Venture Capital Musings…
So you are interested in seeking investment from a venture capital fund? If you haven’t been down this path before, there are a few things you might want to be aware of before seeking investment from this funding source.
Fundamentally VC’s are about investing other people’s money. Before they begin to look at specific deal opportunities, venture funds have to raise the fund, a process that if successful can take the better part of a year or more. And like with other businesses that attract outside investment, the pedigree of the fund managers (their previous experience and track record) is a critical factor. Have the fund managers done this before and what is their track record? Do they have credible and comparable business or entrepreneurial experience that would suggest that they can be successful? The adage “bet on the jockey not on the horse” applies here.
So where does this outside investment come from? It can include institutions such as pension/retirement funds, insurance companies, foundations, and corporations as well as high net worth individuals. The VC principals, in the course of raising their fund, create an expectation that they will be able to provide a significant aggregate return from the series of investments they’ll make in the first several years of the fund’s life. Every fund has a sunset (usually ten years) so the investments must be made early enough in the life of the fund so that the invested companies have enough time to mature and work towards a liquidity event. This is important because the VC and their portfolio companies need to be on the same page as far as any potential exit event is concerned. VC’s are not passive investors. They will want to have significant and active representation, often a controlling interest, on the portfolio companies’ boards and thus may influence the composition of the management team. And because venture investing is a high risk proposition, it must provide for high rewards, i.e. – a good return for the limited partners, on the small number of deals invested in that account for the success of the portfolio. Here the 80/20 rule generally applies: 80% of the return is on average generated by 20% of the deals.
Another facet about VC’s is that they focus – on technology verticals and markets – things that they know. For example, one VC may focus on manufacturing companies while another will deal exclusively with IT related tech companies. They specialize on investment sweet spots that help them manage and reduce the risk profile of their portfolio. They’ll look at a lot of deals, conducting their deep evaluation/due diligence on only a few and will end up investing in fewer still. Of each 100 business plans that a VC sees, on average only 1-2% will obtain investment from them. So just because a VC is willing to talk to a company is not meaningful until they decide to invest the time to conduct due diligence, a process that can take a month or more of full time engagement from one or more of the fund managers.
Typically there are threshold criteria requirements that come into play for a VC to seriously look at an opportunity. Generally, there needs to be a complete or nearly complete management team – that “bet on the jockey” also applies here. They want to know about how big the market opportunity is and what the competitive landscape looks like. (How the company competes and wins.) Additionally, they want to know that the fundamentals are in place such as a validated business model, an effective marketing/sales strategy, and if there is intellectual property, how it is protected. Also a key factor is financial performance. Most VC’s have levels of revenue and earnings that they are looking for. A revenue threshold of $5 million is not uncommon. And while some VC’s invest in early-stage and pre-revenue deals, these are a small percentage of their overall portfolio. These may be companies that have seasoned and successful management teams or have technologies that are complementary to other companies in which they have invested and for which there may be opportunity to combine the businesses in some fashion to leverage position in a given market.
So for those companies that receive term sheets from a VC, there are a whole series of things to consider around valuations and deal structure – much more than can be discussed in this brief space…
John LaMarche, Principal at Venture Net Iowa