The first step is research. Which firms are a good match for your type of business and the stage of financing you are looking for? According to Melissa Lassiter, an investment manager with Parish Capital in Research Triangle Park, NC, early stage capital is increasingly available only through the small venture funds. Many of these are spin-offs of larger funds, where a successful individual or two from an established VC fund goes out to start a fund of their own.
Today, the larger, better-known funds are focusing primarily on sizable “growth capital” rounds for established, profitable businesses. So before you call the top funds in town seeking to raise $1 million to get a new business going, do a little research to identify the smaller guys with whom you have a legitimate shot at securing some capital. For a list of venture capital funds and their target markets, check out www.vfinance.com, www.entrepreneur.com OR www.nvca.org. Yahoo also has an extensive list.
In selecting the funds to approach, be sure to visit each firm’s web site to see if your business is a fit for their strategy. Pay particular attention to who their portfolio companies are, as this will give you better insight into their true appetite than the general parameters they list on their home- page. VC funds that have invested in the same or a related industry sector are often the most receptive, and if not, at least they are less likely to waste your time if there is not a fit.
Kathy Harris, with Atlanta’s largest venture capital fund Noro-Moseley, says the best way to approach a venture firm is through someone who has done a deal with them in the past. This might be a management team member or board member from one of their portfolio companies or even an attorney who has previously done business with the fund.
If you have a good meeting with a fund that decides not to invest in your business, ask them who they think would be a good fit, and ask if they will make an introduction. According to Bill Henagan, chairman of Atlanta Technology Angels, relying on an agent to promote an early stage deal is “the kiss of death” because early-stage investors don’t like to see a meaningful chunk of their investment going to pay fees. It also shows a lack of resourcefulness on the part of the entrepreneur; it is not difficult to identify whom to call in the close-knit venture capital community.
But before you pick up the phone and start dialing for dollars, you need to be sure you have the type of business that professional investors will look at and that you have the information they will be asking for written down on paper.
There are countless great business ideas out there and many ways to make money. A good business model, however, may not be sufficient to attract venture capital. VC firms are looking for a business concept that can become a very large company, i.e., more than $100 million in revenues, if the enterprise is successful. The market you are going after must be sufficiently large to accommodate a new entrant that will grow to that size.
I have reviewed many well-written plans in which the company would have to capture a 100 percent market share to achieve any meaningful size. Define your market and quantify how large it is before even contemplating approaching a VC fund.
Also on the checklist for VC funds is a valid “use of proceeds.” Be sure that you can explain exactly why you need someone else’s money and what you are going to do with it. I have never met a business owner that didn’t believe that they could grow much faster if they had more capital. By definition that is usually the case. However, you need to show that rapid growth and scale are required to succeed in your business and that internally generated funds are inadequate to finance that growth. In other words, there needs to be a window of opportunity that will close if you do not secure greater financial resources.
What else do professional investors look for? Paramount is evidence that the management team is up to the task. You need to have not just the potential but also to have demonstrated the capacity to build a company in the sector you are in. This experience is referred to by VCs as “domain expertise.”
Having run a similar business unit for another company or possessing a track record of building successful businesses from scratch are the best ways to demonstrate that you can accomplish what you have put on paper. Of course, the same VCs that preach the importance of “management” today all threw millions at baby-faced Internet wizards a few years ago. Because most of the VC funds got burned abandoning their number one principle, they say that they really mean it this time.
Absent a track record, you will have to deliver a proprietary advantage in the form of technology or relationships that will get your business to the stage at which you can bring in the appropriate management team to take the company to the next level. But even a great new technology is not adequate to attract venture money. There are countless inspiring technologies in search of a market.
No matter how great the idea is, you have to be able to explain your “financial model.” A financial model is an articulation of how your concept will produce profits. That means you need to know how much it will cost to produce the product or service — on a fixed and variable basis — and how much you can charge for it given the dynamics of the market you are going after.
Over the years, I have probably seen a dozen business plans from entrepreneurs who claim to be able to turn trash into energy. While that is a noble concept, unless you can demonstrate that the cost of converting the trash to energy is low enough and the amount of energy created is high enough to compete with existing energy alternatives, you don’t have a commercially viable technology. The price point for your product or service needs to be low enough to capture the market share indicated by your financial projections, yet high enough to generate an attractive return for professional investors.
The return VC firms look for depends on the size of their fund and the stage of company in which they are investing. Generally, it is in the 30 percent to 40 percent range. That means if you achieve what they believe to be a reasonable level of success, and they cash in their investment in five to seven years, they can expect a compounded annual return on that investment in the 30 percent to 40 percent range.
While this may sound high to an aspiring entrepreneur, their required return reflects the amount of risk they are taking. Out of every 10 investments, a professional venture capitalist expects to hit one or two home runs (quadrupling their money or better); a couple of doubles, a few singles and to strike out three or four times. Starting with an expected return of greater than 30 percent for every deal provides them the discipline to avoid business models that lack the potential to be an extra-base hit. In fact, the reality is that over long periods of time, venture capital funds in the aggregate have an abysmal track record. So even targeting returns of 30+ percent does not often result in achieving them.
While Harris says that Noro-Moseley seldom fails to close a deal because of a difference with the owner in price expectations, before you approach a VC fund, you should run the numbers to see what percentage of your company you can expect to give up for the amount of capital you are seeking and still provide the investor a return in their desired range.
Finally, when you are ready to send off your proposal to VC funds, be sure to send an appropriate document. Because the partners in these funds have an inbox dozens deep on any given day, they do not have time to read that 50-page treatise you wrote on the company. A one-page overview won’t do either. You should prepare a five- to 10-page executive summary that addresses all of the above issues, plus a brief analysis of the competition and why you have something to offer that other companies don’t or can’t.
As mentioned, the best entrée to a venture capital fund is an introduction from someone the VC firm respects, but the reality is that most first-time entrepreneurs do not have such connections. If that is the case, make sure you have a powerful executive summary, and mail it to the VC firms that are a fit. They are used to receiving proposals over the transom and they will eventually give it a look and get back to you.
Your chances of receiving a prompt and favorable reply, though, are greatly enhanced if you carefully select which funds to approach and send them a document that articulates answers to all the obvious questions they will ask prior to reaching for their checkbooks.