Now that you know and understand the specifics of your business—you know your numbers cold, you have the financials prepared, you understand how much you need, and grasp the fundamentals of valuation—it is about finding and evaluating the right investors for your specific deal. But navigating through the universe of investors can be confusing, even for the most experienced entrepreneurs.
Finding the Right Venture Capitalist for Your Deal
Before we help guide you to the right VC for your deal, here is a quick situation analysis of their investment activity. The amount of money that venture capitalists have invested has declined every quarter since the start of 2000. To summarize what we discussed in previous Articles, in 2001 venture capital investment activity decreased 62 percent—to $41 billion from $106 billion in 2000—as the venture capitalists concentrated more on building up their previous investments than dealing with new investments. This $41 billion was invested in 3,798 ventures through 4,679 rounds. In 2001, the number of first-round financings as a percentage dropped from 27 percent in 2000 to 18 percent. A total of 1,172 ventures received first-round funding in 2001 compared to 3,333 ventures in 2000 and 2,448 ventures in 1999. The amount of first-round financings dropped harshly from $29 billion in 2000 to $7.3 billion in 2001. The average first-round investment was $6.3 million, and the average valuation of the investee at the time of the first-round investment was $27 million.
For a broader perspective we examined more than ten years of datum. Between 1995 and 2001, venture capitalists invested $258 billion in 24,349 ventures through 30,458 rounds. A total of $74 billion went to first-round investments, representing 29 percent of the dollar amounts. There were a total of 12,156 first rounds representing 50 percent of the deal flow. The average first-round investment was $5.6 million, and the average valuation of the investee at the time of the first-round investment was $24 million. For a more granular analysis of first-round investments, sector by sector, see the Figure below. In this Article, to simplify our sector-by-sector analysis of first-round investment activity, the seventeen sectors we identified and discussed in the previous Articles have been pared down to nine sectors.
What Makes a Great Venture Capitalist?
Now that you know and understand the specifics of your business—you know your numbers cold, you have the financials prepared, you understand how much you need, and grasp the fundamentals of valuation—it is about finding and evaluating the right investors for your specific deal. But navigating through the universe of investors can be confusing, even for the most experienced entrepreneurs. As a start, examine the Figure below, which provides a comprehensive summary of our discussions with respect to financing an emerging growth venture.
Today, uncertainty dominates the venture capital industry. Unsure of their ability to guess at what will be the next big thing, venture capitalists are choosing to work together. According to Greg Galanos, managing director at Palo Alto-based Mobius Venture Capital (formerly known as Softbank Venture Capital), “The big change between the bubble and now is everyone was in ‘hog-the-puck’ mode before.” Investing in early-stage new business ventures is a very risky business, and the risk is commonly mitigated among other venture capital firms by sharing information and due diligence at the beginning, and sharing the combined efforts in relationship building. In these syndicated or conjoined deals, the role of the lead investor first agrees to the term sheet and then helps put together the syndicate, helps set the value, and starts the due diligence process. But it will most likely be up to the entrepreneur to manage all the different interests and informational needs.
Venture capital is an “eyeball-to-eyeball” business, meaning they personally get involved in venture building. Venture capitalists help entrepreneurs and their venture teams build great companies. They see themselves more as builders than financiers. Brad Jones, a partner at Redpoint Ventures, once told entrepreneurs, “The great value VCs bring is experience and helping avoid making mistakes. They can help you step back and take a look at your markets and your strategies. Based on experience of working with perhaps hundreds of entrepreneurs like yourself, they have a sense of what direction to turn in tough times.” Besides providing cash, venture capitalists add value in a variety of ways. See below for some examples of roles they can play. After they make an investment, VCs will spend about 50 to 70 percent of their time supporting their portfolio companies. The most intense involvement is with early stage ventures. As Bill Stensrud, a partner at San Diego-based Enterprise Capital, said, “A good venture partner will not only provide money. They are a good test of the quality of your business opportunity and, when you get funded, your investors should be great partners in helping you succeed.”
Roles Venture Capitalists Play in Venture Building
– Serve as a sounding board in crafting and flight testing ideas and strategies.
– Business consultant with unique industry experience.
– Developing, negotiation agreements, and executing strategic partnerships.
– Developing and executing an acquisition strategy.
– Developing financial plans and assisting in follow-on rounds of funding.
– Developing a global business strategy.
– Negotiating licensing or royalty agreements.
Social and Supportive
– Company building experience.
– Can help manage the transition from entrepreneurial to professional management structures.
– Been in the trenches, written payroll checks—they know the ropes of entrepreneurship.
– Been around in hard times, now providing sound advice and encouragement.
– Have a complete repertoire of mistakes and stories to share.
– Knowledgeable of industry trends and exposed to insider knowledge seeing deals and plans.
– Vital business coach, mentor and personal friend, confidant.
– Support for, during and after initial public offerings or other liquidity events.
– Credibility to venture team.
– Helping recruit key management and board members.
– Providing access to industry experts and knowledgeable advisors.
– Providing access to the right professional service providers, in particular legal and accounting firms.
– Instrumental in opening doors to key marquee customers that otherwise might not take a new venture seriously.
– Instrumental in opening doors to key suppliers.
– Introducing the venture team to other private equity investors.
– Providing access to the investment bankers for preparing a viable exit.
– Providing access to executives overseas for strategic alliances, investments and resources.
– Making key contacts with banks and leasing companies.
– Providing a close-knit relationship with other ventures in the portfolio.
Segmenting the VCs: Objective Research
During the 1990s, the number of venture firms in the United States more than doubled to somewhere around 1,200, and settled around 1,000 at the start of the new century. There are many kinds of venture capitalists who invest in different types of opportunities. Some venture capitalists prefer to provide only seed capital; others prefer investing in mature companies looking for expansion capital; others might invest only in specific industries and locales. It will take a concentrated effort to objectively research the industry and screen out potential investors. In one study of entrepreneurs who received venture capital, they spent on the average forty hours gathering and evaluating information about their potential investors, with 29 percent spending more than one hundred hours.
We suggest that you start your search at the National Venture Capital Association (NVCA). Founded in 1973 to foster a broader understanding of the importance of venture capital to the vitality of the U.S. economy, it is the trade association that represents the venture capital industry. Its membership consists of professional venture capital firms and organizations that manage pools of risk equity capital designated to be invested in young, emerging companies. In 2003, the NVCA had some 450 member firms, representing the majority of the $250 billion of venture capital that was invested in U.S.-based companies in the decade of the 1990s.
Another source to search is the MoneyTree Survey, a quarterly study of venture capital investment activity in the United States. A collaboration between PricewaterhouseCoopers, Venture Economics, and the NVCA, it is the definitive source of information on emerging companies that receive financing and on the venture capital firms that provide it. The study has become a staple of the venture capital industry, entrepreneurs, government policymakers, and the business press worldwide.
Based on your searches through these and other resources, and considering your financing strategy, narrow the universe of investors to a workable shortlist of twelve to fifteen firms with the following questions:
– When in the entrepreneurial life cycle do they prefer to invest?
– What business sectors/niches do they prefer?
– How much do they typically invest per deal?
– Do they have any industry experts in their firm?
– In which ventures in your space have they already invested?
– How are their investments typically structured?
– Do they prefer to lead deals? With whom have they completed conjoined deals?
– What is their geographic focus?
– Who are the key partners?
– What are their backgrounds (schools, degrees, companies, etc.)?
– Who are their limited partners? And how are their interrelationships?
– What is their average size of investment?
– What is their record with IPOs and other exits?
– What do they consider their best investments?
– What is their network effect potential?
– How much “dry powder” do they have available to invest?
Segmenting the VCs: Subjective Research
According to Brian Bedol, founder of ESPN Classics, it is important to “choose your investors well. They need to be supporting you during rough times as well as sharing in the good to great times.” In other words, subjective due diligence is a two-way street, and unless you are talking with the top tier of venture capitalists, you should be equally interested and concerned about the qualifications of your potential investors. Especially if you are dealing with angels, you will need to ask for references and resumes that detail their professional and educational backgrounds. Venture capitalists are surprised that most entrepreneurs do not take this step. So besides performing a general search on Google, ask for the names of your investors’ bankers, accountants, and attorneys, and then have your banker, accountant, and attorney check their professional reputations. You also need to consider which investors might hurt your venture, and which ones, once invested and involved, might steer your venture the wrong way.
Before you accept an investment, ask your investors for a list of their portfolio companies available for you to research, and also find out about any of their investments that have failed. It is important to understand these relationships between investors and the entrepreneurs in the portfolio companies.
Ask the entrepreneurs who have received funding these questions:
– What pre-investment support did they provide?
– How would you describe the chemistry between your venture and the VC firm?
– Were they reasonable to work with?
– Were they difficult to deal with, and if so, how?
– What is it like working with them now?
– How have they been most helpful?
– What is the best thing they have done for you to date?
– How active are they in your business? How often do you talk to or see them?
– How did your investors behave during the rough times?
– Have you gone out for other rounds? If so, how have they helped?
– What did you learn in the negotiations?
– How long did it take to get your financing from the VC firm?
– Who are the investors’ representatives on your board of directors?
– What’s the one piece of advice you could give us?
– How are their relationships with their limited partners?
– Are they involved in any litigation with stockholders? With their limited partners?
– If you could sell out today and start all over again, would you do it with the same VC firm? Why or why not?
Personalize the Connection
Finally, while performing this research on the firms and managing partners with whom you may soon be negotiating a deal, consider how you can personalize the connection. Work through your contacts in the industry, through your networks and advisors, and through your consultants and board members. Find out from them which venture capital firms on your list are good candidates for you to approach and how they can help you place your plan. Great chemistry begins at the first point of communication. Consider how you can work your first contact point with a potential investor to help create a positive relationship, rapport, and optimistic negotiating environment at the closing table.