Finding a way through the venture capital maze

Finding a Way Through the Venture Capital Maze Albert V. Bruno, Tyzoon T. Tyebjee, and James C. Anderson

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Albert Bruno is the Glenn Klimek Profes- sor of Business and Tyzoon Tyebjee is an Associate Professor of Marketing, both at the University of Santa Clara. James Anderson, a partner in Merrill, Pickard, Anderson & Eyre, has extensive experience in helping entrepreneurs with the early phases of high-growth companies.

Venture capital is an excellent source of funds for entrepreneurs seeking startup or expans ion capital. Yet many profitable ventures never get off the ground because the entrepreneur does not know how to present the business concept so that it is most likely to be funded. T h e ideas presented here to help the entrepreneur are developed from practical experience and the results of a four-year study.

E normous amounts of venture capital have become available since the liberalization of the

federal capital gains tax law in 1978. In 1983, more than $1.5 billion in venture capital was com- mitted, the largest amount ever in the history of this country. Every day across the U.S. new ventures are being launched with the aid of these accumulated funds. Yet, in spite of the availability of capital, a number of entrepreneurs are not successful in seeking funds, often because they do not understand what the investors require.

We seek to rectify this situation by providing tips to the prospective entrepreneur on how to develop and consummate a venture capital deal. We discuss the problems that entrepreneurs should anticipate and

entrepreneurs should anticipate and resolve as they make their way through the winding venture capital maze.

Preparing the Essential Ingredients

T he foundation of any new business is a strong understanding of the funda-

mentals. For the entrepreneur, this means a complete understanding of the three critical elements in launching any new venture: the management, the product, and the marketplace.

Without question, management is the most critical ingredient in the venture equation. Professional investors in startup financings are faced with all sorts of variables and uncertainties, most of which are completely beyond their control. A

Business Horizons /January-February 1985

Finding a Way Through the Venture Capital Maze

solid management team can represent the one constant in the venture equation. Outstanding management is the best hedge any venture capitalist can have against the myriad risks the business will inevitably face. The founders ' experience should be concentrated in those areas critical to the business. For instance, a startup in the computer-aided-design (CAD) area should be run by managers who have had experience developing and marketing CAD systems. With this kind of experience, young companies can avoid having to learn lessons that older companies already have under their belts. Ide- ally, the founding team should have previously held the positions proposed for them in the new venture, and some or all of them should have worked together before. The prospective CEO should have had experience as a profit-and-loss manager.

It should come as little surprise that traditional venture capital wis- dom holds that investors would rather back an "A" team in a "B" market than the reverse. In fact, truly outstanding management talent is so rare that occasionally venture investors will fund ex- ceptional managers on an interim basis while they develop their business plan.

The product concept is the second key element in a new business. The product should fill a real need; it should be unique (to differentiate it from competit ion); and it should be defensible so others cannot copy it easily. It must also be cost effective and provide a dramatically superior solution to a customer's problem. The product should be designed with the customer in mind--fulfilling an existing and pressing need the customer can recognize. The product also needs to be capable of development in a timely and predictable fashion. Too often entrepreneurs underestimate the amount of actual time (and thus money) required to bring a product to market.

If the product is to be based on a proprietary technology, then a candid discussion of the technology and an estimate of the risks involved in acquiring and developing that technology is essential. Ven- ture capitalists often shy away from investing in research or the development of altogether new tech- nologies, such as the invention of a radical new computer device. In-

David Sutton

stead, venture capitalists prefer to invest in the application of existing technology to a new prob lem-such as the use of computers in office automation or on the factory floor.

The final key area is the marketplace and the business strategy for reaching it. Many entrepreneurs, especially technically trained ones, assume that a product will sell itself. Yet marketing questions are

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important: How large is the market? How fast is it growing? What is the competi t ion? Who will buy the product and why? What are the contingency plans for a slower- than-expected market acceptance or an unexpected change in the competitive climate? To answer these questions, investors will need more than a gut feeling and personal conviction. The need for some outside validation and support for the existence of a market cannot be overstated.

Market research can provide support for projections. University libraries and trade publications provide data at virtually no cost. This data, however, will invariably need to be supplemented by a market research stud,,), of prospective customers.

Writing the Plan

K nowing how a venture capitalist reads a business plan may be helpful to the entre-

preneur writing it. With no previous exposure to the company or the business, a venture capitalist may spend less than ten minutes review- ing the business plan at first sitting. He is interested in some very simple data. First, he will try to gain a feeling for the marketplace the company is addressing and the uniqueness of their product. Sec- ond, he may turn directly to the management resumes to get a feel for the background of the people who are involved. Third, he may glance at the financial forecasts, first in terms of the revenue projections and second in terms of the amount of cash that the company expects to spend in order to bring the product to market. A well- written executive summary giving a brief history of the company, the management, the concept of the business, and the present status is extremely helpful to the venture capitalist. A table of contents with a good index is a must. Also, tables, charts, pictures, and graphs are al- ways helpful in communicating the

message quickly and concisely. The reader of a business plan is anxious to get the essential information quickly and concisely. Background information should be left for later or consigned to an appendix.

A famous author once wrote, "I didn't have enough time to write you a short letter so I 'm writing you this long one instead." The same concept applies to the writing of a business plan. Venture capitalists require a relatively small amount of data in order to gain an appreciation of your business. Brevity is a virtue in business plans as well as letters.

When writing a business plan, describe strengths judiciously. Avoid overstatement. Don' t cover up or omit discussion of defi- ciencies, but rather describe them clearly and indicate how you plan to overcome them. Write your business plan yourself or with co- founders rather than delegate the job to others. Relying on a professional, such as a CPA, consultant, or at torney as an objective, third- party reviewer, however, is a good idea. Try to anticipate the objec- tions which will be raised by venture capitalists by thinking through several alternative scenarios of the future. Ask what happens if sales are 20 percent less than expected for the first year of operation. What happens to your organization if product development is late? What changes can you expect in the competitive arena? Will your firm have adequate personnel and re- sources to react in a timely manner to these and other contingencies?

Overall, the emphasis in the business plan should reflect the demands of the business. For example, if the company is marketing intensive, as a video game company would be, then the marketing sec- tions should be particularly strong. If the company is building disk drives in very high volume, then the manufacturing area should receive special attention. The critical factors for success in the business should be identified; the entre-

preneur should describe how the firm plans to meet them.

In writing about each of the functional areas of the business, keep in mind the importance of conciseness and simplicity. For example, when listing management resumes, put them all in the same format, with the titles and responsi- bilities of each person listed. Don' t discuss the product without suc- cinctly stating the product 's pri- mary function, features, and advantages over the competition. A picture or diagram of the product in a typical configuration is also useful. Additional comments on why this product is particularly defensible against the competi t ion and what, if any, technical risks the company may face in developing the product are important.

Entrepreneurs invariably seem to have difficulty with developing the marketing section of a plan. This is probably because not only is it the most difficult, but also it is the area where the entrepreneur is the least objective. Yet, for the venture capitalist, the marketing strategy and analysis is crucial. The market being addressed is the one aspect of a company which is im- possible to change. A well-written marketing section should include a description of the target customer and marketplace, its size and growth, and a discussion of the distribution channels planned. Pro- jections regarding market size, penetration for the new product, and so on, should all be accom- panied with data as to the source of your information and the basis of your assumptions. All too often business plans allude to a large, rapidly growing market (such as the one for personal computers) but fail to describe accurately what segments the product is uniquely suited to address. Thus, it is difficult to project how the venture will do versus the competi t ion and what share of the market it will receive.

Making a clear connection between your product 's capabilities and the overall market needs is a


difficult but important concept. Too often this section is cloudy and confusing, probably because the entrepreneur is slightly confused about the market himself. Evalu- ating the market potential for your product is frequently the most difficult task of the prospective investor. The easier you make this task for him, the more likely you will be to get financed.

Avoid the typical new startup trap of arguing that " if we gain only 5 percent of a really large market, we'll be phenomenally successful." In the personal computer market, an alarmingly large number of competitors are fighting for the same 5 percent of the market! As one supplier to this industry noted: "If the sales forecasts of all our customers were added up, the total market would be twice as large as the industry forecasts." Providing a list of customer prospects who hre familiar with your product concept and who would buy it when it is available is extremely helpful in convincing potential investors of the existence of a market. If possible, include such a list in your business plan.

In the financial area, it is all too easy [or the typical entrepreneur to lose sight of the objective in as- sembling the financial information. Remember, it is not nearly as important that you generate class- room-perfect cash flows, balance sheets, and income statements as it is that you understand the relationships implicit in the economics of the business. Finance is the one area where an outside professional such as an accountant may keep you from becoming entangled in the mechanics of presenting information. Be sure to highlight the amount of cash absorbed by the business over a given period of time. In venture capital parlance, this is known as the "burn rate" of the company, and it is a key mea- sure of how expensive it is to keep the business afloat prior to profit- ability.

Another section overlooked in

many plans is a rational discussion of the true risks which the company will face. This is often left out because the person least likely to be objective about the proposed business is the entrepreneur himself. Even the best-laid plans run into problems, and pointing out these areas to the venture capitalist demonstrates that you have thought about the risks and have built in contingencies to deal with them.

A final p o i n t - b e open to criti- cism and be willing to change. Too often entrepreneurs who have been turned down receive rejection poorly and go on to talk to the next investor without taking stock of the advice or signals that they may have received. A well-written plan can be the foundation for a well-executed business. Take the time to build a sound foundation.

Establishing Professional Relationships

p rofessional service organizations, such as banking, legal, and accounting firms, can

be of invaluable assistance to entrepreneurs. In addition to providing a service, these organizations may also provide an entree to the venture community. Therefore, choose your legal, accounting, and banking relationships with care.

Some general guidelines apply to the selection of any service organization. Ask to meet the of- ricer or partner who will handle your account and sit down to discuss with that person what experience he or she and their firm have had previously in dealing with startup companies. What special services do they offer to young companies and can they help accom- modate your anticipated rapid growth? For example, a small, rapidly growing firm can fast out- pace the lending limits of a small bank, yet a larger bank may be sluggish in responding to your changing needs. It is totally appropriate to ask for and check refer-

ences. References will not only help you make a selection as to which organization to use, but will also help you learn about how to work with that particular organization.

Recognize that many profes- sionals will discount their services initially, realizing that young companies are short on cash in their early months and years, but can grow quickly in to lucrative long- term clients. Some may accept equity in lieu of services. In the case of legal relationships, where there may be a future need for patent work or technology-related litigation, it is important that the partners in the law firm have experience in dealing with such issues. For banks, find out the criteria for lending under various arrangements (accounts receivable, inventory, and equipment financing, secured and unsecured credit), and how the loan limits will be modified or extended.

Reputation, personal chemistry, and the depth of understanding between the company and the professional should be important criteria in the selection of any service firm.

Choosing the Venture Capitalist

S electing a source for venture funding also requires some homework. Most well-estab-

lished venture capitalists fund only 1 to 2 percent of all the proposals they receive. Thus, it is critical that you learn which venture sources are likely to be most receptive to your particular plan and approach them accordingly.

It is also important to select an appropriate type of venture capital firm. Of course, the choices range all the way from wealthy individuals to the organized, traditional venture capital partnership; each has its advantages and dis- advantages.

The traditional venture capital partnership is the most well- publicized source of venture funds. More than 800 of these firms are currently operating in the U.S.

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Some specialize in startups, and others focus on later-stage financing. Some prefer to invest as a group or syndicate, and others prefer to operate alone. Within each of these groups, the focus of different venture funds may vary by investment areas. Some prefer high- technology exclusively, while others are more comfortable in consumer goods, medical technology, or even leveraged buy-outs. All expect a high return in a relatively short time for having their capital at risk.

A variation of the traditional venture partnership is the small business investment company, or SBIC, as t h e y ' a r e commonly known. These organizations are licensed b y . the Small Business Administration and were formed by the government to encourage the development of small business. SBICs are limited by law to minori- ty shareholder positions in companies (although, as a group, they may own a majority interest in a company). Moreover, they can invest no more than 20 percent of their equity capital in any one situation. The federal government encourages SBICs b y allowing them to borrow an amount of debt up to thre.e times the initial equity which they put up. Thus, if the owners of the SBIC invest $1, the government will match it with an additional $3 of federally guaranteed loans. Be- cause SBICs often have substantial interest payments due to this debt, their preference may be for interest-bearing debt investment. One disadvantage of this form of investment for the new venture is the cash requirement; servicing this debt can often strap a firm at a time when cash is already scarce enough.

For very small capital needs, or when the concept is in too early a stage to appeal to more traditional sources, wealthy individuals may provide a source. The risk with wealthy individuals is that they may try to dominate the venture or may lose patience if agreed-upon

milestones are not being met. How- ever, these informal sources of capital may be your best bet at the very early stages, especially in financing the "homework" described in the previous section. Although some traditional venture capitalists specialize in seed capital, most are less interested in investing at the stage when capital needs are relatively small and the time requirements are quite severe.

Other organizations that make venture capital investments include major corporations looking for a "window on technology" or a potential acquisition. While the money may be welcome, bear in mind that the corporate venture capitalists are often interested in growing their own acquisition candidates and, at the time of the initial investment, may make an arrangement by which they can acquire a majority equity position at a future date. Thus, they represent the one source of capital where the investors' goals may be more strategic than financial. Before ac- cepting money from a large cor- poration, get a candid assessment of the investor's true goals.

A prospective entrepreneur with a well-written business plan in hand must take the initiative in approaching a venture capitalist. Sel- dom will the entrepreneurs be sought out. At this stage, well

connected co-founders, lawyers, CPAs, consultants, and board members can provide the entree to the venture capitalist. Making a cold call or mailing a business plan without prior contact is not advisable. Nor should a plan be distributed to a mailing list; some discretion should be utilized. It is appropriate to approach several potential veri- ture capital investors at the same time rather than one after another, bu t this should be accomplished in phases and the number of firms involved at any one phase should be kept small.

Keep in mind that potential deals are brought to the venture capitalists' at tention from several sources. Approximately one-fourth result from unsolicited cold calls. Almost two-thirds are referred to the venture capitalist from a variety of sources including other venture capitalists, banks, CPAs, lawyers, and consultants of various types. Since the typical venture capitalist receives far more proposals than can possibly be funded, most venture capitalists spend more time with those proposals which come through someone with whom the venture firm has worked previously. In addition, most venture capitalists apply criteria to reduce the set to a more manageable number for more in-depth evaluation. Among the criteria used for screening are:


- t h e size of the investment and the investment policy of the venture fund;

- t h e technology and market sector of the venture;

- t h e geographic location of the venture;

- t h e stage of financing. Be certain to have checked on

these criteria before approaching the venture firm.

Once interest is generated, the initial contacts will involve face-to- face discussions, management team reference che~Sks, and product fea- sibility assessments from both a technical and marketing point of view. If interest continues to be strong, subsequent meetings will involve negotiating the deal. The entrepreneur may find that including his at torney in the negotia- tion process will be expeditious. If a deal is made, the entrepreneur should expect that conditions and restrictions will accompany the funds that are invested by venture capitalists.

Usually, the venture capitalist expects one or more seats on the company's board of directors. For the entrepreneur, this is often the appropriate opportuni ty to evaluate the make-up of the company's current board. Milestones will be mutually discussed and agreed upon. Often, the infusion of venture money will be timed to coin- cide with these milestones.

Negotiating the Deal

D etermining how much stock to give up in exchange for invested capital is perhaps

the most difficult and least under- s tood aspect of the venture capital process. Stock prices are, at best, a subjective assessment of the future and in this respect, public stocks are no different from private ones. For publicly held securities, the market sets the price. For private stocks, a market also exists, although it is a bit more elusive. Still, the number of venture financings taking place have created, in effect,

a private marketplace. Buyers and sellers in the venture industry reach a negotiated agreement on value and, in spite of the complexities of venture pricing, different venture capitalists often independently arrive at the same price for any given company.

Venture capitalists almost never use any form of discounted cash flow analysis based on the company's business plan in order to arrive at a price for a company's early stock. Instead, market "com- pa rab les" -composed of companies similar in size, growth, and stage of deve lopment -a re more helpful to venture capitalists. While no two companies are exactly alike, there are enough similarities to establish a price range.

To understand the venture capitalist perspective, it is important to explain the mechanics of venture pricing. As an example, assume that an initial $1.8 million round of financing at $1 per share is invested co purchase 60 percent of a company's stock. This 60•40 split between investors and management is typical and serves to demonstrate several aspects important to remember in pricing.

Since 60 percent of the company was deemed to be worth $1.8 million, the total value of the company is $3 million, and the remain- ing 40 percent is imputed to be worth $1.2 million. This remainder is often referred to as the "pre- money valuation" placed on the company or the value of the company prior to receiving any financing.

In this case, since no previous investors exist, management's carried interest of $1.2 million, or 40 percent of the company, is the same as the pre-money value. Each dollar invested is added to this pre-money figure to yield the total company valuation or post-financing value--in this case $3 million. As we shall see, even though more shares of the company may be sold in later financings, thereby diluting management's share of the total

stock, the actual value of that stock can increase dramatically.

Notice the relationship between management's carried interest in the company ($1.2 million) and its 40 percent ownership. If the company had raised $2.8 million instead of $1.8 million, the total company valuation would have been $4.0 million. Management's carried interest would still have been $1.2 million, but after the financing it would have owned only 30 percent of the stock.

This change in percentage reflects the additional capital the company has available in order to achieve its business plan objectives. Thus, there are actually two num- bers to be negotiated with the initial investors-management 's carried interest, and the amount of money to be raised. Raising more money earlier is less risky for the company, but comes at a time when equity is most expensive. Alternatively, raising less money may jeopardize the company's chances of achieving its business plan.

Management's carried interest deserves special comment. This number is frequently a point of discussion at the time of a company's initial financing and requires careful definition. It may represent the amount of stock available for the existing management, or it may include a reserve fund of shares for future additions to the management team. This distinction is critical since inclusion of a management reserve fund requires the issuance of no further stock. That is, no further stock dilution to either investors or existing management is required until this reserve is used up.

Next, consider a second-round financing where the company raises an additional $3 million at $3 per share-a price three times that of the first financing. In this case, the pre-money valuation placed on the

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company is $9 million and the value of management's carried interest has tripled to $3.6 million.

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With the additional $3 million, the company has a post-money value of $12 million.

Note that while the first $1.8 million purchased 60 percent of the company, the next $3 million purchased only 25 percent. This reflects the progress the company has made toward enhancing its future potential as well as reflects com- mensurate reduction in risk. Notice also that these future stock sales dilute both management's share of total stock and that of existing investors on a pro-rata basis.

Assuming the company continues to do well, future financings can take place at increasingly higher valuations and the consequent dilution suffered by shareholders is reduced. Of .course, should the company do poorly, stock may have to be issued at a lower price, resulting in a "dilutive" financing.

In contemplating pricing, the entrepreneur should realize that several specific elements enter into the venture pricing equation. The stage of development, the com- pleteness and caliber of the management team, the relevance of its background, the size of the market, and the performance (if any) of the company to date are all factors. Finally, the public stock market 's v i e w ' o f companies in the same industry can affect valuations. For example, computer peripheral companies typically carry a lower price-earnings ratio than systems companies. Thus, similar differences in pricing may be reflected in the private rounds as well.

One frequent concern of management teams is the issue of control of the company. Entrepreneurs often feel reluctant to sell more than 50 percent of the stock to investors for fear they will lose voting control in their own company. Such concerns are rarely of consequence, particularly where t h e investor/management relationship is a strong and healthy one.

Problems arise, however, when the company is not doing well, and bo th the investors and the manage-

ment are disappointed in the progress. In this case, there may be legitimate differences on how to proceed, but since such decisions invariably require the use of additional capital, economic control or the willingness to invest further capital is more important than voting control. Stated bluntly, this means that if the current investors choose not to invest again, new investors will be reluctant to make the commitment.

A number of financing alternatives are designed to help the management team maintain a greater share of the company. The most popular of these alternatives is the R&D partnership, which is some- times used together with venture capital as part of an early financing strategy.

The experiences of 125 high- technology firms which had outside investors illustrate how the equity position of the founders changes and additional rounds of capital are infused into the venture. After one round, on the average, the founders controlled about a two-third interest in the company. After additional rounds, however, the equity position of the founders can fall as low as 20 percent. The point, of

course, is that the percentage of ownership must be interpreted in terms of the size and the success of the entity.

Value Added by Venture Capitalists

O nce the venture capital deal is consummated, the venture capitalist is no longer

sitting on the other side of the table. He is now a partner and collaborator. The smart entrepreneur learns to use his venture capitalist investor as a unique kind of consultant, one who is an out- sider bu t who holds a stake in the company.

The venture capitalist brings to the venture more than capital, although that is obviously the most tangible value added. Besides being an investor, he is a disciplinarian, a sounding board, and a point man with a valuable network of contacts. The ability of the venture's management to utilize these values effectively depends on whe the r management shares the objectives of the venture capitalist. The investor's objectives are transparent: to make money. If the venture's management does not share this


objective, there is a problem. The only resolution possible is to realign management's objectives to those of the investor. This helps management, particularly members of the founding team, to impose a business discipline on their decisions. If the venture management continues to balk at establishing a business discipline, the venture capitalist may be forced to replace part or all of the management team.

The venture capitalist can help management in several ways.

Recruiting a well-balanced management team. Managing a growth company requires experience. Suc- cessful companies typically grow much faster than do the skills of its founding management. The gap between management ability and company needs often becomes wider and wider. The venture capitalist can be a valuable asset in locating and recruiting veteran managers from mature companies. Having done it many times for malay companies, it is far easier for the venture capitalist to spot the seasoned manager with a flair for marketing and the ability to take calculated risks.

Networking with support services. The venture capitalist maintains ongoing relationships with bankers, lawyers, accountants, executive searchers, and other profes- sionals. He knows who are the best and who are particularly sympa- thetic to the needs of young growth companies. Moreover, the investor can provide connections with distri- butors and vendors and even assist in the cross-licensing of technology.

Bringing strategic planning to the venture. Startup management tends to have tunnel vision, which focuses on the short time horizon of day-to-day decisions. The CEO may look only six months ahead. The venture capitalist with broader experience can often look twelve to eighteen months ahead. While managers slowly mature into strategists, the venture capitalist serves as the eyes and ears of the company.

Keeping the business on track. The business plan is a benchmark against which to gauge performance. The management of a company which is performing at 200 percent of plan is likely to pat itself on its collective back. The venture capitalist can help orient the management to a potential problem in this situation. Is management too conservative in its planning? Why were the original objectives set so low? In another situation, management may be sinking too much into its marketing budget. Marketing dynamics may demonstrate this to be marketing overkill. Here the venture capitalist can be the watch- dog who draws the line on spending and maintains an orderly and profitable growth rate.

Some Concluding Thoughts

W e have sought to demysti- fy the process of raising venture capital funding.

Prospective entrepreneurs should bear in mind that the process will take longer than they expect. Most firms spend four to five months searching for a round of financing.

Typically, the first round takes almost twice as long as subsequent rounds.

What happens if you are turned down for funding by a venture capitalist? Don't despair! Studies show that a number of ventures which ultimately raise venture money have been rejected at least once and some have been rejected several times. Of 193 firms denied venture capital, 70 percent con- tinue to survive. Of those surviving, two-thirds raised capital from other sources. If you are denied financing, you might find it appropriate to either reduce the amount of capital that you are requesting or increase the percentage of equity that you are willing to relinquish.

From the point of view of the entrepreneur, it may seem that capital is scarce. However, for the venture capitalist, the reverse is true. Rarely is the venture capitalist's investment activity con- strained by a shortage of capital. Most of the venture capitalists known to the authors report that they are limited by the availability of attractive investment op- portunities and the time to pursue them. To this end, the guidelines in this article can help transform an entrepreneur's vision and dream into an attractive investment op- portunity for the venture capitalist and, thereby, a successful business venture for the entrepreneur. V-]

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Finding a way through the venture capital maze