Owners and managers of early-stage growing companies often have mixed views toward the institutional venture capital industry. On one hand, they welcome the money and management support they desperately need for growth, but fear the loss of control and various restrictions that are typically placed on the company by the investment documents.
In order to achieve the delicate balance between the needs of the venture capitalist and the needs of the company, business owners and managers must understand the process of obtaining venture capital financing.
Preparation is the key to obtaining an initial meeting with the institutional venture capitalist. There are three central components to the preparation process:
- business and strategic planning;
- effective networking;
- and narrowing the field.
A well-written Business Plan and financing proposal is a necessary prerequisite to serious consideration by any sophisticated source of capital. Effective networking means using professional advisers, commercial lenders, investment bankers and consultants who may be able to assist you to get the Business Plan into the hands of the appropriate venture capitalists. Institutional sources of capital are often flooded with unsolicited, “non-introduced” plans that are more likely to end up in a wastebasket than before an investment committee. Remember that the average venture capital firm will see thousands of business plans per year, so you need to find ways to increase your chance of survival as the field of choices rapidly narrows. Finally, most venture capitalists have certain investment preferences regarding which companies they will include in their investment portfolio. These preferences may be based on the nature of the company’s products and services, geographic location, projected rates of return, stage of development or amount of capital required. Rather than waste precious resources by blindly sending business plans to any and all venture capitalists in your region, take the time to research the venture-capital industry to match the characteristics of the proposed investment with the investment criteria of the targeted firm. It may turn out that your company’s stage of development will determine which kind of venture capital investor you’ll approach, and the structure of the financing you’ll receive, so it’s important to identify which stage of business development financing you require before embarking on the search for capital.
The first level is seed financing, in which small amounts of capital are provided to the company for initial product feasibility studies, development, market research, refinement of strategies and other preliminary analyses.
The next level of financing is start-up or early stage financing, which is generally for completion of product development, recruitment of a management team, refinement of the long-term business plan and the commencement of marketing efforts. Recent capital market trends have had most venture capitalists investing in later-stage companies and companies already in their portfolios, with a greater emphasis on the company’s ability to generate current income and return to the investors.
Next is first-stage financing, which usually funds the first phase of the full-scale manufacturing, marketing and sales. It is also at this stage that any missing components of the management team are completed.
Second-stage financing is typically for a company that has begun its production and distribution, has established inventories, contracts and accounts receivable, but now needs working capital to fuel expansion. Third-stage financing is usually for a company that is already operating at a profit, but needs capital to research and develop new products, expand its physical facilities or make a significant increase in sales and marketing efforts. Finally, in bridge or mezzaine financing, venture capitalists will provide capital to a company which expects to go public within the next 12 months, but requires additional working capital to bridge the gap. Firms will also consider providing capital to finance mergers and acquisitions, joint ventures, leveraged management, buy-outs or recapitalization, efforts to “go private” or other kinds of transactions, if the return on investment meets their criteria.
Meeting the Venture Capitalists
If your business plan submission survives the rigid initial review of most institutional venture capital firms, then the key to your first meeting and success thereafter is PREPARATION! Keep in mind the following points:
- Have a dress rehearsal. You need to rehearse your presentation many times. This involves different audiences asking different questions, replicating the actual meeting that you’ll have with the managers of the venture capital firm. Make sure your rehearsal audiences (such as lawyers, accountants, business school professors, and entrepreneurs who have raised venture capital) have the background and the training to ask the right questions (including the tough ones) and be able to critically evaluate your responses. Do your homework on the venture capital firm and learn what their “hot buttons” may be so that you can address key issues in your presentation. As the saying goes, “You never get a second chance to make a first impression.” The rehearsals will help you survive the first meeting and get to the next steps. Be prepared for the tough questions and don’t be scared, intimidated or upset when the really hard ones start flying at you. If the venture capital firm’s team doesn’t ask tough questions, then they are not “engaged” into your presentation. If they are not engaged enough to beat you up a little, then there will probably be no next steps and no deal.
- Have a mentor. It’s always helpful to have a venture-capitalist coach or mentor who has himself either raised venture capital or been an adviser on or negotiated venture-capital transactions. The mentor or coach can help stay focused on the issues that are important to the venture capitalists and not be wasting their time. The mentor can reassure you during the difficult and time-consuming process, teach you to remain patient, optimistic and levelheaded about the risks and challenges that you face.
- Have a detailed game plan – Prepare a specific presentation that isn’t too long or too short (usually 15 minutes is about right). Don’t attempt to “read” every word of your business plan or put every historical fact of your company on a Power Point slide. Keep it crisp and focused and be prepared for questions and to defend your key strategic assumptions and financial forecasts. Remember that every minute counts. Even the small talk at the beginning of the meeting is important because the seasoned venture capitalist is sizing you up, learning about your interests and looking for the chemistry and the glue that is key to a successful relationship.
- Have your team available to meet the venture capitalist. Don’t overlook the “personal” component of the evaluation. In many cases it can be the most important factor considered in the final decision. The four “Cs”-camaraderie, communication, commitment and control (over your ego)-may make or break the outcome of the meeting. Any experienced venture capitalist will tell you that, at the end of the day, the decision depends on the strength of the people who will be there day to day to execute and manage the future of the company. The venture capitalist will look for a management team that’s educated, dedicated and experienced (and ideally has experienced some success as a team prior to this venture). The team should also be balanced, with each member’s skills and talents complementing each other so that all critical areas of business management are covered-from finance to marketing and sales to technical expertise.
- Have passion but not rose-colored glasses. Many entrepreneurs fail to make a good impression in their initial meeting with the venture capitalist because they come on too strong or not strong enough. The experienced venture capitalist wants to see that you have a passion and commitment to your company and to the execution of the business plan. However, he or she does not want to be oversold or have to deal with an entrepreneur who is so enamored of an idea or plan that he or she can’t grasp its flaws or understand its risks.
- Have a way to demonstrate your personal commitment to the project. All venture capitalists will look to measure your personal sense of commitment to the business and its future.Generally, venture capitalists won’t invest in entrepreneurs whose commitment to the business is only part-time or where their loyalty is divided among other activities or ventures. In addition to fidelity to the venture, the investor will look for a high energy level, a commitment to achievement and leadership, self-confidence, and a creative approach to problem solving. You will also have to demonstrate your personal financial commitment by investing virtually all of your own resources into a project before you can ask others to part with their resources. Remember, any aspect of your personal life, whether it’s good, bad or seemingly irrelevant, may be of interest to the venture capitalist in the interview and due diligence process. Don’t get defensive or be surprised when the range of questions are as broad as they are deep-venture capitalists are merely trying to predict the future by learning as much as possible about your past and current situation.
- Have an open and honest exchange of information. One sure deal killer for venture-capital firms is if you try to hide something from your past or downplay a previous business failure. A seasoned venture capitalist can and will learn about any skeletons in your closet during the due diligence process, and will walk away from the deal if they find something that should have been disclosed to them at the outset. A candid, straightforward channel of communication is critical. A previous business failure may be viewed as a sign of experience, provided that you can demonstrate that you’ve learned from your mistakes and figured out ways to avoid them in the future. On a related note, you must demonstrate a certain degree of flexibility and versatility in your approach to implementing your business plan. The venture capitalists may have suggestions on the strategic direction of the company and will want to see that you are open-minded and receptive to their suggestions. If you’re too rigid or too stubborn, they may view this as a sign of immaturity or that you’re a person with whom compromise will be difficult down the road. Either one of these can be a major deal “turn-off” and a good excuse to walk away.
- Have a big market and a big upside. Make sure your Business Plan and your presentation adequately demonstrates the size of your potential market(s) and the financial rewards and healthy margins that strong demand will bring to the bottom line. A venture capitalist who suspects that your product or service has a narrow market, limited demand and thin margins will almost always walk away from the deal. If your target market is too mature with already established competitors, then the venture capitalist may feel the opportunity is too limited and will not produce the financial returns that they expect. They’re looking for a company that has a sustainable competitive advantage, demonstrated by a balanced mix of products and services that meet a new market need on both a domestic and overseas basis. Remember that most venture capitalists want a 60% to 80% return for seed and early-stage or post-launch deals and at least a 25% to 35% return on latter-stage and mezzanine level investments. When the S&P 500 offers 30% returns and when the average investor can double his or her money with investments in lower-risk companies like General Electric and Intel, then your Business Plan and presentation had better demonstrate that the venture capitalists’ money will be better served in your company.
- Have an understanding of what really motivates the venture capitalist’s decision. You must have a good idea-one that’s articulated in a business plan that truly expresses the risks and opportunities and how your management team will influence the odds of success and survival. But then, it must make money for both of you. The venture capitalist wants deals where both the investors and the entrepreneurs can enjoy the upside and the scale is not weighted in favor of one over the other. Finally, the I’ll back you component reminds you that in exchange for capital and wisdom, the venture capitalists expect to have some controls and “checks and balances” built into the structure of the deal, the governance of the company and protection in the documents to ensure that their investment and ability to participate in the growth and success of the company are protected.
- Have an exit strategy – The saying “Begin with the end in mind,” clearly applies to venture capital deals. Investors aren’t looking for a long-term marriage; they will be very focused on how you intend to get their original investment and return on capital back to them within four to six years. Your business plan and oral presentation should include an analysis and an assessment of the likelihood of the three most common exit strategies, namely: an initial public offering; a sale of the company; and a redemption of the venture capitalists’ shares of the company by the company directly. Other exit strategies include restructuring the company, licensing the company’s intellectual property, finding a replacement investor or even liquidating the company.
Due Diligence is A Two-Way Street
At the same time that your Business Plan is under the microscope during the venture capitalist’sevaluation and due diligence, you should be assessing the prospective venture capitalist’s strengths and weaknesses. Consider the following questions when determining whether the venture capital firm fits into your current and projected requirements:
- How well does this firm know your industry?
- How often does it work with companies thatare at a development stage similar to yours?
- To what extent has it worked with owners and managers of more seasoned companies in a turnaround situation?
- What assistance can the venture capitalist bring to you in terms of management expertise, industry contacts and support services?
- What is the reputation of this firm within the financial community? If this firm is to serve as the “lead investor,” then how effective will it be in helping to attract additional co-investors?
- Has the firm asked for any special reward or compensation for serving as lead investor?
- What effect will this have on the willingness of other co-investors to participate?
- Will this firm be able to participate in later rounds of financing if the company continues togrow and needs additional capital?
To answer these questions, you should speak with investment bankers, lawyers, accountants and other venture capitalists who are familiar with this particular firm. Most important, you should speak with owners and managers of other companies in the investor’s portfolio, to determine the level of support, conflict and communication typically provided by the firm and be sure to talk to both successful and unsuccessful portfolio companies. Find out how the venture capitalist reacted to companies that got into trouble, not just those that outstripped projectionn.
Structuring the Deal
The negotiation and structuring of most venture capital transactions depends less on industry standards and more on the need to strike a balance between your needs and concerns and the venture capitalist’s investment criteria. Initial negotiations and alternative proposed structures for the financing will generally depend on an analysis of the following factors:
Your Main Concerns
- Loss of management controls;
- Dilution of your personal stock;
- Repurchase of your personal stock in the event of employment termination, retirement or resignation;
- Adequate financing;
- Security interests being taken in key assets of the company;
- Future capital requirements and dilution of the founder’s ownership; and Intangible and indirect benefits of venture capitalist participation, such as access to key industry contacts and future rounds of capital
Their Main Concerns
- Your company’s current and projected valuation;
- Level of risk associated with this investment;
- The fund’s investment objectives and criteria;
- Projected levels of return on investment;
- Liquidity of investment, security interests and exit strategies in the event of business distress or failure (“Downside Protection”);
- Protection of the firm’s ability to participate in future rounds if company meets or exceeds projections (“Upside Protection”);
- Influence and control over management strategy and decisionmaking;
- Registration rights in the event of a public offering; and
- Rights of first refusal to provide future financing
Concerns for Both of You
- Retention of key members of the management team (and recruitment of any key missing links);
- Resolution of any conflicts among the syndicate of investors (especially where there is a lead investor representing several venture capital firms);
- Financial strength of the company post-investment; and
- Tax ramifications of the proposed investment.