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The Truth About Venture Capital

Myth: Getting venture capital is impossible. Reality: It's not easy, but it can be done. We show you how.
February 1, 2000
URL: http://www.entrepreneur.com/article/18894

Some entrepreneurs beat the bushes in search of venture capital. Some pound the pavement. Others look high and low. Still others search with a fine-toothed comb or cover all the bases. Then there's Mark Fletcher, who did none of the above. (He avoids idioms.) Fletcher--chairman and vice president of technology for eGroups Inc., a free e-mail community service that allows Internet users to connect around common interests--sat back and let venture capitalists come to him. Well, maybe he didn't just sit back.

"We started working on eGroups [formerly ONElist] in August '97 and went online in January '98," recalls Fletcher. After nine months running the new business evenings and weekends while working full time, "we got calls from [venture capital firms] CMGI and Bertelsmann Ventures saying they had gotten together and were interested in investing in us. The Tuesday before Thanksgiving [1998], they called to set up a meeting the following day. We got the terms of the offer the day after Thanksgiving, and on Monday we signed a term sheet." In less than a week, the 29-year-old entrepreneur had arranged for a $4 million investment in his start-up.

Does Fletcher advise other entrepreneurs to wait for VCs to approach them? "No," he says emphatically. "My philosophy creating the company was: Let's get the service up and prove ourselves first. By Thanksgiving [1998] we were approaching a million users, so we could go in and say, `Here's what we have; here's how it works; it's a proven commodity.'"

Fletcher's experience would seem to perpetuate the myth that there is an abundance of venture capitalists in search of needy entrepreneurs. Fact is, there's more funding than ever, but there's no shortage of would-be takers. Tens of thousands of companies are unable to arrange any financing. Based on a PricewaterhouseCoopers Money Tree national survey, of the estimated $20 billion in VC funds invested in 1999, more than 90 percent went to tech ventures (including biotech, communications, computers, software and Net-based companies).

Does that confirm the myth that only high-tech companies qualify for venture capital? No, says John Martinson, chair of the National Venture Capital Association, the industry trade group. "There's certainly a segment [of the VC industry] that invests in consumer and low-tech companies--maybe not restaurants, but restaurant chains, for example," says Martinson, who also is managing partner of Edison Venture Fund in Lawrenceville, New Jersey. His member firms look to build sizeable companies that can command a premium value, either in an IPO or upon sale to a larger company--"companies that can be $100 million in annual revenues in three to five years," he explains. In today's market, that usually means technology companies.

But Dee Powers thinks there's more money available now for nontech firms. "Most VCs are mesmerized by the dot.coms," observes the cofounder of Profit Dynamics Inc., a research and consulting firm in Phoenix. "[But] since last summer, they've begun returning to quality and value investments, looking at management and markets. Entrepreneurs still have to look harder for nontech capital, but it's there."

To find it, Powers recommends checking the library for Pratt's Guide to Venture Capital. Or try VC directories, then call firms directly and ask for their requirements. While your best path to capital is a referral from your accountant or attorney, another option is searching the Internet. A Lycos Web search found 30 VCs seeking queries from nontech businesses.

Another prevalent myth: Venture capital is available only if your company needs millions of dollars. High-tech start-up veteran Neal O'Farrell agrees: "[As a high-tech entrepreneur,] unless you're looking for $4 million or more, forget venture capital. Of course, that's a generalization." In reality, the generalization is contradicted by the experiences of countless entrepreneurs and diminished by the formation of more and more small venture capital firms and Internet portals targeting start-ups needing smaller amounts.

As managing editor of Bottom Up (www.bottom-up.com) in Cincinnati, O'Farrell helps match start-ups with investors. His e-zine connects compatible parties while providing entrepreneurs with news, information, a panel of high-tech consultants and more. O'Farrell, author of Stepping Into Magic: A Handbook for the High Tech Start-up (Pylon Books, $24.95, 513-677-6749), has seen "tens of thousands of great ideas that won't make it because they aren't big enough. They might do $50 million [in sales], but that's not enough for VCs." His goal at Bottom Up is to help fill the funding gap for start-ups that don't yet appeal to the VC community.

Apple Computer's former chief evangelist, Guy Kawasaki, is eyeing a comparable niche: the gap above friends and family and below Sand Hill Road. Kawasaki's third and latest start-up, Garage.com, in Palo Alto, California, is intended "to help guys and gals in a garage find seed capital ranging from $4 million to $1 million," he says.

The Web site (www.garage.com) has a two-stage submission process. The first stage asks for a three page "executive summary" (who you are and what you want). The second stage is a detailed 10-page amplification. The best prospects are directed to a group of VCs and angel investors to exchange one-to-one e-mails. In the first nine months of 1999, Garage.com helped 20 start-ups raise more than $60 million.


Contributing writer Paul DeCeglie writes our monthly "Money" column.

Control Freaks

Kawasaki, who recently authored his seventh book, Rules for Revolutionaries (HarperBusiness, $25, www.harpercollins.com, raised $4.25 million for each of the first two rounds of financing for Garage.com, and raised $12.5 million more last September.

Which leads to another myth: Entrepreneurs risk losing control of their businesses to VCs. That may be true, says Spencer Kluesner, president and CEO of CyberLoan.com, a Denver firm with an online application system for business and commercial real estate loans. "Venture capitalists usually demand a larger percentage than an angel investor, and often take controlling interest, but your private company is probably worth only half that of a public company with the same revenues."

Which is to say, in the words of Guy Kawasaki, "I have never met an entrepreneur who, after an IPO or an acquisition, said, `I'm worth $22 million, but if I'd taken 10 percent less dilution I'd be worth $25 million. I'm unhappy.' You're either worth $22 million or you're worth nothing. Don't focus on [dilution percentages]."

What should you focus on? "Build a solid business before courting VCs," says Bill Tomeo, president and CEO of Tellsoft Technologies Inc. The Colorado Springs, Colorado, company, provides technology that enables customers to use any telephone to create, broadcast and archive live audio to the Internet. "Do your homework. Determine which firms play in your market, what their expectations are and at which stage they invest. Perhaps more important, evaluate your management team. Before VCs put money into your business, they want to ensure you have a [capable] management team."

Tomeo should know: He was brought in to assist the company's founders, former MCI engineers who lacked management experience, as part of TellSoft's initial $1 million round of venture funding. The founders remain aboard as executive vice presidents, and the company secured second-round financing of $7.3 million in October 1999.

In a recent survey of VC firms by Profit Dynamics, management caliber was the primary factor influencing investment decisions. The other determinants, in order of importance, were:

1. size of the company's market;

2. proprietariness, uniqueness or brand strength;

3. return on investment; and

4. potential for growth.

While two or three years ago VCs wouldn't even talk to inexperienced entrepreneurs, many VC Web sites now reflect a more relaxed posture, calling for "an experienced management team or the willingness to build one." It seems VCs are accepting the fact that the entrepreneur may constitute the entire management team.

Does that discredit the myth that VC firms are out to wrest control from founders? "It's not about replacing existing management, unless they're underperforming," says Kluesner. VCs, he says, look for "a balance that will provide investors with an outstanding return and motivate the founder to become wealthy in the process. We have never had a success where the company leaders did not become multimillionaires. The question is, how wealthy the founders will be relative to returns to our investors. And sometimes those founders are displaced."

Which may not be such a bad thing, argues Arthur Lipper, whose British Far East Holdings Ltd. in Del Mar, California, arranges financing for companies with extraordinary risk-related potential. "Investors frequently prompt management changes" when projections aren't met, says Lipper. He sees that as good for the entrepreneur, who, after all, is also an investor. "Coaches retire pitchers when they aren't performing. Why shouldn't entrepreneurs be retired [similarly]?"

To minimize the risk of being phased out, negotiate an employment agreement. But don't insist on control. Venture firms want top-level management--people who have taken companies public, have venture-backed management experience and boast a high-growth history. If that's not you, be prepared to step aside, because even if your technology is unique and the potential great, venture capitalists will walk away from an intransigent founder unwilling to relinquish control.

Know Your VC

One risk that certainly is not a myth is that of unscrupulous brokers who present themselves as venture capitalists. "Anyone who asks for money upfront is not a venture capitalist," says Kluesner. To determine if you're dealing with a broker or a VC, "ask who their investors are," Kluesner says. "A VC will rattle off names and fund sizes. If they say, 'It depends on the deal,' that's a broker."

Once you've determined a VC is legit, there are more questions to ask. "Find out who they've invested in and talk to those companies," says Kluesner. "Concentrate on VCs that invest in your industry. [Otherwise], you'll spend too much time educating them in your business, you won't benefit from their advice, and in the end they aren't likely to make that jump. Remember, they're not only investors, they're also your [potential] partners."

That proved true for David Cremin who, at 29, cofounded Vis-A-Vis Entertainment, a company that amassed a library of songs for distribution over telephone lines. "We were a little ahead of our time," Cremin reflects 10 years later. Intending to solicit capital infusion from a company called DigiDesign, Cremin inquired about the company through its financier, Silicon Valley venture capital firm Draper Fisher Jurvetson. "When I explained why I was looking for DigiDesign, Draper expressed interest in financing my company."

Draper invested $450,000 in seed capital in return for 33 percent of the company. "I couldn't have found a better VC," Cremin says of the relationship that lasted until 1998, when Cremin left Vis-A-Vis to become a partner in Draper's new Los Angeles firm, Zone Ventures (www.zonevc.com), which invests between $750,000 and $1.5 million in IT companies with huge market potential and great management teams.

Edward P. "Ned" Grace III, president of Phelps Grace International Inc., an investment firm in Orlando, Florida, urges entrepreneurs to understand the character, background and motivations of investors. Many founders put a lot of time and research into starting companies, "but risk blowing it all by not knowing their investors," he warns. "These people can, in the end, control [your] destiny." Grace further advises: "Look for value added from venture capitalists or any investor. What are their contacts? What is their power base? What do they bring to the table besides money?"

That persuaded Mark Fletcher that CMGI and Bertelsmann Ventures would make ideal partners for eGroups, which now has more than 10 million users. "CMGI was the initial funder of GeoCities, Lycos and others we have synergies with," says Fletcher. "Bertelsmann Ventures gave us access to [parent] Bertelsmann AG, the third-largest media company in the world. That enabled us to enter Europe. Not to mention, they own Random House, Doubleday, 50 percent of barnsandnoble.com, and have a board seat on AOL."

If you can find an investor who shares your vision, if you've done your homework, and if both parties agree it's a mutually beneficial fit, the remaining steps should be easy: The VC firm will give you a nonbinding term sheet to review. If that presents no problem, both parties investigate each other's facts and figures before negotiating the final points of the deal. Then lawyers draw up the documents. About a month later, you receive a check, and the VC firm appoints a director to your board. You and your VC share the same goal: to see your business grow and prosper. Once you've joined forces with the proper partner, Cremin says, "Get ready for the ride of your life."

Don't Be Myth-Led

1. Venture capitalists want to take control of my company. Not true. Most VCs want a fair portion of the company in return for their capital, but don't consider control unless your management team fails.

2. Venture capitalists load their deals with unfair terms. Some terms may seem unusual or unfair to an entrepreneur. For example, there may be a provision requiring the company to redeem investors' stock at a certain price after a certain period. Keep in mind that such a redemption represents a failure on the part of the VC, which will do everything possible to avoid taking this step.

3. Venture capitalists are only interested in numbers. VCs with finance backgrounds may want to dig into numbers. Those with technology backgrounds want to understand the technology. Management-oriented VCs want to spend time with key staffers. Overall, venture capitalists focus more on market, technology and people than on pure numbers.

4. Venture capitalists have unrealistic performance expectations. Our limited partners are making high-risk investments and expect high rewards. We must provide an overall return significantly better that the S&P 500. Top-quality, venture-backed start-ups have proven it is possible to achieve 40 to 50 percent annual growth.

5. Venture capitalists harp on "exit strategy." Limited partners expect a return on their investment in the form of cash or securities. Without an exit strategy, there is no return to investors.

6. Venture capitalists give me a lower valuation than a private placement. Sometimes. Venture capitalists, especially early-stage investors, spend significant time with entrepreneurs. We participate in business planning, sales strategy, key hiring decisions and links to the larger capital markets for additional investments or an IPO. In contrast, private investors tend to be less involved and offer less value in the long run.

7. Venture capitalists won't invest in small deals. The growth of venture capital "megafunds" that lean toward deals of $5 million or more has opened up opportunities for smaller funds to specialize. Smaller venture deals can get financed; you just have to look in the right places.

8. Venture capitalists are too quick to pull the plug. Almost never. That drags down the overall performance of the portfolio. Most VCs do their best to keep a company afloat.

9. Venture capitalists don't like signing nondisclosure agreements. True. Good ideas often arise in more than one place. If we sign overlapping nondisclosure agreements, it can become impossible to work with a company without violating covenants with someone else.

10. Venture capitalists are impossible to get on the phone. Guilty. In the early stages, it's far more effective to communicate electronically. After the investment, the VC will return your call. It's our money, too.

Stephen Fleming is general partner of Alliance Technology Ventures, an early-stage venture capital firm specializing in life sciences and IT startups.

Do's And Don'ts

Venture capitalists aren't untouchable--they're just busy. So send a business plan and cover letter before--or instead of--calling. Don't expect a response. Submit the plan to several firms. If invited to call (or if you must call), keep conversations brief.

In addition to a business plan, be prepared with a business summary focusing on the management team, profit projections, market position and exit strategy. Also put together marketing materials and due diligence analyses on the company, management and industry.

Take these materials--along with your product, if you have one--to your meeting to help the venture capitalist fully understand your product or service. Focus on your business plan. No pie-in-the-sky plans or dreams, no mention of products or services not covered in the business plan.

Don't:

Do:

E-Leads

Involvement in the venture capital market is complex. An accountant and attorney with VC experience and connections are essential and will provide your best leads to VC firms. For additional leads, check out the following: