General Law

Thinking Like A Venture Capitalist

Written by Team Farallon | May 28, 2019

“If your business had no risk, you could go get a bank loan and call it a day. VCs like risks – without them, venture capital wouldn’t exist. But they need to be risks that VCs are good at assessing and managing.” – Jose Ferreira, American businessman and entrepreneur.

Understanding how VCs do business and approach potential investments is key for entrepreneurs in securing investments from such VCs. The very first thing entrepreneurs should know about VC is that the VC accepts that taking on risks is necessary in doing business with an entrepreneur. In fact, as Jose Ferreira stated at the beginning of this article, VCs like risks. Most VCs will not actively look to add low risk investments to fill their portfolio. It is the high-risk investments that catches their eye.

Most VC firms face a performance benchmark in the region of a 40%+ Internal Rate of Return (or “IRR”) in relation to the funds it manages. In that regard, VCs will not look for low risk investment. The IRR for such low risk investments are unlikely to allow a VC to meet his targeted IRR. Instead, to achieve such high IRR within a period of 5-7 years, the VC has to take on high risk investments. Simply because such high-risk investments usually lead to high levels of reward.

A VC’s portfolio will inevitably have failed investments. In fact, failed investments comprise of up to 20-30% of the VC’s portfolio. About half of the VC portfolio will not exactly fail but their modest returns render them as failures as they likely fall below the performance benchmark a VC faces. Therefore, that leaves approximately 20% of the VC fund’s investments to generate the profits for the entire funds. Therefore, faced with the need for such high rates of return, the VC has to adopt the “high risk high reward” approach to investments.

In that regard, the VC’s thinking is premised on assessing the risks and managing the risks. This article, written by our team of lawyers in Singapore, will consider how a VC assesses and manages such high risks and how understanding how the VC approaches an investment will aid an entrepreneur in structuring a proposal that will more likely succeed in convincing a VC to invest.

A RELIABLE SOURCE

The VC does not typically shop around for investment opportunities. In fact, one of the most fundamental way a VC reduces his investment risks is by ensure that such opportunities come from a source who knows what he is doing and has the requisite experience and knowledge to let the investment flourish. In that regard, the VC will spend time building a proprietary network, composed of key figures within the industry sectors. Such key individuals include senior executives, serial entrepreneurs, engineers, scientists, and developers.

Any business that these key group of individuals enter into has a high chance of succeeding and, to that end, invoke a greater sense of confidence from the VC. They are familiar with the ins and outs of the industry and understand the need of a successful collaboration with the VC. Therefore, any proposal that they put to the VC is likely to be engineered in such a way that investment looks attractive option to the VC.

Therefore, for an entrepreneur to increase his success of securing investment, the entrepreneur has to attempt to find a way to access the VC’s proprietary network.

EXCLUSIVITY

VCs love for exclusivity of a deal to be granted to them early on in the investment process. By securing this period of exclusivity, the VC can take comfort in knowing that they have first dibs to this investment opportunity and will not face another rival gazumping this good opportunity. In that regard, it can take its time to properly analyse the business and conduct adequate due diligence.

The entrepreneur should consider giving this period of exclusivity to its preferred VC. However, it should also be aware of how to protect its interest during this period of exclusivity so as to not lose other potential investors or the market to rival products.

DUE DILIGENCE

As mentioned in the previous section, the VC will conduct adequate due diligence to determine if a business is viable for investments. This process is extremely intrusive to the business and could cause severe disruption by taking away the management from the business. In that regard, the more prepared the entrepreneur for such due diligence, the lesser the disruption caused to the business.

TRANCHING INVESTMENTS

One way the VC manages the risk of an investment is by drip-feeding cash into the investment. They will typically feed sufficient investments into the business until the next valuation (i.e. the next round of funding) or they will provide for tranches of payments to the business dependent on the business hitting certain milestones, such as sale figures, opening of the first store, or entering the next stage of development for the product.

This form of investment allows the VC to manage the amount of funds entering the business and allows it to continue to participate only if the business is flourishing according to schedule. Entrepreneurs should be aware that VCs will not typically dump its entire pool of investment into the business at one go and will likely not consider investing into a business if the entrepreneur insists on not allowing incoming investment in tranches.

SYNDICATION

The VC will also tend to practice equity syndication. This practice is simply the VC sharing an investment opportunity with others. This practice is practiced because VCs believe in “safety in numbers” – the risk is spread on that single investment across multiple investors. Although the VC might lose a bit of value if the business investment is successful, it reduces its risk in that investment and gain some valuable opinion from the second or third investor.

Furthermore, it might not be as familiar with the industry as compared to another investor who might be more comfortable and knowledgeable in that area. In that circumstance, the VC will simply “hitchhike” and let the more experienced investor lead the investment. It simply inserts itself in the opportunity by investing funds.

Finally, VCs believe in equity syndication because it believes that if it introduces a good opportunity to another investor, that investor will eventually reciprocate. This allows the VC to broaden its horizon in the industry and expose itself to good business opportunities it would otherwise never had the chance to encounter.

INTERNAL GOVERNANCE

Entrepreneurs should also be aware of how the VC firm operates. He should be aware of how long the VC firm takes to consider the opportunities presented to it and also at which stage would approval for investment be granted. Having good knowledge of the VC firm allows the entrepreneur to “work” the VC firm by knowing how to appeal to the right parties in the firm and also to expedite the investment process and also increase the chance of success by focusing on the pertinent areas/processes.

EXIT STRATEGY

The VC’s end game is not simply making the investment opportunity succeed as a business. VCs look for a viable exit strategy as soon as they pump funds into an investment. VC firms get their funds for an approximate period of ten years, whereupon they will have to return such funds with interest. In that regard, they will look to achieve a viable exit from the opportunity within 5-7 years.

A savvy entrepreneur should be aware of the VC’s investment timeline too. The VC will attempt to identify a viable exit and will work towards crystallising that exit strategy by moving the business in the appropriate director.

The entrepreneur should therefore be aware that for him to secure that piece of investment easily, he has to create an obvious exit strategy for the VC. The more obvious and viable the exit strategy, the more attractive the business opportunity is to the VC. The entrepreneur should not attempt to resist any manoeuvres made by the VC in an attempt to manufacture an exit strategy as this will simply cause conflict and friction within the business. The VC will also be more likely to pull any further investments to the project if a clear exit strategy does not present itself.

HIGH RISK HIGH REWARD

As mentioned earlier, the entrepreneur does not need to worry that his business is too risky for the VC’s liking. VCs love risks. However, the key point in secure the investment is managing such risks and to understand exactly where the business opportunity fits within the VC’s portfolio. Does the VC have further appetite for further risks? Does the VC desperately require an opportunity, that although is risky, is primed for a big reward if successful?

Knowing exactly how to fit into the VC’s portfolio will increase the likelihood of success in term of securing investment from that particular VC. If the entrepreneur’s business “plays it safe” in an attempt to mitigate risks by sacrificing potential returns, then it risks being unrewarded in terms of investment as VCs do not look for opportunities with moderate returns.

RISK MANAGEMENT

Then the question remains – how should all that risk be managed?

The savvy VC will assume that all of their investments will perform poorly. It will not take an optimistic outlook in relation to all its investments. In that regard, it will actively seek out protections against the risks of investing in the entrepreneur’s business.

Tranched Investments

What are the tools that the VC will actively seek out then? Firstly, as mentioned earlier, it will look to make investments in tranches. This allows the VC to pull out further investment commitments if the business is no longer viable but an entrepreneur should realise that doing so might restrain business operations to what is offered to each tranche. The business is limited by the resources provided by each tranche and should therefore seek lesser tranches or more generous offerings in each tranche.

Anti-Dilution Price Protection

Secondly, the VC will look for protection against dilution of its shareholding. The VC will use price protection mechanism to protect itself from, amongst other things, poor business performance. The main price protection mechanism that the VC practices is anti-dilution protection. If there is a subsequent investment or fundraise, and such exercise is done at a lower value, then it will argue that its investment should be re-evaluated at the lower price. This allows it to get more shares in the company and retain its shareholding proportion.

In that regard, entrepreneurs should be aware of the risks of fighting for a high initial valuation of the business whilst allowing for an anti-dilution clause in the investment agreement with the VC.

Follow on rights

VC will often ask for a preferential right to future capital fundraising and financing as a form of risk management technique. This might sound counter-intuitive at first. However, consider if a company with a brilliant concept is only doing poorly due to external reasons beyond its control (e.g. poor market), and the VC recognises this. Then the VC will want to invest more into the business while its valuation is lowered. This allows the average cost of investment to be reduced. The cost price of each share is now lower and the investor has a bigger share in the business which would likely succeed after it tides through this difficult period.

Veto Rights

The VC is likely to be a minority shareholder and uninterested in managing the business. The savvy VC will let the people who are experienced in the industry manage the business. However, it does want to retain some form of control of the business. In that regard, the VC would ask for veto rights (or any form of negative control). The VC will not want to captain the ship and direct its course. However, it would want to prevent the business from moving in a direction that is contrary to its interest (i.e. negative control).

In that regard, the entrepreneur should realise why VCs seek veto rights and how they might use it to “control” the business.

Tag Along and Drag Along

If an early viable exit strategy presents itself when the business is not doing as well as expected, the VC would want to move for the exit while the entrepreneurs might wish to fight another day. Therefore, the VC would typically wish for a tag along clause or a drag along clause so as to tag onto other shareholders who manufactured an exit or drag along all the other shareholders so as to realise its investments and call it a day for the business.

THE HUMAN ASSET

Finally, VC firms do not strictly invest in an idea. It also invests in the human capital of a business. Entrepreneurs should realise this and should not strictly focus on selling an idea to the VC but also allocate equal focus on the people who are managing the business.

VC firms will focus on the management teams that they are investing in and also seek to reinforce that team with experts and advisors, and/or relevant knowledge and skills. They will often make sure that they have a wide array of advisors who they can rely on to supplement the management teams of their investment so as to maximise the chances that their investment (and the business) succeeds.

The proprietary network maintained by the VC that we mentioned earlier in the article also serves this purpose of supplementing the management teams of the VC’s investments.

Entrepreneurs should therefore choose their VCs wisely. Find one that has an adequate network of advisors and assets and also do not hesitate in asking the VCs to provide such advisors, aid, or knowledge so as to increase the likelihood of success of the business.