For Startups, It Pays to Partner With a High-Quality VC, Even If You Give Up Some Equity

August
25, 2021

5 min learn

Opinions expressed by Entrepreneur contributors are their very own.

The variety of enterprise capital (VC) funds has exploded in recent times, giving entrepreneurs extra choices than ever to finance their startups. There at the moment are near 2,000 VC corporations within the U.S. alone, with over $54 billion invested in early-stage startups every year. Discovering the precise VC to associate with could be make or break for a younger firm, figuring out how a lot cash it raises and the recommendation, networking and assets it beneficial properties entry to. How can entrepreneurs establish one of the best VC for his or her firm and keep away from turning into one of many overwhelming majority of startups that don’t make it?

When fundraising, entrepreneurs typically have their imaginative and prescient muddied by the will to maintain as a lot fairness as potential, hoping to take care of better management and the opportunity of an even bigger payoff down the road. Nevertheless, my analysis as a professor on the College of Southern California’s Marshall Faculty of Enterprise exhibits that VC high quality is far more necessary than fairness share or different contract phrases. In a latest research, my colleagues and I discovered that the highest-caliber VCs provide founders a smaller slice of an even bigger pie, taking extra fairness however practically doubling the worth of their corporations in comparison with lower-quality VCs.

Associated: 5 Unconventional Methods to Appeal to VCs

Founders could be rewarded for giving up some fairness in the event that they choose the precise VC

It’s true that VC traders take a considerable stake of the businesses they fund. Our evaluation of first-round funding for greater than 2,500 startups over the course of a decade confirmed that VCs sometimes took extra fairness and stronger contract phrases than had been optimum for maximizing an organization’s future worth. An efficient investor stake of 28% (together with fairness and different preferential contract phrases) led to the very best firm worth, however the common deal gave VC traders a stake of practically 50%.

This discovering might sound to substantiate founders’ fears about giving up fairness. Nevertheless, our analysis additionally confirmed that the influence of VC high quality — a holistic measure combining many various elements in our mannequin — greater than makes up for the tendency of one of the best VCs to take extra fairness. Startups that obtained funding from the highest-quality VCs had been valued 89% increased than people who obtained funding from the lowest-quality VCs. In consequence, the founders’ share was value 33% greater than if they’d partnered with a low-grade investor. Painful as it might be on the time, founders could be rewarded for giving up some fairness in the event that they choose the precise VC.

The distinction VC high quality makes displays the numerous issues these traders do for a younger firm. VCs are sometimes very hands-on and assist with connections, recruitment and strategic recommendation, particularly in the event that they obtain a board seat as a part of their funding. Analysis has repeatedly proven that corporations funded by high-caliber VCs are extra profitable at reaching an IPO or acquisition than their friends. As well as, partnering with a well known VC could be a popularity increase: Corporations with a distinguished VC backing them exit quicker and at increased valuations.

Even one of the best VCs don’t demand overly lopsided phrases nowadays. The sheer variety of VCs, together with the expansion of different early-stage funding choices like angel networks and crowdfunding, has led to better competitors to put money into promising startups. VCs additionally know that they will hamper a startup’s future development and their very own earnings by taking an excessive amount of fairness.

Associated: The three Massive Issues VCs Search for When Funding Startups

Founders ought to community early and infrequently

It’s clear from our analysis that figuring out a high-quality VC is crucial to a younger startup’s success, however defining “high quality” is extra of an artwork than a science. To start, founders ought to take into account a VC’s popularity and monitor report and get enter from different entrepreneurs who’ve labored with that investor up to now. Discovering the precise match is extraordinarily necessary since an investor will sometimes be a associate within the firm — and doubtlessly a board member — for years to come back. The higher a VC understands and helps the founders’ imaginative and prescient, the extra they will be capable of contribute to the startup’s growth.

Founders ought to community early and infrequently and speak to as many VCs as potential, evaluating what every can deliver to the desk and whether or not that justifies giving them the next stake. Having a number of affords offers founders extra bargaining energy when it comes time to barter contract phrases. As well as, founders ought to ask potential companions about how their fund is structured and what cash might be obtainable for follow-on rounds. All through the method, founders ought to focus totally on the lead investor since they may negotiate the phrases, obtain the lion’s share of fairness and be probably the most concerned in serving to the corporate develop.

Elevating the primary spherical of VC funding is a defining second within the lifetime of a startup. Because the variety of VC corporations and different fundraising choices has grown, discovering the precise associate has grow to be extra daunting. My analysis exhibits that selecting a superior VC can practically double the overall worth of a startup and result in a greater payoff for each VCs and founders. Given the necessary position VC high quality performs, founders ought to look past fairness stakes and contract phrases and take into account what an investor can do to assist them develop their firm — even when it means giving up a bit extra fairness within the course of.

Associated: VCs Need to See Product-Market Match: This is Find out how to Show It