By Rick Stephan-President, Quanta Corporation
A business that fails is always a company out of money. And though there are any number of factors contributing to an empty bank account, inadequate capitalization tops the list.
Countless studies have proved that, as Edward Roberts reported in Technology Review, “the larger the amount of initial capitalization and the larger the number of founders, the greater the likelihood of the company’s later success.” So, once you’ve run through your own money and the savings of your friends, family, and partners, and once you’ve exhausted those second and third mortgages, inevitably, you’ll need to convert some of your company’s stock into cash. That’s what venture capitalism is all about.
How to Negotiate Your Venture Capital Deal-
There’s perhaps no more important negotiation as an entrepreneur than determining how much equity to give up for seed funding. Usually it’s a make or break deal for your business. Is the investment worth giving up control of the company? Is the funding promised worth turning over the percentage of stock that they’re asking for? Can I make a better deal somewhere else for less stock?
To know the answers to those questions, and to be able to negotiate an equitable arrangement it’s crucial to search out and select the right venture capitalist to begin with, understand how their venture- capital fund works, and then be able to translate their investment criteria into a valuation model for your business.
Where to Find Venture Capitalists
No matter how compelling your business, venture capitalists are not going to beat a path to your door. Even though they invest billions every year, venture capital firms still review hundreds of business plans for every one they fund. So you need to do the legwork.
Of course, instead of legwork, initially, you can do your research online. The Venture Capital Association maintains an informative site. You can also begin with basic bulletin-board venture- capital sites to learn more about funding criteria. For example, Access to Capital Electronic Network (ACE-Net) is a non-profit site developed by the US Small Business Administration for investors and entrepreneurs.
Sites like Vcapital.com are complete venture capital portals that combine access to deals and funding with all kinds of information and services. In addition to learning more about the venture capital process, you can begin to narrow your search of possible backers. By registering your firm, you also immediately become a candidate for financing, and can be automatically matched to a venture capitalist based on their funding criteria and your specific needs.
Some sites like Garage.com more closely resemble traditional investment banking firms. Although there are some informational services for entrepreneurs, this site primarily reviews business plans and evaluates applications for the participating venture capitalists. Nvst.com (pronounced “invest”) doesn’t screen candidates, so venture capitalists can look at what they want from the searchable database. Nvst.com also provides information on private financing, online publications, and online classes.
All these portals offer a way for you to quickly begin your selection process and potentially strike up a relationship online that can lead to some further transactions.
But remember, although venture capitalists may invest in high-tech businesses, they may not run their business in a high-tech way. Face-to-face meetings and relationship building are critical in their decision-making process.
Selecting the Right Venture Capitalist
In your search, target firms with expressed interest in your type of products and services. Look for a specialization as close to your business as possible. You also need to determine whether there are any geographic limitations. Some firms specify minimum and maximum levels of funding, and only choose companies at certain stages of development. Some will only act as the lead investor. So it’s important to create a match, as much as possible, between your own investment preferences and all their stated objectives.
Once you’ve narrowed the search, it’s time for some due-diligence. You need to analyze the entire spectrum of your potential relationship with each venture capitalist. Just some of the issues to consider include:
~ What is the venture capitalist’s experience with similar businesses?
~ How active are they in the management of the company?
~ Are there any competing companies in their portfolio?
~ How compatible are their personalities with your own team?
~ Can they handle additional rounds of financing?
~ Do they bring any proven professional services to help in the startup?
~ Do they have a network of contacts that could help develop your company?
The wrong answer in even one of these categories can spell disaster down the road. So evaluate each venture capitalist as you would any potential long-term partner. Ask all the important questions now — leave no important condition for your own satisfaction unexplored.
Venture Funding Reinvented
Because of the enormous growth in new high-tech businesses and a more competitive field, venture capitalists are now creating completely new models for their funding activities. Most of these developments are designed for the benefit of entrepreneurs, and you might want to specifically search out these firms.
Some venture capitalists look to create an over-all entity from the separate companies in their portfolio, like an intertwined family, so that members can help each other succeed. Kleiner Perkins popularized this idea, and now many other firms are looking to create synergies among their startups. By finding other companies within a venture capitalists’ investments that you can profitably partner, strategize, and share resources, you can strengthen the bonds of partnership and the benefits on both sides of the table.
Another new model is an “incubator.” These incubator firms like Idealab Capital Partners and eCompanies Venture Group put several companies under one roof, not only to help keep costs down, but to encourage the startups to share their expertise. Again, if you want to quickly add a full range of professional resources as much as the investment dollars, these new types of funds are your answer.
Typical Venture Capital Funds
Venture capital firms are usually set up as general partnerships that invest money from the participating limited partners. Limited partners range from private individuals to corporations, insurance companies, pension funds, endowment funds, government bodies, and even other venture capital firms. Money raised from the partners is then committed to a fund, usually with some specialization such as biotechnology, Internet commerce, broadband infrastructure, etc.
A typical fund of, say, $50 millionto$150 million, will actively invest for three to five years with very specific return-on-investment (ROI) requirements. The ROI expectation of the partners in the fund is crucial, for that forms the single most important criteria for the venture capitalist in his evaluation of potential investments. Venture capitalists will usually look for a 30% to 50% annual ROI, sometimes more and will probably expect a total return of between 5 to 20 times their initial investment.
The Stock for Cash Trade-Off
At the start of your negotiations, the positions may appear as follows: you want to raise as much money as possible for as little stock as necessary and the venture capitalist wants to put in as little as possible for the largest stake he can get.
In reality, though, that’s not going to work for either party. On your side, you need to be as precise as possible with your capital requirements, because excess funding, in the end, is going to cost you ownership. As for the venture capitalist, he needs to meet his ROI requirements but leave enough ownership with the founders and managers to assure there’s enough incentive for success.
So how do you arrive at the balance of interests? The first step is to agree on the stage of your development, and so the investment risk involved. There are four stages:
Stage I – No product revenues or expense history
Stage II – No revenue, but expense history related to development
Stage III – Product revenues, but operating a loss
Stage IV – Product revenues and operating profitably
As an entrepreneur, you must understand that, the lower your stage of development, the greater the risk for the investors. If you’re in Stage I, expect to turn over more stock for your capital. But if you’re in Stage IV, obviously, you have greater leverage because of your operating history. You’ll need to factor this range of risk in the valuation guidelines that follow.
Future Market Valuation Model
Pricing any deal can be extremely subjective, but perhaps the best guide for balancing venture capitalist and entrepreneur interests is the future market valuation model. Simply put, you estimate the future value of your company at the end of the investment period, then; based on that value, determine the percentage ownership necessary for meeting the venture capitalist’s ROI and investment goals.
For example, if the future market value of your company is estimated to be $60 million after six years, then to create a 30% ROl on a $4 million investment, the venture capitalist would need to own 32% of the company (32% of $60 million = $19.2 million = 30% annualized ROI over 6 years). If the future market value is higher based on profitability and earnings multiples, say $100 million, then a smaller ownership percentage of 19% would earn the required 30% ROI over the six years.
The future market valuation model not only guides you through your negotiations, but also provides an objective measure for determining just how much ownership to relinquish. Regardless of any other issues involved with your venture capital deal, this return-on-investment criteria remains the foundation for turning stock into cash.
