Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
Raising venture capital financing--as a first-time founder in particular--is a difficult task, even in the strongest of financial markets. At a recent conference, a panelist opined that over 95 percent of entrepreneurs decide not to raise venture capital. The response from another panelist: "Just like over 95 percent of my friends have decided not to date supermodels." Knowing what to expect can often be half the battle. The following are a few common misconceptions entrepreneurs often have when seeking early-stage venture capital financing.
Myth No. 1: "By demonstrating the tremendous value of my idea, I will be able to demand a high valuation for my new company."
Many early-stage entrepreneurs focus extensively on the value of their new enterprise, constructing elaborate discounted cash flow models to demonstrate the net present value of their future projected revenues.
Reality: In early-stage venture capital financings, the concept of valuation is simply a proxy--it's really all about percentages. Putting aside seed financing transactions involving less than $2 million, the typical post-financing capitalization for a company's first venture capital financing breaks down as follows:
- Lead VC: 20 to 25 percent. Venture capital firms typically insist on owning at least 20 percent of all early-stage portfolio companies.
- Co-Investor VC: 20 to 25 percent. Most VCs prefer to invest alongside a co-investor, which (dilution aside) is generally considered to be more favorable to both the investors and the company.
- Option Pool: 15 to 20 percent. Unless the VCs truly intend to bring in a new CEO prior to the next round of financing (and sometimes a discussion regarding option pool size will reveal that), negotiating the size of the option pool is a surprisingly effective back-door way of negotiating valuation (as the option pool is part of the "pre-money" side of the valuation equation).
- Founders: Whatever's left.
Unlike valuations of later-stage companies, valuations of early-stage companies generally do not fluctuate with the financial markets. Instead, economic downturns result in fewer early-stage companies getting financed, and in smaller funding amounts for those companies that are successful in raising capital.
Myth No. 2: "I am going to retain control of my company."
Entrepreneurs who are overly concerned about control will need to find a path to success other than venture capital. A glance at the typical ownership percentages above shows that after a single round of financing, the founders no longer have "control," not to mention the specific veto rights that the VCs will have over key matters (such as acquisitions, the next round of financing, etc.).
Reality: As compared to other types of corporate finance transactions, the terms of venture capital financings are structured around alignment of incentives, not control. VCs recognize that founders must have a sufficient incentive to create value for the benefit of all. As such, the terms of a typical venture capital financing provide that, after a return of capital invested, the investors do not profit unless and until management does. Likewise, management does not profit unless and until the investors do. A principal issue with multiple liquidation preferences and other more onerous financing terms is that they result in a misalignment of incentives, which runs counter to the general VC philosophy that has resulted in the creation of so much value over the years. Unfortunately, a control structure in which a board of directors lacks the ability to hire or fire the CEO at will also runs counter to this proven wealth-generating structure.
Myth No. 3: "By taking less money now, I will avoid dilution."
The amount of financing a company should raise is often a controversial issue. Although this is less true in certain market segments in which a technology needs to be developed in a serial fashion, many early-stage companies are able to construct an equally credible budget and use of proceeds for either $500,000 or $10 million. Entrepreneurs will sometimes intentionally elect to raise lower amounts of funding in order to minimize dilution or "remain attractive for the quick flip in a sale of the company," but a significant majority of the time, that decision is later regretted.
Reality: Raise the amount of funding that will enable accomplishment, with some cushion, of the key milestone that will justify a significant increase in valuation. Valuations of early-stage companies generally do not increase in a linear fashion over time, but instead in a "stair-stepping" fashion, jumping upon a key accomplishment (such as a product release, a certain level of customer traction, a big deal or a technical milestone) and then flattening (more or less) until the next milestone. Taking a $500,000 seed investment to be able to raise "Series A" at a higher valuation makes sense, but only if that key milestone can actually be reached with $500,000 (if not, then the future valuation is likely to remain at a similar level).
You also don't want to leave cash on the table. As noted above, early-stage valuations are generally more about percentages than true "valuation." So if a company can raise $10 million in initial financing as opposed to $7 million, it is likely that the ownership percentages will be similar either way. In addition, very few entrepreneurs have ever regretted taking additional funding when it is offered. At the end of the day, start-up businesses fail for one reason: because they run out of money. Raising money opportunistically helps to weather the storm caused by external factors such as market or economic conditions.
Myth No. 4: "I am going to be able to choose the right VC for my company."
There are entrepreneurs who, mostly as a result of their past experience building companies to successful exit events, are able to meet with a few top VCs they know well and raise funding from one or two of them. If Bill Gates decided to start a new company, there would probably be some folks willing to back him. But for the other 95 percent of venture-backed companies, it takes more work than that.
Reality: The one VC (or two or three VCs) who ultimately delivers a term sheet will instantly be the right investor (and the smartest guy in the room). A company should obviously be selective about the investors they choose to approach by targeting those that would be a good fit, but the VC process is ultimately more or less self-selective.
David Young is a partner in the Corporate and Securities Group of DLA Piper LLP (US) in its San Diego and Los Angeles offices. Mr. Young specializes in representing emerging companies and the venture capital firms, strategic investors and investment banks that finance these companies. Nicholas Hobson, a Corporate and Finance associate in DLA Piper's Los Angeles office, also contributed to this article.