Why startups need to better understand how VC works, and how it goes both ways

Not enough African startup founders understand properly how venture capital works, but investors also need to ensure they can empathise with founders if meaningful relationships are to be established.

In episode nine of Disrupt Africa’s “The month in VC” podcast series, released in partnership with Katapult Africa, Hlayisani Capital, ARM Labs Lagos Techstars Accelerator, and Atlantica Ventures, we chatted to our investor friends about how founder preconceptions around VC are often wrong.

Oyin Solebo, managing director of the ARM Labs Lagos Techstars Accelerator, said this is her experience, and that addressing these misconceptions is something her team really works on.

“One of the things that we are really deliberate about at Techstars is really encouraging our startups to be really thoughtful about how they approach VCs, who they approach and when, how they keep them updated… Because ultimately for both sides, both for the VC and for the startup, their time is super critical. So it’s really important that the right conversations are being had between the right VC and the right startup,” she said.

But what specifically do they not understand? It starts with something as simple as picking the right investor.

“A lot of startups, when they go into conversations with VCs, they don’t ask themselves that upfront question of “what is important? What is it that I’m really looking for, beyond money?” Because not all money is equal. So I really encourage our founders to be really deliberate when they are choosing an investor. That means making sure that they’re doing some research on who that investor is, what their investment thesis is, does it actually even align with theirs, what stage of investment do they make so…” Solebo said. 

“There’s no point in a pre-seed startup going and speaking to a big Series A investor that’s not going to look at them though. They’re wasting both of their time. And also understanding whether they even have capital at that moment to deploy. So it’s really important for a startup to do that initial research.”

A lot of startups also don’t know how they should approach VCs.

“On many occasions, a warm introduction or referral is really important, but in some cases there are some VCs that are actually really open to cold introductions, really open to these founders reaching out to them on LinkedIn or other social media platforms. They may even have something on the website where a founder can put information about their startup on that platform,” said Solebo.

She also believes a lot of startups waste time at this point because they don’t ask upfront what the process of the investor in question is.

“Each VC will have a different process. There are some that have a really stringent five-step process, and if you ask them, they will tell you that upfront. Knowing that upfront is of so much value, because it enables the founder to get prepared, so they know what information they’re going to need to share at each stage. But number two, when the Vc starts to go off process, they can see that and they can see that actually the conversation is not going the way they intended, maybe it’s not the best use of time,” said Solebo.

Startups also often don’t know how to continually engage with a VC, both before and after an investment is made.

“They’re not sure how many times they should keep following up with the VC, and they are not sure whether or not they should add them to their investor updates. Or, in fact, in many cases, what an investor update email should actually look like,” said Solebo.

She believes that startups often don’t realise how much value they are bringing to a VC, viewing it as a hierarchical relationship rather than a symbiotic one.

“The startup needs the VC for capital, but the VC also needs a startup to generate a return for their LP. Because that relationship is symbiotic, it means that it should be more equal. It’s not just a case of a VC asking for information, asking for data, and then going cold. The VC, if they’re a good VC, knows that they should also be adding more value to that startup. They should be providing them with strategic and tactical guidance and commercial introductions, or introductions to other investors if they’re doing follow-on funding rounds,” said Solebo.

So it goes both ways. In more ways than one, in fact. Muthoni Wachira, partner at Katapult Africa, says many investors don’t understand enough about what it takes to grow startups.

“There are a lot of preconceptions and misconceptions both ways. We’ve not had VC to a great extent in Africa until quite recently, so we are all still learning, and it will take some time for startups to understand VC and for VC to understand startups. But I think there needs to be concerted efforts from both sides,” she said.

Startups also need to realise that not all businesses are venture-backable.

“As a venture capitalist, when we’re making a decision, we’re asking “can we get a 10x return?”, simply because a large portion of our portfolio won’t get there. They’ll fail, or they will return 2x or 3x, modest returns,” Wachira said. 

“But we are looking for those that will return 10x, so at the outset where we’re making the decision we need to have a high degree of conviction that this is a real possibility given the size of the market, the business model, the team… Not all business models have that aggressive revenue growth that we’re looking for, and so if you’re not in that category seeking venture capital is foolhardy. There are alternatives, not many, but there are alternatives, including having really healthy unit economics and growing off your own revenue and profitability, which is what traditional businesses and SMEs have done for eons.”

Mathew Palin, partner at South African VC firm Hlayisani Capital, says he believes understanding is improving drastically.

“We’ve got a lot of really good initiatives out there with educational content, so I think that education is improving. We make our term sheets or the template term sheet freely available to anyone, but of course you might be able to read a term but not really understand its implications and what it means. It’s always going to be this journey of understanding,” he said.

Due diligence is often thought of as a one way street, but it is equally important for startups to do due diligence on potential investors.

“It’s like a marriage, they are going to be working together for a long period of time. So it’s really important that the startup knows who they’re getting into partnership. It’s really important that they’ve got a great track record of adding value to the founders, and a great track record of being good to the founder when times are bad,” Solebo said.

Wachira agrees.

“You’re essentially getting into bed with this investor for a long period of time, 5-10 years, which is a significant part of your journey as a founder,” she said. “Some investors demand a board seat, so they will have significant influence on strategy and how you expand as an organisation. I heard once that if you can’t have a beer or a glass of wine with the investor, don’t take their money,” she said.

Palin says too often startups do not do their diligence, which he puts down to a scarcity in funding.

“An investor will come to you and you might not have any other option, so you’re kind of forced to go with it. But there can be problems out there. You should always vet what other investments have they made, and try and speak to those people. What are they like as a board member? You need to understand what they like from that perspective. You also don’t want bad money or corrupt money, and obviously there’s some of that that unfortunately floats around our ecosystem too,” he said.

Increasingly, the startup and VC worlds are starting to overlap – as successful founders become investors themselves, and movement between the two becomes more common.

“I think that this convergence of operators becoming investors is a great thing for the ecosystem because they’re not just coming with capital, they’re coming with firsthand operational experience of what it takes to build a startup,” said Solebo.

Wachira says regardless of previous operator experience, fund managers are also entrepreneurs in their own right, working with their own investors.

“They are walking a similar journey to startup founders in identifying investors who are good for their own baby, their own fund, and working with them to ensure that they are aligned in interest and that they’re supportive,” she said. “For us, startups are our customers. So we straddle both sides in a similar way that startups do, having customers on one end and investors on the other and having to create value and make a return.”

In fact, it is fair to say that there are many similarities between startups and venture capital funds. Palin says he still refers to Hlayisani Capital as a startup, even after 10 years and various funds. 

“We sometimes go without salaries, like some startups have had to do and are doing, and when there’s challenging times in fundraising. A venture capital business is a business just like any other business, and we go through that process of the challenges and also the joys,” he said.