In the coming weeks, we'll discuss funding for tech services companies. Our mission at Vixul is to build the same ecosystem for tech services companies that exists for product companies. Funding is an essential part of that ecosystem. With the returns early tech services companies are able to provide in their growth, many founders are surprised when they discover that most funding sources will not take them seriously. But before looking into available funding options, we wanted to develop a better understanding of why funding for tech services companies is different from tech product companies.
Understanding Traditional VC
When we think about funding in tech companies, our thoughts immediately go to venture capitalists in Silicon Valley. HBR provides a great primer on how VC is structured and works. Tech services founders quickly discover that traditional venture capital does not invest in services companies. This is because of the particular way a venture fund is structured and the expectations they make with their investors.
Venture Capital (VC) firms typically target a high Internal Rate of Return (IRR) between 25-35% due to the high risk associated with investing in early-stage companies, many of which may fail. However, it's important to note that VCs invest in a portfolio of companies expecting that a small number of investments will yield exceptionally high returns to offset losses from the majority that may underperform or fail. In general, a VC needs a company in their fund to give returns of 10-20x for their fund to deliver on its promise. This translates into a 60%+ rate of return on the investment.
More than half of the portfolio will be a complete loss. Almost all of its money will be made on 10-20% of the investments that are fundmakers. These investments will give more than 10x the returns and make up for the losses. The goal of the VC is to optimize the probability of finding fund-maker companies.
Different funds will have different risk profiles. The risk profile will affect the industry and company size among other factors. The company size is a crucial factor because smaller companies have higher growth, but they also have different timeframes for getting returns on investment. Different levels of due diligence are also required. VCs will be setup for reviewing deals at a particular stage of company growth and size. They will optimize their deal review and due diligence according to the companies they focus on.
Why Do VCs Reject Services Companies
When services companies try to raise funding, they’ll realize the traditional VCs will not invest in services companies. We identified three decision criteria for VCs:
Company size;
Expected IRR;
Risk.
The truth is, for companies of a similar size, the expected IRR and risk are both lower for a service company. The only time a services company and a VC have a match in IRR and risk is at a very small size. And at that size the minimum investment size would not match with the needs of the service company.
Services companies are also not as cash-starved. They do not have as much upfront investment and, ideally, bring money in from day one. Most service companies are able to flourish without needing money in the very early stages. In other words, founders don't need to give up equity at the highest risk and reward stages of the business.
Wrapping Up
You’re running a fast-growing tech services company. You can see the pent-up demand. You need to grow. You’re under a lot of stress to continuously hit the bull’s eye. And you’re frustrated that you still can’t service your demand.
You have to get funding to be able to grow faster and get some buffer to take on riskier decisions. But as you try and look for funding you're confused why no one is talking to you. Why can companies get an 8M valuation on a slide deck and nobody will take you seriously with a million dollars in revenue?
The answer is that sadly you're asking for the wrong people for the wrong kind of money.
Tech services as a business are completely different in terms of their economics. This is why Vixul has partnered with The Boring Syndicate to launch the Vixul Continuity Fund. This is why this series of articles is about telling you where and how to look for money. So please subscribe to learn what funding options are available for tech services companies.