Startups Funding in Nigeria: Venture Capitalist Approach to Assessing a Business  

 

By Omodiaogbe Samuel

Last Updated: December 8, 2023

We all hear stories of great companies like Apple, Google, Microsoft, Facebook, Alibaba, and other successful companies on how they started. We hear how most of them started from the garage or dorm room and eventually became successful. But we usually don’t hear the steps they took from the humble beginning to arrive at the top. Without funding most of them wouldn’t have survived, or at best, remain very small companies. Most of them received series of funding before they eventually went public. For example, Facebook received 11 series of funding, before its IPO (Initial Public Offering) in 2014

Venture Capitalists (VCs) are the early-stage investors of the startups for equity stake. They are not there to remain with you forever, they invest early and stay for about 10 years and then sell off their share in trade sales or recover their investment through an IPO. So, understanding why and how VC invest in companies would go a long way in your preparation for entrepreneurial journey. I hear stories from most entrepreneurs in Nigeria on how they submit their Business Plans to banks for funding, but they never heard from them. Such stories make us feel that banks are wicked, without trying to understand the bank’s business model. Banks prefer to invest in companies that have generated cash flows, as that would enable them to assess the credit worthiness. Banks want you to have collateral to hedge against risk. Banks are not good at assessment of business ideas to know the ones that would fly or not.  Bank wasn’t set up to take equity stake in a company, and so can only lend you money when you meet basic criteria.

Ideally the first option for entrepreneur should be equity investment. This starts from your personal savings, then FFF (Family, Friends and Fools), then to minor angel investors, from there to super angels, before venture capitalists, and then possibly private equity investment. Today, crowdfunding has been added to the equation as well. However, our main focus is on Venture Capitalist, and this is understandably so because they are the major funder of most companies. You only need FFF, angle investors or crowdfunding when you’re at the very early stage, and the amount required is low. But when you want to scale-up your business, then you need substantial investment, and that is where VC comes in. Private Equity buy into established private businesses that they feel were not well managed. They take stake in them and turn things around for better valuation.

How Venture Capitalist Invest

According to research on VCs across the globe, the average VC:

  • Receives 2,000 Executive Summary of 1-2 pages per annum
  • Read 500 of them, and thereby rejecting 75%
  • Ask for the full business plans for the 500
  • Out of the 500, holds appointment with 200
  • At the end of the selection process, fund 20 of the companies, and that makes it just 1% of the original 2,000 that approached the VC for funding

The question is how do you make that top ‘lucky’ 1% or 20 out of 2,000? As the analysis revealed, all the 2,000 companies demanding funds had business plans, and so the issue is much more than a business plan. Besides, the worse crime you can commit is to pay someone to write a business plan for you without you input, and that means you may not be able to defend what was written. So, what does a VC cares about, and want to see addressed in your business plan? We want to look at the main components of the business plan that are of interest to the VC and what they expect to see there before making an investment decision. Our focus here is understanding why and how VCs invest in companies. I know we don’t have many of them around in Nigeria, but that doesn’t mean there are no VC funded companies in Nigeria, particularly in the IT sector. Fundamentally, what we really want to highlight is how a professional equity investor determined whether your company deserve funding or not, and how to prepare your mind for such investment.

By understanding what VCs cares about before funding a company would not only prepare our minds for external investors, but also help us to structure our venture for competitiveness. Now we want to look at the core components of the business plan that are of concern to the VC and how they assess the plan, and then take a deeper dive at each of them

  • Business Concept
  • Management Team
  • Market Analysis
  • Operations Plan
  • Marketing Plan
  • Financial Plan, and
  • Business Model

Business Concept

What problem do you want to solve in the marketplace? You must identify a problem that need to be solved before venturing into a business. The solution you want to offer must be compelling enough to convince the customers to switch to your product or service. This is the first stage a VC want to see to determine whether the effort of going further is worth it or not. The problem you want to solve must be compelling and your solution must be distinctive enough to convince a VC to invest. Having business idea is not enough, anybody can come up with a business idea. The important thing is the market need and how you will deliver on that. For example, you may want to set up sports newspaper company in Nigeria, because you feel lots of people love sports.  The issue is, can you create a viable business out of it given the proliferation of sporting sites, cable TVs, social media, the conventional TV and radio stations? All these factors affected the sports newspaper business and the revenue continued to decline over the years. So, a careful analysis would inform you that there is no gap in the market, and therefore you don’t have a need to fill.

Management Team

For most VCs, the management team is the most important thing they care about. Who are the people behind the company? What is their pedigree? How are they composed? What is their leadership or management capacity? Do they have what it takes to scale-up the business? How willing are they to learn? How does the backgrounds of the team uniquely align together to drive the business to success? These and other questions the composition of your team need address. So, if you’re a sole rider, you’re not for VC funding. You need to have the right team in place, or you give them the timeframe to fill in the missing skills if you don’t have all on board. To a VC, a good business idea is not enough, they believe that good team can even turn a bad idea into a huge success. Your team need to be diverse and each bringing distinctive capabilities on board. VC wants to see diversity, yet a compatible team

Market Analysis

You need to understand the market you are operating in very well. What is the structure of the industry? What is the stage of the market life cycle? Who are your competitors and what is the intensity of competition? What is your competitive advantage? These are some of the questions the VC would like you to provide answers to at this phase. For example, VCs are reluctant to invest in matured or declining market, no matter how compelling your idea could be. They prefer growing markets, most likely above 25% annual growth. They believe that it’s easier to make money in a growing market than matured or declining market. Also, you need to understand the competition in your market and what it takes to be successful. A market with high intensity of competition tends to be low in profitability due to the rivalry nature among the competitors. So, a VC would prefer a market with low competition and high profitability. You need to let them know what is it that makes you unique compared to the existing players, and how you want to leverage on your strength to your advantage.

 

Operations Plan

The way an organization secures, deploys, and utilize its resources will determine the extent to which it can successfully pursue specific performance objectives. The VC is interested in how you run your operations, value chain, supply chain, and your stakeholder management. In all these areas, they want to see your performance relative to the industry standard or benchmarked against competition. For example, if after factoring the cost of production, your cost of producing per unit sachet of tomato is 30 naira, but the industry average cost is 25 naira, then there is a problem in your operation process. They are also interested in your supply chain, distribution channel, and other key activities in your operations. Knowing all those factors will inform their decision of the riskiness of your business. They don’t want a market where a single supplier can hold you to ransom, or where you have a few buyers. Your operations plan should be convincing enough to make them know that you can run efficient operations with minimal risk.

 

Marketing Plan

This comprises of how you structure your marketing system to address issues like the market segmentation, targeting, positioning, pricing, and how you generally relate with the customers. At the end of the day, they want to know how your marketing strategy can help you make enough sales, price appropriately, and generate high profits. To convince them, you should be able to provide data to justify your marketing plan. Your historical data need to be aligned with the forecast data. For example, if your data in the past 3 years shows that you sold 100 units in your first year and 10% growth rates in the subsequent 2 years, then your forecast for the 4th year is 1000 unit and 30% growth rate in the next 5 years, then there is a problem. Such historical data and the forecast are far apart and hard to justify. Let them know how your market is segmented and your targeted customers among the multitude. You value proposition should be distinctive enough to set you apart, and so you need to show the VC what you’re doing differently.

 Financial Plan

 

Here we want to look at financial accounting, with focus on the balance sheet, income statement, statement of cash flow, and the use of proceeds.  For the balance sheet, income statement, and statement of cash flow, you need to provide data of your performance in the previous years, most likely the last three years. Also, you need to provide the pro forma version of them showing your forecast in the next five years. VC is particularly interested in the statement of cash flow, and that is understandably so, no business can survive without cash, and so how you generate and spend it is important.

Statement of cash flow has three components: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. On the cash flow from operating activities, you need to let the VC know how you will generate cash from your operations. This is very important because if you cannot generate cash from your operations, it then means you will always resort to external financing for your investing activities. How will you use the funds from the VC to generate cash in order to scale up your business? Positive cash flow from operations is crucial overtime as you cannot continue to be operating with external finances. Therefore, your pro forma cash flow from operating activities should show a progressive growth towards that end.

Use of proceed is equally very important to the VC. What do you need VC’s money for, and how will you spend the money?  When do you project to be eventually be self-sustaining? What is your plan for future funding in the subsequent rounds? All these are answers you need to provide to the VC on how you will use their money. Most times, the VC money will not be given to you in bulk but in tranches over a period of time. They would like to measure your progress against the projected figure, and therefore will continue to release to you the agreed amount in batches over time.

Business Model

There are lots of business model methods out there, but we are interested in a simple business model here that is comprised of four action points and they are sell high, buy low, collect early, and pay late. This business model is simple and allow the VC to make quick decision about your business

  • Sell High: what do you need to do to be able to sell your product or service at a higher price? You should be able to convince the VC how you will be operationally efficient and eliminate wastages in your operations. Also, you need to show them your pricing structure and why you think that is the best way to price you offering
  • Buy Low: this also has to do with profitability in the area of ability to save cost. You need to convince the VC of your bargaining position with the suppliers and how you will be able to buy you raw material for lower prices
  • Collect Early: you should be able to collect money from your customers as early as possible. Delay in collection means you may need to resort to the bank for loan in order to fill the gap between selling and collecting, and that comes with interest. VC does not want that; they want a business that should not be trapped by the buyers
  • Pay Late: this is the opposite of collecting early. They want a situation where you should be able to delay payment to the suppliers. If you pay suppliers late, it means you would be saving the money you should have spent for such early payment, and that ends up boosting your finance for operating activities

Basically, the business model we have highlighted here is good Working Capital Management in financial accounting. To really understand this, you need to know a bit of account payable, account receivable and inventory management in your financial accounting

After meeting all the above criteria to the satisfaction of the VC, are you now handed over the money? Not yet! That is just the first hurdle you need to pass through, and that will lead you to the second hurdle. The VC need to conduct due diligence to ascertain that what you provided on the business plan is actually the state of things. If you pass the due diligence test, then you go to the contracting stage, and this is where the Term Sheet of the VC comes in

 

                                                      Term Sheet

Term sheet is beyond the scope of what we want to address in this topic, and that is because it requires a topic of its own. However, we need to highlight what it entails by providing bullet point on what you supposed to know about the term sheet. You should be able to speak the language of the VCs to flow along with them, and the language is more reflected on the term sheet

The term sheet is deeply rooted in the New Institutional Economics with emphasis on the Principal-Agent Theory. This theory helps the VC to guide against risk because human beings are difficult to fully trust, and so they would like to avoid information asymmetry, opportunistic behavior and moral hazard. On the information asymmetry, one side of the two parties may know what the other doesn’t, and therefore use what he knows against the other party. In this case, the VC suspects that there is information you could be hiding about your business despite the due diligence, and so would like to guide against that. On the opportunistic behavior, the VC want to be sure that once he gives you the money you will not spend it on personal interest or projects not related to the business. Moral hazard simply means the VC suspects that once you got the money, you could take on excessive business risks, after all if anything happens you don’t have anything lose, it’s the VC’s money. All these factors are what the VC want to guide against with the Term Sheet, particularly on the control part.

The venture capitalist term sheet has two parts, the economic term sheet and the control sheet. We don’t want to go into details of each of them but just to provide bullet points of what you should expect to see. The below terminologies are the language of the VC you need to be familiar with by knowing what the mean

                                 Economic term sheet: Terminology               

·         Stocks

·         Valuation

·         Pre-money

·         Common stock

·         Redemption rights

·         Post-money

·         Preferred stock

·         Option pools

·         Vesting

·         Convertible notes

·         Cap vs. ‘no-cap’ notes

·         Warrantee

·         Stock rights

·         Conversion rights

·         Dilution

·         Liquidation preference

·         Preemptive rights

·         Anti-dilution

·         Participating preferred

·         Ratchet

·         Pro-rata rights

·         Dividend preference

·         Full ratchet

·         Buyout

·         Series

·         Accredited investor

·         Trade sale

·         IPO

·         Callable and puttable securities

·         Right of first refusal

·         Exit ratchet

·          

·          

                                         Control Term Sheet: Terminology

 

·         Information rights

 

 

·         Confidentiality

 

 

·         Exclusivity

 

·         Enforceability

 

·         Protective provision

 

·         Redemptive rights

 

·         Registration rights

 

·         Co-sale rights

 

·         Right of first refusal

 

·         Board representation

 

·         Drag-along, tag-along

 

·         Control rights

 

·         Lock up

·         Permitted transfer

·         Staging technique

These terminologies are all subject to negotiation, as a matter of fact they are the basis of negotiation with a VC. Although you may need the services of financial experts, lawyers that understand startup funding, startups consultant, and experience management experts to better negotiate these terms, but you need to know what is obtainable. For example, if you don’t know the difference between pre-money and post-money valuation, you may end up signing out a substantial part of your company only to realize it during trade sale. Certainly, for the technical details, you need experts to help you negotiate the terms, but you have to know what is been negotiated as you’re the one to sign the contract at the end of the day. This may not just apply to the VC alone, but any professional investor will negotiate with you based on those terms

Adaptive Business Plan

Your business plan need not be generic, it should be flexible. All we have stated above is CV focused plan, and we deliberately decided to focus on the VCs because they are the largest funders of startups across the globe. Next to the VC are angel investors, and what is applicable to VCs is almost the same expectations of the angel investor because they are professional investors as well. There are other investors, financiers or stakeholders out there that you might need to approach for funding or finance that would also require your business plan, and what they might be interested in could be different from what a VC is interested in. Therefore, you need to prepare your business plan to suit the interest of different stakeholder in a flexible approach. For example:

  • Impact investors or an NGO: you might need funding from them, and they are more interested in solving social problem or tackling sustainability issue. Therefore, your business plan should emphasis more on how you want to solve societal or sustainability problem, rather than what a VC could require
  • Bank: before they offer you credit facility; a bank might request for a business plan. Bank is more interested in your cash flow, because they want to determine your ability to pay back the loan and interest as scheduled. So, your business plan needs to focus more on what you need to do to generate positive cash flow from your operations
  • Government agencies: there are government agencies that assist entrepreneurs with grants, low interest loans or interest free loans. What they care more about is job creation, and so you need to emphasis how your business can create jobs
  • Key employees: before they decide to join your team, they want to see your business plan to determine whether the risk is worth it or not. Their main concern is about job security and the ability to fulfill their career ambition in your organization, and so your business plan needs to focus more on what you need to do to create a viable business

Basically, your business plan needs to be flexible enough to address the needs of a particular stakeholder you are dealing with. For example, if you want to secure funding from impact investor but emphasis more of what a bank should require, then thing might be difficult. Take note; I’m not saying you should be writing different business plans all the time. It should be the same business plan that emphasis different things to different stakeholders. All our focus here has been on CV and by extension, other professional investors, and the business plan emphasized what they care about and want to see. The topic was not how to write a business plan, but focused on how a VC assess a business, that was deliberate because VCs are the largest funders of startup across the globe. You might start small, but when you want to scale-up your business you might require investment from VC or other professional investors, and that has been our focus

                              Conclusion

Research has it that venture capitalist only ends up funding 1 out of every 100 proposals they received, and so our aim was to highlight how they eventually arrived at that 1. We know in Nigeria, VC activity is low, but the whole idea was to prepare your mind on how a professional investor would look at your company in determining whether it’s worth investing in or not. Writing a business plan in not enough to secure funding, VC needs to determine the feasibility of your proposal based on different criteria. VC is not charity, but companies that equally have investors too.  So, they want to ensure that you have the proper structure on ground to make the company successful. They don’t only provide funding, but support you with their managerial competence, networks, and moral support.  They work with you all through the journey before the final exit either through trade sale or IPO. Most great companies you know of in the US, Europe, and Asia were largely funded by VC, and our aim is to make Nigerian companies to be attractive to VC funding, and to be globally competitive

Omodiaogbe Samuel, MSc. CMC, ChMC, FIMC

Omodiaogbe is a Strategic Management Consultant, and he the Principal Consultant/CEO at Vast Thinking Consults Ltd where he help organizations and business leaders to create superior value. Omodiaogbe holds BSc. and MSc. in Economics. Also, he is a Certified Management Consultant (CMC), a Chartered Management Consultant (ChMC), and a Fellow, Institute of Management Consultants, Nigeria. He is an Instructor on Coursera, where he teaches 25 courses in Strategic Management. Omodiaogbe is one of the world’s leading MOOCs learners on Coursera and Edx with over 500 Certificates from top-ranked Universities and Business Schools. His areas of expertise centers on Strategic Management

Contact him:
Email; somodiaogbe@vastthinking.com.ng
Visit: www.vastthinking.com.ng

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