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Inside look at venture capital - nine facts, eleven keys and five lies

The premise of a relatively new asset class, venture capital companies (VCCs) is that investors get tax benefits and strong returns. Clive Butkow, chief investment officer, recently launched Grotech, where investors are entitled to deduct the full amount of their investment from their taxable income in the tax year ending 28 February 2016. The tax relief is 41% for individuals and trusts and 28% for companies which mitigates the investment risk and significantly enhances the potential return.
Inside look at venture capital - nine facts, eleven keys and five lies
©Ion Chiosea via 123RF

A former COO of Accenture South Africa, as well as the former lead of its technology business, Butkow has 28 years of experience in management, technology consulting as well as venture capital. As a mentor to entrepreneurs, Clive says that the most frequent question he is asked is, “How do I find the money to start or grow my business?” In this article, he shares what he has learnt from sitting on both sides of the table so that you can increase your chances of raising capital for your business.

Clive explains that there isn’t any magic, and contrary to popular myth, nobody is waiting in the wings to throw money at you just because you have a new and exciting business idea. He believes that the most important question you need to ask when building or scaling your business is not, "How do I raise venture capital?" but rather, "Do I need to raise venture capital?"

Key facts about raising capital in South Africa

1. Less than 1% of businesses raise start up venture capital and less than 2% raise capital from angel investors.

2. In 2014, R141 million was invested by venture capitalists in 34 transactions.

3. The average cheque size in 2014 was R3.4 million.

4. Most of these investments were made in high tech companies.

5. The VC industry today in South Africa manages around R1.87 billion across 168 active deals.

6. The VC asset class continues to expand in line with an increase in high tech activity in the market.

7. Exits are increasing.

8. Only 7% of businesses in SA reach their third birthday.

9. Most businesses in SA are self funded – only 3% are funded by VC or angels.

10 keys to the investor’s vault

Key lessons which I learnt about raising institutional capital from angels or venture capitalists

1. Million dollar entrepreneurs are in short supply. It is a myth that there is insufficient capital in South Africa in the entrepreneurial ecosystem. In fact, it is difficult to find suitable entrepreneurs to fund. There are millions of ideas but not many million rand entrepreneurs. There is an enormous skills gap between an entrepreneur and a scaleable entrepreneur, or gazelle. The world is not short of great ideas or products but the world is short of great entrepreneurs - there are many more R1 million opportunities than there are R1 million entrepreneurs.

2. Raising capital does not validate your business model; only customers do. Capital plays a critical role in the ability of a business to progress, but it is not the only catalyst for success - a bad business with or without capital is still a bad business, just one with more time to fail. Raising outside capital isn’t the only way to grow a business - it’s only one way. The goal is to build something great, no matter how or whether you raise capital.

3. Investors back the jockey before they do the horse. Investors actually invest in people and not ideas, products or services. Investors prefer to invest in teams than in individuals, so you need to attract a team smarter than you. It’s not what you do that will define your business but how you do it (innovation and marketing). Have you put the right team together? People are far more important than the idea or product. Money follows management in the world of business capital. Whilst many entrepreneurs have a great product or service, they do not demonstrate the business skills to build a successful business around that product or service.

4. One is not a team (100% of nothing is nothing). Do not try and take the journey alone. Decide if you want to be king and be in control or to if your desire is to create wealth? Dilution is less important than success because 100% of nothing is nothing. Rather have an abundance mentality. Every startup needs two types of people: the product development people and the sales people - someone that can make it and someone that can sell it. In tech speak, it’s the hackers (coders) and the hustlers (the folks that can sell). Product development and sales are on a par and every startup needs both. Hire the best team on the planet.

5. Bootstrap your company before you try and raise institutional capital. Funding the business yourself will help you avoid giving up too much equity too early. Rather focus on signing up customers to increase the value of your company. Get traction, or paying clients, before the investor pitch. The prototype or traction is one of the most critical steps in raising capital; not the business plan. Very few companies get seed funding without some kind of traction.

For VC, it provides early evidence that there is a problem and your solution or product is going to have a shot at addressing it. Incidentally, some people think that a bootstrapped business must by its very nature be a trivial one. They are wrong. Companies such as Hewlett-Packard, Dell, Microsoft, Apple, and eBay all started with a bootstrap model.

6. You are either running and building your business or raising capital. Raising capital is extremely time-consuming and it can be better spent getting customers and developing your market. Most businesses do not fail due to product development, they fail due to lack of customer and market development.

7. Think like an investor - make the deal attractive to the investor. Put yourself in an investor’s shoes and understand his business model. Investors look for scaleable businesses, so to raise finance you need to show your traction and how you will scale. Remember they are looking for a home run with every deal which equals a minimum 10 times the return. Are you a VC type of deal? VCs will look at your deal from three angles and you need three yeses to get capital:

• Are you investable?

• Is the deal investable?

• Is the risk investable?

Many viable businesses do not raise VC funds as even a good business does not equal an investable business. VCs know that out of ten swings at the bat, they may get seven strikeouts, two base hits, and if lucky, one home run. The base hits and the home run pay for all the strikeouts. They don't get seven strikeouts because they're stupid; they get seven strikeouts because most startups fail, most startups have always failed, and most startups will always fail.

So logically their investment selection strategy has to be a credible potential of a 10x gain within four to six years on any individual investment. This means that the winners will pay for the losers in the timeframe that their investors expect. From this, you can answer the question of which startups should raise venture capital and which ones shouldn't. Startups that can be sold or go public for a 10x gain on invested capital within four to six years from date of funding should consider raising venture capital.

8. Investor hot buttons. There any many ingredients required to make a startup successful. For me the most critical three ingredients are:

• Good people - have the best team on the planet.

• Make something customers want by confirming product market fit.

• The ability to sell and make getting and keeping customers your number one priority by adding more value to your customers lives than anyone else is adding. Your product or unique selling proposition needs to be ten times better than anything else on the market. Investors want to see early traction - some sort of indication that not only is your idea is great, but that you talked to customers, built a minimal viable product and you have some kind of traction, i.e., proof that you can do it and it may work.

Other hot buttons for an investor include:

• Potential for high growth

• Large market potential when you scale

• High margin business

• Repeat customers and annuity revenue

• Viable risk reward relationship

• Obstacles to competition.

9. Prepare well and make your forecasts realistic. To be ready to fundraise, you need to have strong knowledge of the problem you are solving, the reasons you started your business and your customers, the market opportunity, competition, distribution channels, break even and burn rates, runway that the capital injection will provide. Explain to the investor exactly how you will use their funds, but do not ask for high salaries as investors will not fund your lifestyle.

You are going to be asked lot of questions and if you are not prepared it will come through and it will be a big turn off. Do not use a top down approach when calculating your numbers; instead use a bottom up approach. Validate your financial figures and show that you have achieved product market fit. Your forecasts are a bunch of hypotheses or guesses – but for a startup it is more about market research, initial traction and the team.

10. Begin the discussions for money before you need the money. Investors don't want to meet you, they want to be introduced to you. Get a soft introduction to an investor if you are serious about raising money. This is about relationship capital - develop the relationships with VCs before asking for money. A soft introduction to an investor is the most effective one. Leverage your network for access. Grow your network at every opportunity. An entrepreneur’s network is their net worth. The best way to manage your VC is to meet your projections. Remember venture capital is not for everyone, as every venture capitalist wants to fund the next Google.

Don't assume your VC can always add value - they have numerous investments and board positions and don't always have the time for your company. Have realistic expectations of venture capital. All investors are different. They like different verticals. They write cheques of different sizes. Just because they are an investor does not mean they are the right investor for you. Doing research, understanding what a particular investor likes and why you might be a fit is important. It is equally important to get an introduction from someone who knows you and knows the investor. People will decide quickly and the first couple of minutes is key to winning over the VC. Don't spend 15 minutes on the background!

11. Not all money is the same - you want smart not lazy capital. Every entrepreneur needs four types of capital to grow a successful scalable business. Firstly, mentorship capital: the exposure to experienced entrepreneurs that you will meet and who will provide mentoring though training, the pitching and judging process and many other interactions. Secondly, social capital: the access to the networks of these entrepreneurs to open doors to help you start and grow your business.

Thirdly, human capital: every business needs the best people and you will through this network have access to the right people to help you scale your business. Lastly financial capital: the capital awarded to the finalists as well as opening doors to other institutional capital like angel and venture capital. There is no shortage of money looking for a home but you need four types of capital from an investor and not only financial capital.

Five lies entrepreneurs tell VCs

• My forecasts/projections are conservative.

• I have no competition – no one else can do what we are doing. (If there are no competitors you are most likely building something no one wants.)

• Gartner says it will be a R10 billion industry in five years and all I need is to get 1% of the market.

• I have secured ten of the top JSE 100 companies and they are ready to do business with us.

• Hurry up because other investors are about to do the deal.

Five lies VCs tell entrepreneurs

• I liked your company but my partners did not.

• If you get a lead investor, I will follow too.

• We have lots of bandwidth to dedicate to your company.

• This is a standard contract, sign it quickly.

• We love to co-invest with other firms.

• Show us the traction and we will invest.

Both parties are prone to using these lines. The difference between the two is that the investors have money.

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