Venture Capital

Venture capitalists are an interesting lot.

These are people who raise money from other sources like banks, rich people with extra money, pension funds, mutual funds, etc., to create a venture capital fund. Once the venture capital fund is created, the venture capital fund managers who created it scour the planet for young companies which currently lack money but have the potential to generate large profits in the future. When such companies are found (or, more likely, knock on the door), the money is then poured into the young companies in return for part-ownership of the company. What the venture capital fund managers are looking for is a very high return on the investment in the young company. This high return is what is promised to investors in the venture capital fund and is what prompts them to give money to the venture capital fund in the first place. In essence, the venture capitalists are making long shot bets on companies that show a promise of future payoff.

This does not mean that VC funds are loose-fisted gamblers or injudicious in their investment decisions. Hardly. Thousands of applicants for VC funding present themselves to VC fund managers each year. About two-thirds of these applicants are thrown directly into the trashcan without anything more than a cursory review. Of the hundreds that actually get reviewed, only a dozen will be selected for funding in any given year. VC fund managers are careful with the money that they put into risky investments, and your idea had better be a good one if you want to get their attention. Moreover, your business had better either have a good track record for a few years or it had better be the next Netscape if it has no track record. Venture capital is not invested lightly.

The amount of money invested by venture capital funds has dropped steadily over recent years due to changes in the tax code that took effect in 1987 (although it has been rising again in recent years). Of the $15-20 billion available to new and emerging companies, only about $5 billion is supplied by the venture capital funds. There are roughly 950 venture capital funds located in the United States and Canada, according to “Pratt’s Guide to Venture Capital Sources.” A large number of these funds are located in California’s Silicon Valley area and the East Coast pockets of high-tech industry.

VC funds almost always take a large portion of a firm’s equity when they invest their money. But entrepreneurs are giving up more than just stock when they take VC money. Entrepreneurs often see their company as something akin to a child which they have raised and nurtured, and selling a portion of this “Child” seems wrong and upsetting. Moreover, once a venture capital fund puts money into a company it wants a large say in how that company is run. So entrepreneurs who used to make decisions on their own suddenly have to call the VC fund managers whenever important company decisions are being made. In addition, the interests of the entrepreneur and the VC fund sometimes diverge (e.g., the VC people want to expand sales of existing company products because it will quickly drive up the market value of the company while the entrepreneur wants to focus on developing a new and exciting product which will shock the industry with its innovative design). In such cases, the relationship between the VC fund managers and the entrepreneurs can be strained. Nonetheless, the entrepreneur usually cuts the deal because the money is usually necessary for the company to grow.

But VC fund managers can relate to entrepreneurs. In fact, VC fund managers often say that the business of venture capital is the “business of building business.” This is true to some extent. With the extremely high risk involved and hit or miss nature of the business, venture capitalists sometimes resemble entrepreneurs, albeit financially-focused rather than product or service-focused. The only way that the VC fund sees a payoff is if the company does very well and eventually can be sold to another party or to the public. This, then, is the basic goal of the VC fund managers.

What VC people look for when sizing up companies for investment money

VC investment decisions are art, not science. The decision by VC fund managers almost always involves a good portion of personal and subjective decision-making on the part of the VC fund managers. But the general outlines of the decision about whether or not to invest are easily listed, much like you can list the basic elements to a beautiful painting or well-choreographed dance.

In their search for higher-than-average returns through equity ownership of startup companies, VC fund managers look for some basic qualities in a young company: experienced management, innovative or unique products services which are not readily duplicable by competitors (due to cost of entry into the field or intellectual property protection), and a growing market for the products or services offered by the young company. We will look at these factors more closely.

a) Management

This is the most important variable considered by VC fund managers when deciding whether or not they will invest in a company. The type of management that these people seek, however, is not fortune 500 CEOs, rather the VC fund managers seek good entrepreneurs who can fight tough against failure when the odd are overwhelming. In other words, VC fund managers are looking for people who do not know when it is long past the time to quit and who are fanatically opposed to losing.

But the entrepreneur has to be more than that. They have to show self-confidence, high energy-levels, long-term involvement, high level problem solving skills, goal-orientation, ability to learn from failure, personal responsibility, and the desire to make money. Having these qualities and being an entrepreneur is, therefore, necessary to getting the VC fund manager’s fickle, fleeting attention, but it is not enough by itself. It is also important to have a good management team which possess complementary skills and functions well as a group. VC fund mangers generally prefer to give money to teams of entrepreneurial people rather than just one person.

After the VC fund managers are convinced that you have a steady, focused and capable management team, they will look at the next most important area of the business: the market for its products or services.

b) Market for Services or Products sold by the Company

Not as important as the management of the company, but more important than the other variables, the market in which the startup company operates is very important to the decision made by the VC fund managers about whether or not they should invest in the startup venture.

There are some crucial questions asked by the VC fund managers: How large is the market or the potential market? How fast is the market growing and how sustainable is that growth? Is the company in a position to develop and maintain a strong presence in the market?

The first two questions are answered by information that does not involve the startup venture at all. Using basic research techniques taught in business schools all across the country, the VC fund managers will try to estimate the potential market demand for the startup company’s product. Market forecasts by industry experts and their own subjective analysis informs the VC fund managers about the market in which the startup business operates.

It is essential to the art of market forecasting to define the market as narrowly as possible. Your company is going to build computers? Well, we need to know exactly what kind of computers, and what type of functions are being performed. There are many sub-markets in the larger computer market, and knowing what the trends will be for the computer market at-large tells us nothing about how the sub-market in which the startup operates will perform. All kinds of variables come into play: end applications for the services or product, customers and potential customers and the amount of value added by the startup’s offerings, channels of distribution, and, of course, the direct and indirect competition the startup faces in its market.

Competition in the marketplace will depend in large part on industry structure. Industry structure determines how much competition is possible or probable. To give you a basic idea about how to determine the market structures for your particular business, this link provides a primer on analyzing industry competitiveness.

Not surprisingly, VC fund managers prefer startups which operate in markets where the market is either growing or highly fragmented (and thus requires a keen sense of how best to service that market through better products or services than are currently offered). “Growth markets”, as such markets are called, have some common characteristics: technological change and uncertainty, short time horizons, products with high initial costs to produce but which will lower quickly as the number produced increases, and competitors who are also in the startup phase.

“Fragmented markets” possess different characteristics. The cost of entry into the market is low, numerous potential sub-markets with individual needs that can be catered to, easy to differentiate products, lack of economies of scale (often associated with short life spans for products, low overhead costs, creative content required for product or service to be effective, need for proximity to customers or suppliers, or customers who need customized products)

c) Proprietary Rights or Innovative Products

Of course, another important factor in the VC funding decision is whether the company owns proprietary rights to some technological innovation or a really good product or service that is not readily copied by competitors. It is important to remember two things, however. The technology cannot be so innovative that there is no ready market for it. (Imagine trying to sell artificial heart valves before the development of heart surgery!) Moreover, the innovation generally has to be already developed when you go to the VC fund managers. They may invest in an idea that still has to be developed, but you cannot expect investors to fund your plans for developing cold fusion. VC fund managers are not the government, after all, they need to see some return on their investment.

d) Company Strategy

Let’s face it. You probably cannot expect a startup company to compete with larger, more established companies on the basis of price, so you are going to have to have a different type of focus. Efficient product development, creativity, special technological or engineering skills, the ability to service customer needs more quickly, these are the hallmarks of the successful startup company. Leave the reliance on financial resources, large manufacturing facilities and distribution networks to the pachyderms who depend on such things for their survival. Startups need to be the hungry wolf: nimble, sly and running with their own kind unless they are going to get a good deal from their slower-moving competitors. Much like Thoreau said, a startup should simplify and keep its focus narrow, at least at first. Find that profitable niche and work the hell out of it. VC investors want to be sure that the people who run the business know that business better than the next guy, otherwise the next guy gets the money. Growth can come after the VC money comes in, do not try to get there before you company can afford it.

Valuation

After sizing up the company and its markets, the VC fund managers start taking a closer look at a company. And one of the first things they may do is value the company. They’re asking, “Before we put our money into this business, what is worth?” They want to know this because this will give them an idea as to how much of the company they should get for their money.

The cliché among VC fund managers goes something like this: The VC fund has to take enough ownership interest so that if things work out and the company is a success, they can get a very good return on their money. But at the same time the VC fund must recognize that the people who built the business up to this point are the ones who will make it grow further, so they need to retain enough of the company to motivate them to work towards its eventual success.

VC fund managers will be sedulously saying this even as they accidentally load your children into the truck they’re using to take their “cut” of your company for the money they invested. But don’t blame them, after all, that is what they are hired to do.

Knowing a little about the valuation process might help if you ever get to the VC investment level. The typical amount that a VC fund will take is 50-60% upon their initial investment of money, the rest is left to the builders of the company. The best way to make sure you are getting the best deal from a VC fund is to shop around, and don’t be shy about letting them bid for a stake in the company. If they’re professionals, they will understand that this is part of business, so don’t let them con you with talk about how “the two of us had a relationship” or some smack like that–this is money we’re talking about, and money is a hell of a lot more fickle than love! If you are a one in a million company, you may even get more than one VC fund interested in you. So talk to a few VC funds. You may think that your company is worth more, and it may very well be. But remember, what you can get others to pay is entirely different from what you think the company is worth. Don’t let the amount of money invested and the percentage of the company given in return become a bigger issue than it already is (and it is a big issue!). VC investment is usually a good thing for a company even if it is painful to let someone else walk away with half of your “child”.

Subjective Factors

As mentioned earlier, the vast majority of ideas and companies presented to a venture capital fund manager will not even be seriously reviewed, let alone scrutinized and poured over by the VC fund managers. Where the people are clearly unsuited to build a business or the idea is crackpot rather than crackerjack, the VC fund managers will (at most) send a polite letter informing the applicant of the decision not to fund them.

At the other end of the spectrum, a few ideas or businesses will come to the VC with a superb blend of management personnel and potential for growth that makes them irresistible to the VC fund managers. If a Microsoft vice-president comes to a VC fund and tells them that he is quitting his $500,000/year job in one of the world’s most successful companies because he and this brilliant software developer have an idea that will make them “rich”, you can bet that the VC fund is going to listen to this guy, and probably fund him without as much scrutiny as they would give other applicants. (We have seen it happen!) But very few people in the world have this kind of credibility with VC fund managers.

In truth, only about a 10-15% of ideas actually get a serious review from the fund. These are the risky plans that may pay off, but they may not. This is where the VC fund managers earn their money rather than just make it. Many of the companies reviewed may fit all of the criteria given above, and they may all look very attractive, but the VC fund manager knows they will not all pay off. Which ones, then, are to be chosen? This is it, dear readers, this decision to fund attractive but ultimately unpredictable companies is where VC becomes an art. This is where the brushstrokes of business acumen lick the canvas with beauty or clumsily smear the fiscal paint. (Yes, yes, that analogy is over the top, I know, but this is neat stuff nonetheless!)

After the Marriage

Entrepreneurs should recognize that they are getting more than money from a VC fund, they are also getting “partners” who will do everything to help their company become successful. The VC fund managers will help a company develop long and short-range business plans, obtain proper management consulting, aid in the recruitment of key personnel, give referrals to specialized technical support, and other problems that often plague young companies. Of course, the amount of involvement and the depth of it vary according the industry, the company and the VC firm.

For instance, if a startup business is being run by a proven executive from the industry in which the startup is operating, a person with his own contacts and skills to rely on, then the VC fund may try to stay out of his or her way and let the professional do the work. If, on the other hand, the company consists of a brilliant 21 year-old computer program designer who has created the best accounting program ever seen, and the 21 year-old is wondering what do to next with it, the VC people will be very involved in the investment, up to the point of running it if need be. The VC fund managers look at the companies in which they invest and determine what skills the entrepreneur probably lacks, they then work to provide that expertise, thus decreasing the likelihood that the company will tank because of the perceived weakness.

This is the proper time to point out the downside of this help: it may come even when it is not desired. When a company takes on a VC fund as a “partner,” it must be understood that the fund managers will play a role in every significant business decision made after the investment; they paid the fiddler, after all, and thus they too can call the tune. Entrepreneurs who are used to operating on their own, or as part of a small group of people whose friendship was forged by the trial of starting a business, must be prepared to have another group of people actively involved in business. But recognize, the VC managers are only useful insofar as they can add value to the company, and they cannot do that without being actively involved in the company. Moreover, the idea of actually running a startup company is usually anathema to most VC fund managers; they know where their area of expertise is and it isn’t running the business that someone else has successfully created.

If you go looking for VC money, be patience and persistent. Good luck.