's changed, like I said, drastically over the really, kind of year to date timeframe.
Brandon Averill (05:24): I think those are fantastic points. And at the end of the day, to simplify it a little bit, if you're the entrepreneur, what you're trying to raise is enough to get you, like you just alluded to, to the next fundraising round. So what do you need to do within your company and how much funding do you need to get there? And then there's going to be the evaluation on the investor's side. So the venture capitalists might look at it and they're going to start to question why that amount?
Brandon Averill (05:52): And we just saw this recently, there's a company that's raising in the web three space, very, very hot right now. Or at least it was up until this last week, but it's still very hot, but it's a white paper and they're trying to raise a hundred million for their first funding.
Brandon Averill (06:13): When you start to put things out there like that, the investor, I think there's a natural tendency to have caution for good reason, because if you're raising $100 million at, let's say a $500 million valuation, the process that the investor goes through or should be going through is what has to happen to this company for me to get my expected return back? And to frame that somewhat, if you're a venture investor, the unwritten, I would say, benchmark is hopefully you're getting at least a 3X.
Brandon Averill (06:47): So if you invest $100, you're getting $300 back at the end of your fund. And in order for that to happen across an entire fund, you have to have the belief that the individual companies that you're investing in probably need to at least 10X. So you put $100 in, you're getting a thousand back.
Brandon Averill (07:07): And so you think about that company I just mentioned, they're raising at a $500 million valuation. I mean, to 10X that company, you're looking at a two and a half, $3 billion valuation. Those are hard companies to grow. So, I think going back, that's where the entrepreneur, the founder has to be really thoughtful, because those are the questions that as the investor, most of your investors listening to this should be thinking about on the other side.
Brandon Averill (07:34): So, that's the initial maybe thought process, even just around an idea, Justin. Once we go through that, and let's say that founder had a little bit more reason to him in our view, and maybe they're raising $5 million to get this off the ground at a $50 million evaluation, what's our next step? What's the next step to starting to look at the opportunity and whether this is something that we want to bring to our investment committee or not?
Justin Dyer (08:02): Sure. And it's thorough, is the short answer. Oftentimes, what you see initially is what's called a teaser deck or a little blurb, maybe it's a five to 10 page PDF or PowerPoint presentation. And that's not sufficient. And they make these so that you get attracted to the idea. It's more of a marketing ploy, the marketing department's probably more involved with that than ... if they have a marketing department, than actual founders, CFOs, et cetera, et cetera.
Justin Dyer (08:37): But it makes sense. It's called a teaser, let's kind of wet your whistle, but it should give you a general idea of the company, the market that they're trying to attack, what's the potential opportunity? Where are they within the stage of the company, the maturity of the company, but you really need to go deeper.
Justin Dyer (08:56): And so, what are the common tools that we use to go deeper and that founders, and even funds. So there's a distinction here, Brandon mentioned it, just want to call it out too. We're talking about investing directly in companies for most of this conversation. There's a very similar conversation around investing in a venture fund, where especially with this topic here, what is provided or what should be provided to the end investor, whether you're going directly into a company or directly into a fund, it's a thorough list of documents.
Justin Dyer (09:31): Generally what happens is a data room is created, lives in the cloud, and those data rooms will have a number of different documents within it, financials. If it's a more mature company or a company that's been in existence for some time, how much revenue have you earned? What are your expenses? What do you expect them to be going forward? Et cetera, et cetera. There would also be a more formal pitch deck in there. The legal documents that we love reading through, but hey, they're incredibly important, often very long and good reading before you go to bed at night, but these things are all really, really important. And you need to wrap your head around each and every one of these aspects.
Justin Dyer (10:15): I mean, if the operating agreement or the legal agreements say something that is more favorable to the founder and that was never discussed, and it's probably not listed in some sort of marketing presentation or pitch deck, that's something you want to be aware of. Now, hopefully that doesn't happen, but hey, you need to go into these with a certain amount of skepticism to protect yourself, to do the proper due diligence, so if you do decide to make an investment, one, two, three years down the road, you don't get blindsided by something that was slipped in there or was more favorable to the founder or the general partner than you, the end investor.
Brandon Averill (10:58): I think that's a great point. And you're going through this entire process and really as the investor, you're keeping in mind what stage is this company at? Are they going to have to raise additional capital? What is the potential? You brought up dilution, but do I have enough money reserved that I can actually invest at every raise ahead because that's ... we want to continue to follow our winners on the investor side. So you need to think about the size of the opportunity. How are they going to attack the market?
Brandon Averill (11:29): I got a text from an acquaintance yesterday about another one of these sparkling boozy beverages that are out there. And it was one of a teaser deck in that the question was, are you interested in investing? And it's just funny, you come back and say, "Well, I've seen a lot of these at this standpoint, so I'm happy to have a conversation and hopefully get into a data room," et cetera. But you certainly shouldn't just be taking the teaser deck and making a decision on how to invest or not.
Brandon Averill (12:05): And I think you bring up the distinction on funds is really good. I think what we're talking about here is the venture capitalist, the investor building out a portfolio of individual companies, for most of the people listening to this right now, it is probably more of an evaluation on the fund. How do you pick a good VC? And I think that's maybe something we need to dig into over the next few weeks, for sure.
Brandon Averill (12:35): But hopefully this just gave you a really good, we kept it short this week, but really good overview of what you're actually looking for when you start to go evaluate a company. So the next time that you get a text from a buddy in the clubhouse or a fellow entrepreneur, make yourself think a little bit deeper, ask for more information. That's usually the telltale sign you're going to blow a lot of things up pretty quickly.
Justin Dyer (13:02): And I was just actually going to slip that in there. You do have to keep in mind within venture capital and just startups in general, these are companies that are getting off the ground, whether they're BC backed or not, the vast, vast, vast majority of businesses fail. So keep that in mind. The recent history, the last two, three ... well, the last 10 years has been a very favorable time for starting companies, venture capital investing in general. And it's easy to forget and it's human nature to get caught up in the present.
Justin Dyer (13:37): And we still love venture capital as an asset class, but you have to remind yourself, it's not always going to go up into the right or to the moon, whatever phrase you want to use there. And even in particular, the last two, three years, it's been incredibly easy to raise money and then turn around and sell that or go public at very, very attractive valuations. So just keep that in mind that there's a lot to be excited about. There's a lot of potential. Venture capital's a really, really interesting ecosystem filled with really talented, intelligent, optimistic people. It's a fun place to invest in and kind of be a part of, but it's not a sure thing at all. You have to be very diligent and cautious and do your homework, as they say.
Brandon Averill (14:27): And I mean, to just maybe wrap up, I think hopefully people are also listening to this and realizing that we're only scratching the surface at the due diligence that would need to be done and how ... we've talked about before, but how incredibly difficult it is to be a venture capital investor, to figure out which companies to invest into is more than a full-time job. It's kind of all-encompassing from a life perspective.
Brandon Averill (14:56): And so when you look at the venture space, we've talked about this, it's also when you look at the people that, the professionals that are doing this day in and day out, the dispersion of returns are incredible.
Justin Dyer (15:08): Substantial.
Brandon Averill (15:08): So let's not kid ourselves that us as individual investors, we should not probably be looking at making individual company investments too often, or at all, quite frankly. We really should be turning towards the fund, trusting those venture capitalists managing funds to make those decisions for us, because that's going to be the best avenue to success for us over time.
Brandon Averill (15:33): So we're going to get into that next week probably. We'll unpack, we've established now we don't want to do too many direct investments if I'm just an individual investor, but I do want to participate in the space. And so the way to do that is via some of these venture capital funds. So we'll dig into how do you start to evaluate that? We talked about it, not all are created equal, so which are the best ones? How do I get access to them? Et cetera. We'll continue this discussion.
Brandon Averill (16:04): So along those lines, if you got questions about that process, shoot me a text as you know, 602-704-5574. Text comes directly to me. Justin and I will chat about it. We'll address it next week on the podcast. Again, it's 602-704-5574. And until next time, own your wealth, make an impact and always be a pro.
Justin Dyer (16:31): Right on.