Venture capitalists make early investments into emerging startups. As such, it involves a certain level of risk, and hopefully with considerable gain. Capital is offered to businesses that have the potential to grow, and it’s offered in exchange for equity of the company. Often, this is the most suitable option for promising startups with no track record.
“The majority of early stage venture capitalists invest in people,” says Lee Jacobs, a former AngelList partner who has invested in over one dozen tech startups. “We look for entrepreneurs who are relentless, mission driven, and determined to succeed.”
At this year's Sohn Investment Conference, Dan Sundheim, the founder and CIO of D1 Capital Partners, spoke with John Collison, the co-founder of Stripe. Q1 2021 hedge fund letters, conferences and more D1 manages $20 billion. Of this, $10 billion is invested in fast-growing private businesses such as Stripe. Stripe is currently valued at around Read More
Here’s what you need to know about the scope of a VC deal:
What Is a Scope?
First, it helps to under the definition of a scope. Many startup entrepreneurs are great at grinding out code or perfecting out an elevator pitch, but have little close as to what a business scope consists of. Generally speaking, scope is a project management term that encompasses the combined requirements and objectives for a project. While this mostly encompasses product scopes and project scopes, it also applies to the scope of a potential deal.
The VC Advantage
To understand how venture capitalist deals work, you should first realize that there’s much more to a VC deal than simply offering capital to early-stage startups. Venture capitalists can prove instrumental to the future of a business. Roughly one-fifth of the 1.78 million startups launching annually around the world rely on VCs to grow their companies. After all, VCs are it in it for the long-haul. Many VCs stay on board for nearly a decade, taking a startup from those crucial early stages, all the way to exit.
Furthermore, they are networking machines, and can put you in front of key players that can also steer you towards an IPO, exit, or merger. And most importantly, because they’ve worked so hard to build their own reputations and brand, they are often the final selling point in major deals with potential clients.
Understanding the Investment Scope & Pitching
A large chunk of venture capitalists have a systematic approach to how they handle their investments. For this reason, it’s important to focus on your research before you start pitching VCs. When you create a short list of potential investors, it should be based on deals they’ve closed in the past, as well as the stages that those deals have closed on.
For example, if you’re raising a seed round, you may want to veer further away from VCs that are known to closing more advanced rounds. You also want to pay attention to the industries they tend to invest in. Some VCs hone in on healthcare tech startups, while others are focusing on commerce products.
Any time an entrepreneur is pitching their business for an investment, they become involved in the sales process. In the majority of cases, VCs don’t veer away from their scope of investments. It does happen—but it’s rare. To err on the side of caution and increase your chances of scoring a meeting and signing a deal, it’s best to work with VCs that are a compatible fit. If a VC has consistently invested in cryptocurrency companies, your 3D printer probably won’t make the cut.
Putting Together a Term Sheet
After the due diligence phase has passed, and the VC has found everything to be satisfactory, it’s time to draw up a term sheet. A term sheet outlines all the terms of the financial investment that your VC will put into your company. Most often, they consist of three important components: funding, corporate governance, and liquidation. The investor aims to protect their investment if the startup performs poorly, retain vetoes over specific corporate actions that do not act in their best interest, and ensure that key members of the team are locked into board for a while.
On the other hand, the startup team hopes to bring in as much capital as possible to reach critical, value-adding milestones. They also want to protect their personal position in the company and ensure that do not relinquish too much control over the company’s actions.
“A great VC will devise a term sheet that’s’ beneficial to all parties involved,” says Jacobs. “Both the VC and startup team will work together to perfect a term sheet that protects everyone’s interests. The alignment of goals is crucial throughout the negotiation process.”
It’s important to keep in mind that a term sheet in non-binding; it is merely a promise that the VC will offer funding, but this doesn’t necessarily mean that you’ll receive the capital. Take a look at this Term Sheet Template to give you an idea of what to expect.
The Due Diligence Process
During the due diligence process, the investor ensures they’ll get the deliverables they were promised during the pitch and term sheet negotiations. The bigger the investment round, the more complex the due diligence process is likely to be.
If the startup is raising a seed road, the investor is likely to focus more legal history of the company, the team members, and traction they’ve amassed so far. On the other hand, during a Series A, a venture capitalist may pay more attention to aspects like financial details and planning, honing in on the technology, and interviewing your existing clients.
During this time, they will also analyze your legal entities to be certain the business is properly established and no employees have or are currently facing charges (business related or otherwise). It’s important to note that the due diligence process can take anywhere from one to three months, depending on the complexity of the deal and the VC.
What to Know About Board Involvement
In addition to purchasing equity in the company, a VC will likely request board involvement in exchange for the early risk and investment they are taking.
“As venture capitalists, we are acutely aware of the risks we take with every investment we make. Even when due diligence checks out and you’re confident in the team, statistically speaking, the majority of startups will fail. A board seat helps us ensure that the company remains on a trajectory that provides revenue for the startup, as well as return and protection for the venture capitalists.”
There are two primary types of board levels. The director level is permissible to help the company make major decisions that will ultimately shape the future of the business. Another level is a board observer; at this level, the VC has an open invitation to attend all meetings, but doesn’t necessarily have a say in decision making. However, even at the board observer level, VCs can still be influential and can provide valuable feedback based on what they’ve heard.