How Venture Capitalists Structure Their Investments

How Venture Capitalists Structure Their Investments

It is first important to understand how venture capitalists achieve their targeted rates of return of 30% per year. Not every company will make this return on equity but there are ways around it.

Much depends on the exit value of your company. A 30% rate of return reflects a price-earnings ration of 3. If the investor can exit at a higher price-earnings ratio they will earn more than their 30% desired return.

Another way to reach this target is by offering options. An option is the right to purchase shares of your company in the future at a pre-determined price today. If you grow at 20% annually and your earnings were 100 in the first year, your earnings would be 120 in the second year and 145 in the third. By using options the investor can then immediately purchase additional shares at 100 and sell them for 145 which can be added to their 20% annual return to reach the desired 30%.

A 30% return is an average figure and relates to the degree of perceived risk. If you have an early stage company you will need to provide a high rate of return. If you have a more mature business that has traction and you need financing for expansion or working capital, 30% may not be the required target due to the lower risk level.

Younger companies may also be forced to give up a disproportionately high percentage of shares to compensate for the high degree of risk. However, venture capitalists will frequently sell a certain amount back to you based on you meeting clearly defined performance objectives.
Another investment structure is subordinated debt. This usually caries a high yield and is usually not accompanied by equity. Subordinated debt is ideal for companies with solid cash flow and who need addition capital to grow thereby raising the value of their shares before raising any equity capital.

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Angel Funding On The Rise

"Angel funding for start-ups grew 20% in 2004 and helped create 141,200 new jobs, according to the Center for Venture Research at the University of New Hampshire, in Durham, N.H.

The total investment by angel investors rose to $22.5 billion last year compared to $18.1 billion in 2003. The volume of angel investments was 16 times more than the number of venture capital investments, and the number of entrepreneurial ventures that received angel funding in 2004 increased 24% to 48,000.

Barring any major external jolts, funding is expected to grow 10 to 12% in 2005, said Dr. Jeffrey Sohl, director of the Center for Venture Research."

"Software continued to be the most heavily invested sector, garnering 22% of all angel investments in 2004, followed by healthcare services (16%) and biotech (10%). IT services and financial services received 8% of the investments followed by retail (7%) and telecom (6%)."

"Women-owned ventures, which account for nearly 5% of entrepreneurs that seek angel capital, lagged behind their male counterparts. Acceptance rates for women-owned businesses stood at 12.5% (a 6% lag). Just one quarter of women angels, who represent about 5% of angel investors, made an investment in 2004.

Minority-owned firms had better luck with an acceptance rate of 20%, in line with the general rate. Minority angel investors account for just 3.6% of angel investors and only one in 10 made an investment in 2004."

Read more here.

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Do You Need Venture Capital?

"Point B Solutions Group, a Seattle company that provides project management consulting to dozens of clients, was started 10 years ago with a $200 investment from the three founders.

The profitable company now employs 185 people and last year posted sales of $31 million.
Not bad considering that Point B has never raised a cent of venture capital.

"We just didn't need it," co-founder Tim Jenkins said, adding that the initial $200 investment was used to buy letterhead and business cards.

Though often overlooked, there are plenty of companies like Point B that build their businesses organically through revenues and profits."

"Heidi Neck, an assistant professor of entrepreneurship at Babson College, estimates that fewer than 2 percent of companies ever receive venture capital financing. That leads her to believe that too much emphasis -- including media attention, education and government support -- is given to venture-backed startups."

""Historically, some of the greatest companies in the world have started with less than $5,000," Neck said. "There's too much weight put on venture capital. In the last five years, we have put venture capitalists on pedestals where we think they are going to create these great companies.""

"A study conducted on behalf of the National Venture Capital Association found that venture-backed companies were responsible for 10.1 million jobs and $1.8 trillion in revenues. Venture-backed companies headquartered in Washington state -- including Microsoft, Costco and Starbucks -- accounted for 399,863 jobs nationwide in 2003, according to the NVCA's report. "

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Preparing For Raising Capital

"From the earliest "idea-stage" start-ups to some of the largest of the Fortune 500, most companies, even publicly traded ones, raise equity capital through private placements."

"As most experienced entrepreneurs know, raising significant amounts of equity capital for an early-stage company is rarely easy. The uninitiated often believe that all they need is an introduction to a couple of well-to-do investors, an hour or two in a room with them to show them the wonders of their great idea or product, and out will come the checkbooks."

"Below is the general sequence of events in a private offering of securities:

• Prepare business plan• Corporate "clean up" and "due diligence"
• Obtain necessary company authorizations
• Decide whether to use intermediaries and if so, identify them
• Negotiate agreement with intermediaries
• Select desired offering exemption
• Define parameters, procedures, contingencies, timing, and geographic scope of offering
• Identify investor qualification standards (e.g., accredited, sophisticated, state residency requirements)
• Identify prospective investors
• Conduct initial blue sky (or state securities law) research
• Prepare offering terms
• Prepare the private placement memorandum (PPM)
• Prepare offering agreements (e.g., subscription agreement, investor questionnaire, shareholder agreement)
• Set up monitoring mechanism for PPMs
• Identify printer and forward PPM for copying
• Circulate the PPM to prospective investors
• Close the transaction
• Make necessary federal and state filings
• Issue stock certificates"

Read more here.

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What Happens After the Due Diligence Process

What Happens After the Due Diligence Process

If the venture capitalists are interested in your company after completing their due diligence, they will offer a binding term sheet. It will reflect the draft term sheet that has already been agreed to but this one will be a legal contractual agreement. Then the real negotiations start.

There are different types of financing to consider: debt, equity, and mezzanine.

Debt financing is the most objective and is therefore the easiest to negotiate. If you have the assets to support the debt and the income to support the interest payments, the negotiation period will be very short.

Equity financing negotiating is more complicated and revolves around agreeing on valuation and percentage ownership. Discussions usually requires several days.

Mezzanine financing involves a mix of equity, debt, convertible debentures and preferred shares. Negotiating the technical aspects of each so that an agreement can be reached between the investor and your company can be time consuming.

Another dictating factor is the number and variety of financing offers that you receive. It is the intermediary’s role to help you bring more than one offer to the table and assist you in evaluating and negotiating which one is best suited to your company’s needs based on their previous experience.

Venture capital term sheets are time limited. You have to quickly make up your mind if you want to accept or reject the offer. The short time period is in place to prevent you from using one term sheet to solicit new offers from other venture capitalists.

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Learn From Your Angel Investors

"If he were starting up a new business today, said David Fialkow, managing director of General Catalyst Partners, he would first employ the "earnest young man routine" to get an interview with an old guy in business who could explain the ins and outs of the industry. "Keep your hand out of your pocket, show up, and be prepared to listen," said Fialkow, a college dropout who helped create UPromise and a number of other successful ventures.

The goal is to get to market as quickly as possible, Fialkow continued. If you have a good idea, put smart people around a table for a few days, give them good food, and let them figure out the business model, he continued. He also said start-ups should spend more time on market verification and market feedback than on the "front office" issues of building a business.

Fialkow's lessons included trust your instincts; develop solid mentors; hire young, smart people; and pick industries that are going through a sea change. He recalled how a two-dollar ATM fee he once paid at an airport spurred him to start his own ATM network featuring out-of-town banks. Other ventures he helped create were a credit card processing center for supermarkets, duty-free shops on cruise ships, and his current stint at General Catalyst, a private equity fund.

Filipowski, who founded software maker PLATINUM Technology and sold it to Computer Associates International in 1999 for approximately $4 billion, said one ingredient for his entrepreneurial success was doing enough deals to get lucky every once in a while. He still receives royalty checks in the millions of dollars each year from a $40,000 investment he made in a pet business, which he thought had no chance of succeeding."

"Steve Hafner, founder and CEO of Kayak.com, an online travel information site, said an alternative to growing your own customers is to secure distribution through partnerships, such as Kayak's partnership with AOL.

In a discussion on the pluses and minuses of receiving venture capital, Hafner said his company sought funding not so much for the money as for the expertise—"We wanted adult supervision." Entrepreneurs run incredibly fast and focused, leaving little time for thinking about strategy and tactics to respond to events happening in the industry.

Entrepreneurs should be wary if they decide to go the VC route, said Fialkow. "They're smart, but not smart about what you're talking about." The best source of information and funds, he added, is angel investors with domain expertise."

Read more here.

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How Long the Due Diligence Process Takes

How Long the Due Diligence Process Takes
The due diligence process will very rarely last one or two weeks.

Remember that the venture capitalist is also working on other transactions beyond your company.

The due diligence will typically last at least one month. If there are any complex issues such as environmental approvals that have not yet been met, further delays are likely.

When you are considering raising capital, make sure to get all your company records and documentation together in advance. You do not want to wait until you get a draft term sheet before trying to find important documents that the venture capitalist will need to move forward.

More and more venture capitalists are also worrying about environmental assessments. You may consider getting your company and property assessed before approaching an investor.

The venture capitalists will also want to speak with your clients, suppliers and bankers to get an understanding of how your company is regarded by the outsiders who deal with you on a daily basis.

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What the Venture Capitalist Due Diligence Process Looks Like

What the Venture Capitalist Due Diligence Process Looks Like

The venture capitalist due diligence process is intense and can take weeks or months depending on the complexity of your company. It will be the most intensive look at your company that you have ever experienced.

The venture capitalists will want to know everything from your standard articles of incorporation, directors, and shareholder agreements up to the details of how your business processes are run.

The purpose of the initial meeting and draft term sheet is to get an approval in principle. From there the venture capitalist will carefully examine the details of your company before making an official offer.

An intermediary can be helpful in speeding up the process, especially when dealing with the lawyers on both sides. The intermediary is responsible for “cracking the whip” and ensuring the process is progressing. The faster you can make lawyers work, the lower your bill will be. Generally, if you give lawyers enough time, they will make sure to use it and bill you accordingly.

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The Next Steps After The Meeting

The Next Steps After The Meeting
If the venture capitalists are interested, they will very quickly come up with a draft term sheet for you which gives an overview of the conditions under which they would make an investment in your company. (see next page for a sample term sheet)

They provide a draft term sheet so that they can get an understanding of what the deal could look like and ensure that there is not a disconnect between you and them on valuation, methodology or type of financing.

The draft term sheet is not a commitment on the part of the venture capitalist. It is not a legally binding agreement. It is a proposed framework under which the venture capitalist is prepared to do business. The most important element of the draft term sheet is the valuation. If you are too far apart on valuation the deal will not go any further.

The due diligence process is not a 24 or 48 hour process, it is quite time consuming. In order to save time the draft term sheet is put forward to ensure that a negotiable transaction can be reached before investing further effort.

There are also considerable up front fees that the entrepreneur will have to pay. Among these are the venture capitalist’s legal fees. Some venture capital firms will also require a $20,000 to $30,000 non-refundable payment up front before going forward.

The time period given to accept or reject the draft term sheet is not very long. You will have to commit to it or drop it fairly quickly.

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How Intermediaries Can Help

How Intermediaries Can Help


Preparing for the meeting is a key role of intermediaries. They will go through a number of rehearsals with you and sit down for several sessions that could last for a couple of hours each to go over the likely questions you will be asked. They will also make sure you have the right answers committed to memory and can back up your assumptions properly.

A successful meeting with venture capitalists will result in good chemistry having been developed early on and at the end of the meeting. The venture capitalists will have openly expressed an interest in moving on and there will be a general level of enthusiasm at the end as supposed to the objective analysis of the business plan which occurs at the beginning of the meeting.

The intermediary knows the venture capitalists and their different accounts. Intermediaries know the sensitive points and help tailor each presentation to the particular venture capitalist. Every venture capitalist will have a different approach and the intermediaries will help you prepare for their potentially hostile questions.
Preparing for the meeting is much like preparing for a case in court. You only have one chance at it and you better do it right!

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Length of the First Meeting & Your Objective

Length of the First Meeting

The first meeting will very rarely last more than an hour. It is really designed solely to understand if you have the “horses for the courses.” This can certainly be understood in that first hour. The due diligence process will then follow.

Your Objective in the First Meeting

To persuade the venture capitalist to move to the next level.

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What VC's Are Looking For

"The process of getting a VC to invest in your business should be pretty simple. After all, it isn't a complicated formula — VCs have money to invest, and you have a business looking for investment.

While the process shouldn't be complicated, it isn't easy. The overall investment climate may be improving for VC-backed start-ups compared to two years ago, but there is still significant competition for investment dollars between entrepreneurs.

While the VC world is like any other business environment with certain ground rules, some entrepreneurs seem to over-complicate what is really required. They talk about the secret sauce in their business plan, or the need to create revenue models with little probability of attainment in order to demonstrate the mythical hockey stick revenue curve to pique our interest and reach the so-called "second meeting.""

"You need to show us that you are building something that customers need. It doesn't matter whether I think you have a good idea — what do your customers say? I can't afford to spend money to educate customers to buy a product that solves a problem that they don't know they have.

Before you draft a business plan, write a line of code or work on the product framework, there are end-users with urgent problems. They exist today, long before there will be customers for your great idea. Go and talk to them first. It isn't that hard to find people willing to talk about their problems, especially if you are not trying to sell them something. Look for the early adopters, and those that are willing to work with start-ups. Find out what their problems are and what they need in a solution. Separate the critical must-haves from the nice-to-haves.

You need technical validation of your idea, but you also need customer value propositions, case studies and customer references. Once you understand their requirements and business case, you can begin to look inward and figure out how your idea can solve their problem. Then come and see me and tell me about your idea, because a customer-driven focus is what turns an interesting idea into a great idea in the eyes of VCs, and separates entrepreneurs from inventors.

Too many start-up companies remain engineering-driven, spending too much time trying to build the perfect product from a technical perspective, developing features that the market may not need or want. A critical hire, if not already covered by the founding team, is filling the product management/marketing role early on. Find someone that can establish the product requirements based on customer needs and feedback. Build your company so that customer focus is part of your DNA."

Read more

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Other Information the Venture Capitalist Will Ask For

Other Information the Venture Capitalist Will Ask For

Venture capitalists will not go into too much detail in the first meeting.

They essentially want to meet your team and assess them. They will then decide if they want to move forward with you or not and begin their due diligence procedure, a process which continues right up until closing day.

Ultimately the potential investors wants to make sure that they clearly understand how your business operates and how your team can work together to fulfill the objectives of the company.

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Important Business Plan Questions They Will Ask

Important Business Plan Questions They Will Ask

The main questions about your business plan will surround the assumptions you have made. Mistakes are most often made at the assumption level. Prepare for your assumptions to be tested.

Avoid unstated or assumed assumptions. Make sure to write down every assumption that you have made in your financial projections. This is a critical part of developing the persuasion chain and convincing the venture capitalist to understand your numbers and eventually invest in your company.

Intermediaries such as Northern Crown Capital will ensure that you are ready. They know the questions that are likely to be asked and ensure that you have the right answers memorized before going in. You must be confident when walking in the room and in answering every question if you hope to instill confidence in the venture capitalists.

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Major Questions You Should be Prepared For

Major Questions You Should be Prepared For

The first meeting is primarily a question and answer session to see if you have the right management team in place. However, the venture capitalist can have specific questions for you to test such things as your technology. They may bring in a technology expert to get further clarification on points made in your business plan.

The venture capitalist can also use this meeting to test you on sensitive areas such as your company valuation and the eventual exit strategy. Investors will not want to go too far down the road with you if you cannot agree to basic terms with them. If you think your company valuation is $100 million and they determine your value to be $20 million, you have a sizable gap that may be too large to close and come to mutually acceptable terms on.

Another potential problem is that if you are wedded to your company and do not ever want to sell, it decreases the likelihood of an investor exit which lowers your chance of receiving the necessary capital you need to grow.

One example from Northern Crown Capital’s experience was when they found a perfect venture capital match for their client but the company’s management started disagreeing in front of the venture capitalists during the meeting. The marketing people were arguing with the research people and the venture capitalist needless to say did not invest.

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VC Interviews

"Many startups find financing from non-VC sources, such as government grants, strategic partnerships and angel investors. Some manage to make tens of millions of dollars going that route. In the early stage, how do you determine when to write a check or walk away?
BRANDT: Team and technology! If the team is strong and the technology is stronger – defined as protectable and commercializable – we are very interested in investing. Some technologies are just that, others are the base of a solution that can change something that we believe could be a huge market.

FAGNAN: I love companies that bootstrap through grants, partnerships and customers. I call this free money, as it’s usually dilution free from an equity perspective. I also like to pull free money into deals after I have already invested in them. I don’t think free money and venture capital contraindicate each other.

MCCALL: We have two situations when we have to decide whether to write checks or not. The first is during the initial due diligence. VCs look for promising markets with sizable potential, business models that are rational and management teams that you trust can do as they say and generally have a history of doing so. Most plays in the nano and micro realm are solid niche technologies that don’t have the breakout potential required in venture capital. Government and angel funding are great sources to take some of the risk factors off the table before pumping significant amounts of institutional capital into a deal.

The second situation is where we’ve already invested in a company and new funding is required. In these situations, VCs will assess if the company still has a compelling and credible business proposition and if they have trust in the management team to execute. We all make macro bets and assumptions when we back companies. Sometimes it’s clear that the company is treading water, if not sinking. We have to sit down with the management team and assess if there really is a business here or if everyone agrees to find a home for the company. In other cases, you try to manage down the burn rate until the business model is clearer.

QURESHI: One of the important keys is to assess whether the startup truly has a unique and sustainable competitive advantage over the long term, such as through intellectual property. Intellectual property is particularly important for any platform technology. For example, intellectual property around diamondoids and their applications is a key focus area for us at MolecularDiamond. "

Mark Brandt, Managing partner, The Maple Fund

Jeff Fagnan, Partner, Atlas Venture

Matthew McCall, Partner, Portage Venture Partners

Read more here.

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Creating The Perfect Pitch

"Entrepreneurs are invariably in love with their ideas and desperate to explain every last detail. But it is important to make sure that the plan is as brief as possible, otherwise it will end up in the bin long before the investor reaches the end. It should have an executive summary right at the front, setting out all the key facts in one page of bullet points."

"Producing a clear summary of the major assumptions underlying the business plan is a valuable exercise. This is the angle from which much of the questioning by potential investors will come. If you can set out your assumptions clearly and explain the rationale behind them, the plan will come across as being much more professional. There's no guarantee that investors will agree, but at least they will understand the thinking behind the business."

"There are few sure things in life, and the only certainty about business forecasts is that they are wrong. So, working out by how much, in which direction and, crucially, why, is the challenge. Failing to include some sensitivity analysis is a mistake that inexperienced entrepreneurs often make. Business plans need to recognise this and identify what the impact will be if, for example, the business misses its sales target by 10% in the first year."

"Turning the finalised business plan into a professional presentation is the next step in the process. The presentation should memorably - and succinctly - outline what the business does. The pitch is too complicated if the core purpose cannot be explained in 30 seconds, and you risk losing the interest of the investor. There's a lot of truth to the old cliche about identifying a 'unique selling proposition', even if it may have been overtaken by newer management jargon."

"The credibility of some seriously good projects has been destroyed in one fell swoop by a hesitant delivery and, worst of all, when the technology gets the better of an entrepreneur. Practise the presentation as much as possible. And if you're using PowerPoint to deliver your presentation, make sure you have hard copy sets of the slides, just in case the projector bulb blows or the PC crashes."

"And don't sell yourself short. A common mistake entrepreneurs make is not raising enough money. If an idea is sound, a professional investor will be happy to put in a little more, if it gives the business a contingency fund to deal with the unexpected costs and problems that are inevitable with any new venture. Going back later to ask for more is usually difficult unless there is a very good reason why the extra requirement wasn't anticipated at the outset."

"Entrepreneurs must also be realistic about the potential value of the business. Investors will want a meaningful stake in the company, and not just a few per cent, so prepare yourself for giving up a significant share of the action."

"They will also want a very healthy return on their investment and a planned exit route, so that they can see how they are going to get it back."

"Raising money for new ventures is difficult at the best of times, but good professional advice and a planned, strategic approach can prevent it becoming mission impossible."

Read more here.

For more information, visit www.EvanCarmichael.com.

El Dorado Ventures Closes New Early Stage VC Fund

"El Dorado Ventures, a leading venture capital firm that specializes in early-stage investing, today announced the close of its seventh venture capital fund, which will make seed and early-stage investments in the semiconductors and systems, communications, software and services sectors. "

"El Dorado Ventures VII (EDV VII) is a $200 million venture capital fund that will be invested in approximately 20 new ventures over the next three years. El Dorado Ventures (EDV) specializes in helping entrepreneurs start and build new market-leading technology companies and has an 18-year track record of success, including investments in Cyras Systems, EarthLink, Efficient Networks, Novellus and NuSpeed Internet Systems. The firm has more than $700 million in capital under management. "

""We expect to invest EDV VII in the same broad technology sectors in which El Dorado has demonstrated its ability to find and build successful new technology ventures," commented Scott Irwin, General Partner of El Dorado Ventures. "Within those categories, we see large opportunities in areas such as on-demand software, personalized digital media, wireless convergence, and technology-neglected industries," he added. "

"About El Dorado Ventures
El Dorado Ventures (EDV) is a leading early-stage venture capital firm with an 18-year track record of success, including early investments in Cyras Systems, EarthLink, Efficient Networks, Novellus and NuSpeed Internet Systems. Numerous EDV portfolio companies have gone public or been acquired by major technology companies including Ciena, Cisco Systems, nVidia, Siemens, Texas Instruments and Yahoo/Inktomi. Entrepreneurs see EDV as a trusted investment partner that shares their vision and plays an active role in their success. More information is available at www.eldorado.com."

Read more here

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Major Questions You Should be Prepared For

Major Questions You Should be Prepared For

The first meeting is primarily a question and answer session to see if you have the right management team in place. However, the venture capitalist can have specific questions for you to test such things as your technology. They may bring in a technology expert to get further clarification on points made in your business plan.

The venture capitalist can also use this meeting to test you on sensitive areas such as your company valuation and the eventual exit strategy. Investors will not want to go too far down the road with you if you cannot agree to basic terms with them. If you think your company valuation is $100 million and they determine your value to be $20 million, you have a sizable gap that may be too large to close and come to mutually acceptable terms on.

Another potential problem is that if you are wedded to your company and do not ever want to sell, it decreases the likelihood of an investor exit which lowers your chance of receiving the necessary capital you need to grow.

One example from Northern Crown Capital’s experience was when they found a perfect venture capital match for their client but the company’s management started disagreeing in front of the venture capitalists during the meeting. The marketing people were arguing with the research people and the venture capitalist needless to say did not invest.

For more information, visit www.EvanCarmichael.com.

What Happens in the Meeting

What Happens in the Meeting

Meetings with venture capitalists are also referred to as “the dog & pony show.” It provides the first opportunity for investors to meet the management of your company face to face and assess the people behind the business. You could have a brilliant business plan backed by poor management. This will only become apparent to the venture capitalist in the meeting.

There is an old British banking expression that asks: “Is someone the horse for the course?” In other words, do you have the right management team for the task at hand. It then follows that different horses are needed for different courses.

The point of this initial meeting is to test the management face to face. The venture capitalist wants to build confidence with the management team.

The intermediary’s prime role is to get a “dog & pony show” together with a number of venture capitalists.

The venture capitalist may question your business plan to test you. Make sure to have someone with you who understands the finances and who knows the product or technology.

The meeting will usually start off with a 5 minute update as to what has happened since you submitted your business plan. The rest of the meeting will be a question and answer session.

People like to do business with people who they have an affinity for. The development of trust between yourself and the investor is paramount. They must get a feeling that they can work with you and that there is positive chemistry.

As an example, an entrepreneur who walks into a meeting dripping in gold, diamonds and flamboyant suits will have a hard time raising capital because the venture capitalists will not feel comfortable with this person.

For more information, visit www.EvanCarmichael.com.

The Intermediary’s Role in Putting the Plan Together

The Intermediary’s Role in Putting the Plan Together

Intermediaries do not put your plan together but will help you clarify your offering. They will know how attractive your proposal looks from an investor’s point of view and be able to help you improve it

The basic business plan is put together by the entrepreneur and the intermediaries know what the venture capital hot buttons are and how to turn them on or off. They can help ensure that the most attractive elements of your plan are clearly brought up to maximize the chance of investment by the venture capitalist.

As an example, there are many entrepreneurs who have intelligence, common sense, and a great business sense but are not skilled at writing things down on paper and creating a logical business plan. Northern Crown Capital has helped such individuals in clarifying their business plan and assisted them in then going after a significant capital investment.

For more information, visit www.EvanCarmichael.com.