Welcome back to Deep Tech Catalyst, the channel where science meets venture. Together with global investors and experts, we uncover how to turn breakthrough scientific discoveries into investable Deep Tech startups.
Today, we are joined by David Charbonneau, founder, and managing partner at Boreal Ventures, a seed-stage Deep Tech VC fund, based in Montreal, Canada.
This episode is for anyone looking to navigate the complex waters of securing early-stage Deep Tech funding, establishing market traction, and understanding the nuances of venture capital finance.
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🏦 Basics of VC Finance for Deep Tech Founders
Venture capital is one of the riskiest asset classes, hence it seeks higher returns to justify the risk.
For instance, venture capitalists typically look for a minimum internal rate of return (IRR) of around 35%. The expectation of growth for companies that receive venture capital is significantly high because these investors are looking for businesses that can deliver outsized returns.
Most startups won’t receive venture funding; it's often less than 1% that do, which makes it a unique and competitive field.
As a founder, it’s essential to understand that when you offer equity to investors, you’re not just sharing profits; you might also be creating different classes of shares with distinct rights.
Preferred shares, which are often what investors receive, may come with control mechanisms like board seats, affecting the founder’s control over the company.
In summary, when you accept venture capital, you're engaging in a high-stakes exchange: you gain the capital to potentially grow your business rapidly, but you give up a portion of ownership and some control.
VCs need significant returns because they are assuming significant risks, and they need to deliver returns to their investors, the Limited Partners (LPs). It’s a fundamental part of the venture capital model.
Venture capital firms essentially offer capital in exchange for equity in startups. They act as intermediaries between investors (limited partners, or LPs) who may be institutions, banks, governments, or wealthy individuals, and the startups that require funding to grow. The venture capital manager, also known as the General Partner (GP), pitches the expertise and potential returns to these LPs and raises a fund to invest in companies over a typical 10-year period.
VCs earn management fees for running the fund and aim to generate returns through equity stakes in startups. The goal is to make a portfolio of concentrated bets, typically 12 to 15 investments per fund, hoping that a few will yield high returns due to the inherent risk profile of these ventures.
Since it’s challenging to predict which companies will scale massively, VCs look for certain factors like a strong team, a significant market opportunity, market growth, and a differentiated edge.
📊 The VC Game in Numbers
To illustrate with a numerical example: let's say a VC manages a CAD 40 million fund and invests $1 million for a 10% stake in a company. For that investment to pay off, the company would need to reach a significant exit value — in the hundreds of millions — so that the original 10% stake can cover and return the fund's investment. This is why VCs need to see the potential for startups to grow quickly and substantially.
Venture capital is about more than just money; it's about the potential for extraordinary growth and the venture capital firm's ability to guide startups toward that growth. This dynamic also involves time management because the fund has a finite lifespan to generate returns for its LPs. Understanding this time aspect is crucial to comprehending the full dynamics of venture capital.
A venture capital firm typically operates on a 10-year fund cycle. During the first four years, known as the investment period, the VC firm selects 12 to 15 businesses to invest in. The subsequent six years is the maturation period, where these companies work towards significant growth to reach a point where they can exit, through an IPO or sale, converting the VC's shares back into liquid capital.
An investment must align with this 10-year timeframe. For example, a company valued at $10 million at the start needs to scale to around half a billion in less than a decade. This requires intense growth and a culture capable of supporting such rapid expansion, which is the essence of venture capital.
🤝 The Value of Team Building in Due Diligence Analysis
On the topic of teams, VCs invest in people first and foremost. Due diligence involves assessing the individuals, their track record, expertise, and integrity. The ideal profiles include those with deep sector expertise who can foresee trends, researchers who have made groundbreaking discoveries and repeat founders with a proven history of success and an established network.
Advisors are also crucial. The best executives can articulate a clear vision and attract top talent and advisors to their cause. When VCs evaluate advisors, they look not just at names but at the level of involvement these advisors have with the startup. A big-name advisor who actively contributes time and expertise is far more valuable than a figurehead who is disengaged.
💰 The Ask
Finally, when it comes to creating an 'Ask' slide for investment pitches, it's crucial to strike the right balance. Founders should understand the ratio between the capital they need and what the investment will mean for the VC in terms of equity and control. Red flags include a lack of clarity around the use of funds, unrealistic valuation expectations, and a misalignment between the startup's growth trajectory and the VC's investment cycle.
Founders should aim to articulate:
their funding needs
how the investment will be used
and how it aligns with the VC's expectations for growth and return
Indeed, understanding market dynamics and valuation from a venture capital perspective is complex, and the landscape is always evolving. During high liquidity periods, like in 2021, valuations soared, and investors received less for their money. However, when the market contracts, the advantage can swing back to the investor. This fluidity means that startups must stay informed about current market conditions when seeking investment.
My top advice to founders is to build relationships with venture investors well before fundraising.
An informed VC can offer a high-level view of the market, guiding you on what terms might be considered fair at any given time. While founders might aim for a higher valuation, it may be strategically advantageous to accept a lower valuation for a smoother fundraising process, which in turn allows them to focus on building their product and business.
When a founder is raising funds, they are essentially selling a product—the equity of their company—which comes with its own risk profile and potential. Founders should be willing to adjust their expectations based on market conditions and seek advice from knowledgeable investors to navigate this process.
🚫 3 Things to Avoid When Pitching a Deep Tech Startup to VCs
The first is an excessive focus on the technical aspects, losing sight of the business side. Many technical founders forget that the technical part is merely an enabler for generating revenue. A 30-minute conversation dominated by technical specs doesn't equate to a business model. My first piece of advice is to understand your technology's broader scope and how it translates into a viable business.
The second pitfall is delivering a scripted monologue about your creation without building rapport with the investor. Remember, whether it's a Deep Tech startup or not, you're exchanging equity for the capital to reach significant milestones. By doing so, you're not just ceding control; you're inviting someone into your team, governance, and operations. Founders should establish rapport and view the pitch as an opportunity to interview the investor, as they will potentially be partners for the coming decade, steering a venture that's close to their heart.
Lastly, a common mistake is viewing venture capital as a shortcut to avoid asking oneself tough questions, such as actively pursuing sales. Many founders seek venture capital to 'go faster,' but since it's costly, it should be reserved for a particular subset of businesses. Instead of focusing on raising equity, founders should prioritize gaining commercial traction. This is crucial, as market demand for your product is the strongest endorsement you can get. That would be the third pitfall to avoid—using venture capital as a crutch rather than a strategic accelerator for growth.
🎯 Focus on Market Traction First!
Market traction is essentially the measurable evidence that your product or service is gaining acceptance in the market. It’s proof that there’s demand for what you’re offering, which can be demonstrated through sales, partnerships, or even significant user growth. It’s a critical indicator to investors that your business is on the path to profitability and scalability.
Now, regarding strategies to achieve and demonstrate traction, there are a couple of effective approaches.
Firstly, focus on early sales or commitments, such as letters of intent (LOIs), which signal market validation.
Secondly, develop strategic partnerships or distribution channels, which can amplify your market presence and credibility.
🍰 Your Equity, Your Early-Stage Product to Sell
Equity, in simple terms, refers to the ownership of a company. When you're starting a company, especially at the pre-seed stage, what you're essentially selling to investors is a portion of that ownership – your equity – in exchange for their capital. This capital is intended to add value to your company and bring your product to market. Unlike a bank loan, which requires collateral and is repaid with interest, venture capital is invested in return for equity, bearing the risk of the new venture.
This is all for today! 👋
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