Tom Walker, Rev1 Ventures President and CEO
Note: “Rules for Startups Raising Capital in the Midwest” is a multi-part Entrepreneur Toolkit series based on Rev1 Ventures Capital Access Learning Lab. We suggest you review all sections: Part 1 – Basic Information on Venture Capital, Part 2 – Capital Planning Worksheet, Part 3 – Building Your Investor List, Part 4 – Due Diligence, Part 5 – Investor Outreach, and Part 6 – Deal Terms.
This material is also available in Rev1’s Toolkit eBook – Rules for Startups Raising Capital in the Midwest (download here.)
Most entrepreneurs building high-growth companies will need to raise capital to fund the milestones that lead to sustainable growth. The process begins with defining those milestones, understanding the appropriate capital source for each stage, and then matching up the two into a well-formed business plan.
A common misconception is that entrepreneurs must raise a great deal of capital upfront to succeed. That’s not the case. However, when concept companies achieve breakeven and concrete milestones, the time is ripe to start mid-and long-term capital access planning.
Things to Know Before Raising Venture Capital
Institutional venture capitalist firms professionally manage capital on behalf of other investors (limited partners). VCs raise money from those limited partners (LPs) and put that money into a fund and then invest, on behalf of the LPs, in various companies in exchange for equity. VC firms are regulated and bear a fiduciary duty to their investors, meaning they have the legal obligation to act in those LPs’ best interests.
VCs make money through regular management fees and when their portfolio companies exit. Additionally, after the limited partners have been repaid their original investment, VC funds usually receive a percentage of profits (known as carry or carried interest).
VCs expect a return on their investments commensurate with the risk, a multiple of 10X to 20X. There must be an exit event for VCs to realize their return. VC’s Offering Memoranda may state the expectation of a company exit in five to ten years; the reality is that venture funds often run twelve to sixteen years before liquidation.
Venture Capital Is Not for Every Company, but When It Fits, It Opens Doors
“Motorcycles are common. Jet planes are rare. VCs sell jet fuel, which doesn’t work in motorcycles. Bad stuff happens if VCs push jet fuel on a bike owner or if a bike owner thinks they can fly.” Josh Kopelman, Founder at First Round Capital
Not all companies should focus on VC funding. Instead, focus on the funding that is right for the stage of the business. It’s like golf. Match the club to the shot.
Most entrepreneurs self-finance through banks and other loans, grants, and personal savings. Only a small fraction of companies—less than 5 percent according to Kauffman Foundation—ever raise venture capital. However, many large technology companies have.
The ideal VC company shows accelerated growth with a scalable business model that addresses extensive market opportunities. Founders are willing to sell a percentage of ownership to scale that growth.
Venture capital firms do not just invest in software. They seek out high potential sectors in hot industries. These include media, food and beverage, life sciences, hard tech, media, and consumer goods in recent years. Many invest in multiple rounds of the same company. Ideally, as the company grows, a good portion of the next investment round comes from existing investors.
Accepting venture capital dollars commits the entrepreneur and the company to a specific path. That path defines an exit strategy, including when, why, to whom, and how much. Venture investment requires creating a board of directors, to whom the CEO reports. Routine and professional financial reporting is also required.
VCs Invest in Seed, Early, and Later-stage Companies
As an example, in 2019, 430 venture-backed companies received $133 billion in funding. About 60 percent ($80 billion) went to later-stage deals, 32 percent ($43.2 billion) to early-stage deals, and the remaining $9.6 billion (about 7 percent) to angel and seed-stage startups.
At this stage, the entrepreneur is introducing the product to the market to prove the viability. There are limited sales (0 to $1MM in revenue) and maybe even customer pilots. The company likely has two to five employees. The typical company valuation is $2 to $5 million, with VC investments ranging from $500,000 to $2 million. Typical investors are institutional seed-stage, angel investors, and, occasionally, participation from strategic investors.
Early Stage (Series A/B)
Companies at this stage have proven their concept and are seeking investment to accelerate customer adoption and market penetration. They have annual revenue of $1 to $10MM with meaningful customer traction. The company has demonstrated the ability to scale and employs from 10 to 75 employees. Typical valuations range from $10 to $75MM; typical investments for $1 to $15 MM. Investors are institutional VCs and strategic investors.
Later Stage (Growth or Series C+)
These companies have proven market adoption and are scaling, with 75 to 100+ employees and $10MM+ in revenue. Typical valuations are around $75MM+ with investments of $25MM+
Founders in the Midwest Can Raise Capital from West Coast VCs
Across the Midwest—especially in Ohio—the startup ecosystem is robust. In fact, in 2019, Ohio was in the top five states by venture capital raised in 2019.
Our internationally recognized research institutions and corporate innovators drive a pipeline of startups and deals. We can point to recent high-value exits. These conditions attract VCs. However, be aware, a startup in the Midwest will generally have a lower valuation than a company at a similar stage on either coast.
Rules of Thumb for Startups Raising Capital in the Midwest
Funding raising is hard, especially in the Midwest. A smaller capital pool equals more competition. The best way to compete and succeed is to plan, prepare, and execute. It all starts with a capital access plan.
Base your capital plan on an indication and measure of startup traction. Understand the key metrics that investors focus on in your industry.
Common traction indicators
- Letters of intent
- Customer surveys
- FDA stage
- Technical feasibility study
- (SBIR/STTR) grants
- Strategic partner investment
- Annual Recurring Revenue (ARR) or Monthly Recurring Revenue (MRR)
- Monthly growth rate
- Loan-to-value (LTV)
- Customer acquisition coast (CAC)
- Cohort analysis
- Gross margin
- Active users
- FDA stage of the process
- Validated in-vivo studies
- Clinical indication
- Clinical pathways
- Proof of concept – technical viability study
- Working prototype
- Commercially-ready prototype
- Product certifications (i.e. FCC, UL certificates)
Come up with a plan for achieving those metrics and map that plan against the company’s fund-raising timeline. Create a plan that ensures critical metrics immediately before when the company plans to start raising capital.