VENTURE FINANCING – REALITY VS. RUMORS: About Angels & VC’S

Venture Financing - Reality versus Rumors with Dick Brown

I belong to several “special interest” groups on the Internet, generally those relating to entrepreneurs and financing. On one of these on LinkedIn had a simple inquiry:

Where can we find investors in the United States that would be interested in helping us fund our venture?

It was late on Friday. I’d had a good week and was in a wry mood. I replied:

Go to New York. Rent a room at the Plaza. At cocktail hour go to the Oak Bar. It will be jammed with people. At least 75% of all the ones you see in this room have adequate funds available to help finance your deal. Bring your lawyer for the closing details.

Although impish, my comment was quite accurate. Even in today’s environment, it isn’t hard to find people with money that might be interested as an investor. The easy part is finding where they gather.

The trick is selling them.

There’s an old sales adage that says: “In order to sell anything, you first ask the potential customer why they’d consider buying your wares. Then you sell to them, based on what they just told you”

In earlier columns, we’ve talked a lot about many different kinds of investors. You already understand the people that comprise your “3F’s”. Few of you will require the huge capital amounts available from merchant banks. So, most of you will require funding in the ranges supplied by either Angels or VC’s. Here’s some clues on … “why do they buy?”


Angels & VC’s - What They Have In Common
They are both sophisticated investors and require that you have:

• Excellent profit potential,
• A good business plan,
• A competitive product or service,
• An excellent marketing opportunity,
• An experienced management team.

The other things they both like:

• A proprietary product or service, preferably protected by patents, trade secrets, copyrights or unique market timing, know-how and contacts of the principals in the venture.
• Growth potential: large and fast. Able: to reach $25 million to $50 million in sales in 5-10 years.
• High return on investment: at least 20% to 25%.
• Management comprised of seasoned, experienced pros with track records in successfully making money. The venture also has some members of "the club" - people who are already connected to the money community and/or its support staff (lawyers, accountants, bankers etc.)

Angels & VC’s - What’s Different between Them

1. Size of investment:

Traditional VC Investments	Angels/Other Adventure Capitalists
21% are under $2,500,000	90% are under $1,000,000
7% are under $1,000,000	82% are under $500,000

2. Other Issues:

	Venture Capital	Angels
Time to make a commitment:	Slow	Quick
Number of sales leads needed:	Moderate	Many
Whose money?	OPM	Their own
You meet at:	Their office	A private, secure place
“First Man In” Leverage: *	Very High	Medium
Networks:	Huge, National	Small, Regional
Ease of Finding:	Very Easy	Moderate to Impossible
Tolerance for putting in more money:	High	Moderate

* Note: In any sales situation, the first sale is always the toughest. From that point on, the salesperson can always say: “Mrs. Jones bought one and absolutely loves it! Would you like to talk with her?” (i.e.: your “singer”)

Due to the basic characteristics of VC’s, getting one of them to commit to the deal makes it much easier to rope in the rest. As mentioned, the first-VC- in may also bring others with them as a syndication.

For angels, having your first investor is nice, but not nearly as powerful as a sales tool. The angel probably doesn’t know your first investor personally and usually doesn’t care.

Amazingly, I have had angels invest in the early stages that never even asked if anyone else was already in!


The Biggest Difference
For our sales activities, we are going to take advantage of the largest difference between VC’s and angels. VC’s belong to a very large, interlocked club. There is an enormous, day-to-day exchange of information between the members of this club. The motive of every member is to make money for their VC firm and if they find a deal to do this they act, sometimes very quickly. If not, they may refer the opportunity to other VC’s or angels in case the other parties might be interested.

This is also the reason that I urge entrepreneurs that seek funding to include many VC’s in their prospect lists even if the amount they seek is relatively small and could be fulfilled with only one. If you have a good idea for your venture, it’s possible that a mailing to VC’s may wander through a number of hands to ultimately find the VC company, angel or corporation that is very interested.

Conversely, angels are not closely linked (except for the angel clubs and associations) and they are not interested in making money for anyone except themselves and an occasional friend. Contacts/mailings to angels do not have the same potential multiplier/leverage factor than for VC’s.


Another Difference … Time To Market

The graph above shows the typical growth curve of any new product or industry in the US. The left-hand side represents the time of greatest risk and greatest rewards. Companies that enter the market here traditionally sell to the “early adopter” customers. Clearly the major risk is that there may not be enough demand from the early adopters to support the company or other market suppliers. Companies and products regularly fail in this space.

The middle portion of the graph (bars) shows a substantial growth in sales, with demand outpacing supply. Most companies earn their highest profits in this phase.

The right-hand side of the graph shows the products and markets in a near-stable condition. They have reached their “natural peak” and from this point the companies that survived the earlier battles and the larger companies that entered late in the game supply the market. This market is often one in which the majority of suppliers compete solely on the basis of price. This is a tough place for the smaller competitor.

Angels like to play with companies in the left hand side of the graph: Very high risk, very high rewards. This usually terrorizes the VC’s, but sometimes they get right back in that game, looking for huge returns from a handful of investments.

VC’s favorites are still those companies that survived the early stage and are in the middle portion. It’s a lower risk, but still pretty good rewards. Angels will invest in this stage as well. On the right hand side of the graph, neither VC’s nor angels are likely to invest*, unless your company is one of the winners in the market and needs additional capital (“bridge” or “mezzanine” money) to get to an IPO.

* Exception: You might have a chance for financing if your plan has some unique idea that will position your company in a secure niche within the mature market and also make your venture very profitable due to the large, proven, active demand for products.

Market Differences
Angels will invest in anything and often for “cosmic”, not-totally-rational, reasons.

VC’s are focused and disciplined. Generally, their favorites are:

Software	24%
Medical Devices	13%
Biotech	10%
Green Technology	9%
Internet Specific	9%

Your Closing Rate - Summary
One major, Northeast VC receives over a thousand business plans in the course of a year. They invest in around 10 deals. If you're trying to use this VC to raise money, you've a 1% chance of success. When it existed in the .com space, the conglomerate CMGI, received over 1,000 business plans a month.

How do you get to be one of the lucky few?

• First - Work very hard and show your venture to many, many of the potential capital sources you’ve selected.
• Next & Simple - find out what your VC community wants and then sell it to them! Use exactly the same technique with angels.

What's the single, most important thing both want?

They want to make a lot of money!!
Yet, not one business plan in 100 shows how the particular venture will make money ... and, preferably obscene profits, with a minimal investment. Ironically, many plans show how the venture will lose money until some, long-away future time when the red ink finally stops.

Show any angel, investor or businessperson how they can make a lot of money and you'll have their undivided attention!

The Odds
Let’s imagine that you decide to blindly follow all the rest of the sheep and choose only to consider venture capital financing. Further: You throw my columns away; fail to read books or follow anyone’s advice; don’t bother with a good business plan; and, insist that you’re going to trust your “gut instinct” (what you’ve read about the wild success stories of teen-age billionaires depicted in the San Jose Mercury.) You just know that the VC’s will love you and you’ll do your IPO in less than a year.

If you take this “path worn thin by the ignorant”, here are some of the odds:

1. There are 10 “high-tech hubs” (Austin, Boston, Boca Raton, Chicago, Los Angeles, New York, Raleigh/Durham, San Jose/San Francisco, Seattle and Washington, DC.) Some 70% of all venture capital investments are made in or around these hubs. If you’re not in one of these markets, the VC odds are already against you … most VC’s funds deal solely in their geographical area since it’s easier (and cheaper) to monitor the investment.


2. “Not even 1% of the 300,000 or so companies growing at 20%+ a year (e.g.: Inc magazine’s “Private 100”) are backed by VC’s”.


3. During the .com frenzy a “swinger” VC, WIB, (Laguna Beach, CA) was shown 200 deals a month. They reported doing less than 2% of these (That’s 4 deals/month, folks!).


4. The VC firm of Draper Fisher Jurvetson, based in Menlo Park, California with affiliate offices in more than 30 cities around the world gets 10,000 business plans a year and backs some 15 deals. (.15% ... That’s point 15%!)


5. Only one of thirty companies that receive venture capital financing ultimately goes public.

So, based on these numbers, the odds on getting VC funding and going public is far less than 1 in 25,000.

By comparison, your odds of “Death by Lightning in the US” are 1 in 17,400.



NEXT: IMPROVING THE ODDS AND WINNING!

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For more information, please visit Dick's TNNW Bio.

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VENTURE FINANCING – REALITY VS. RUMORS: About Angels & VC’S

VENTURE FINANCING - REALITY VERSUS RUMOR: Understanding VC's

Venture Financing - Reality versus Rumor with Dick Brown

Understanding VC’s - Of all the players in “the entrepreneurs’ game” the most vilified is the “VC” (venture capitalist). The supplicants seeking money blame VC’s for everything: failing to supply them capital; wanting to run all the companies they finance; owning too much of each venture; and, wanting to make obscene sums of money. Why?

Not surprisingly, these comments are most often made by the newest, most immature entrepreneurs. They seem determined to indict all VC’s … yet, they have scant knowledge and it’s based largely on industry myths … most of which are false. The most vocal of these folks have never met a real, live “VC” and would be tongue-tied-terrified to be sitting across from “a real, live one” at lunch.

The entrepreneurs’ role-model for modern VC’s lies close to Shakespeare's “Shylock, the money lender” Similar to that character, latter-day VC’s are accused of providing money at exorbitant rates … thus extracting their "pounds of flesh" from the innocent and noble money seekers. In reality, as in “The Merchant of Venice”, most VC’s have enviable human qualities (“If you prick us, do we not bleed?”) and can become not only sympathetic characters, but staunch, invaluable allies in most ventures, particularly the successful ones. Let’s look at typical VC’s and the truth behind some of the misconceptions

VENTURE CAPITAL – INSIDE, LOOKING OUT
Venture Capital companies invest OPM (Other People’s Money). Each VC company usually has Managing Partners (MP’s) that invest this money, some of which is usually their own. MP’s are measured (and paid) to generate more profit than the pure investors (“LP’s” or Limited Partners) could make putting their investment somewhere else with similar risks.

A typical Managing Partner is a male somewhere between 40 and 60. Although some MP’s were born with the silver spoon, most made their money by starting ventures that grew into successful companies. They are usually well-mannered, aggressive, experienced executives that have survived more than a few battles. They are adept in money matters and can smell a shaky financial deal better than the most experienced CPA. They have heard every excuse imaginable for failure, yet rarely offer one for their own errors. Although they are considered to be among societies’ “successful”, their past glories become unimportant as they strive to beat their VC contemporaries to that top rung of recognized champions in that industry.

Entrepreneurs Versus VC’s
Scenario #1
Entrepreneurs: We had this fantastic concept for a new venture. We did a great business plan and sent it to some VC’s. None were interested. They’re just too dumb to recognize our potential.

VC’s: Entrepreneurs believe we are sitting with bated breath at each mail delivery, wired and waiting for their business plan. They don’t know we can receive hundreds of e-mails a day and well over 1,000 a year. Most are sent by email and are quickly “chucked” unless they show immediate and unusual promise. The majority of the BP’s we receive predictably fall into disposable categories: small business proposals disguised as ventures; Bill Gates look-alikes (“we’re going to beat his growth, but quicker”); inventions that have already proved impossible to implement or market; deals that require multi-million dollar investments from people with no business or management experience. If you send us a BP that will cure cancer at a prescription cost of $1.49 and do not alert us that it’s coming, you might be better just putting it in a bottle with our address and tossing it into the ocean.

Of every 100 BP’s we receive, 95% are automatic rejects. Of the remainder, three may get funded. One company “makes it”.

Scenario #2
Entrepreneurs: We had this fantastic concept for a new venture. We did a great business plan and sent it to some VC’s. We only needed $150,000. They turned us down. They’re too dumb to recognize our potential.

VC’s: Our latest fund was capitalized at $35 million. We won’t get involved in any deal that needs less than $2 million. We sit on the board of each investment and can’t invest in small deals that will take as much of our management time as large ones. If each returned 20%, which ROI would you pick? (You’ll get our same response for a BP seeking investment in a local company that might grow to regional sales of $750,000 in 6 years. If it ain’t goin’ to be big and potentially dominant, forget it!)

While we’re at it, we also don’t like start-ups. If you were going to invest $2,000,000 would you prefer an existing, rapidly-growing company that’s profitable and needs expansion capital or a raw start-up … albeit with a promising idea … to be managed by some grad students from Stanford? We love bridge financing of existing, profitable companies.

Also, we need to keep an eye on our investments and we nearly always have one or two seats on the Board. These usually meet once a month. If our office is in Dallas, we’re not going to invest in companies in Seattle.

Scenario #3
Entrepreneurs: One of our guys met a VC at a church social. He said they vastly preferred to invest in people they already know and that have proven track records. That’s not fair!

VC’s: Nobody said “the game” had to be fair. If you were in my position, who would you pick? Raw neophytes? Want to get our attention? Take 2 or 3 of us to lunch and make a great pitch. Maybe then you’ll begin on the path to become “someone we know, trust and believe in!”

Scenario #4
Entrepreneurs: The guy that met the VC at a church social said VC’s generally expected an investment to return 5-10 times on their money in 3-5 years. That’s obscene and outrageous!

VC’s: He neglected to mention that’s for one of our successes. If we invest in 10 companies, 3-5 will go bust; another 3-5 will survive as “the living dead”, but never go anywhere. One will be a moderate success and one maybe will result in the 5-10 times case. We work hard to increase these numbers. Overall, our ROI varies from year-to-year but historically has run 8% to 30%, depending on our luck, the general economy and a couple of pages of other variables. Sometimes, we even have losses.

Incidentally - in business there’s no such thing as an “obscene profit” and we’ll grab all we can find that are legal.

Scenario #5
Entrepreneurs: One of our guys met a friend at a college reunion. He’d heard bad stories about VC’s and warned against having anything to do with them because “VC’s all want to run your company.
VC’s: That’s pure nonsense. A Silicon Valley VC once described it this way: “We want to supply the bullets, not fight the war.”

Sometimes this label gets stuck on us when one of our companies gets in trouble. By now, you should know we’re in business to make money. If one of our investments starts going bad, we must try and save it. First, we do the best we can to work with current management. In extreme cases, we may need to replace some of these people. This is a last resort and very dangerous for the company, our investment and our partnership. When pushed to the wall, we’ll bring in a “troubled company” consultant, but not one of our own people. If one of our companies “tanks” all the MP’s get a ton of grief from the LP’s.

Finally, I have already run three companies and have no desire to do this again. Right now I’m a MP here and helping to run this partnership. We are not only under severe pressure to make profit, but when our current fund becomes fully funded we’ll start a new one. We’ll go to our current investors first and if they’re unhappy with our performance and the returns, they’ll say, “No”. Our investment community is very small and bad news travels fast. We could have a tough, tough time raising new capital.

Scenario #6
Entrepreneurs: We had this fantastic concept for a new business. My father knows a VC at his country club. He invited us both to a round of golf and over drinks; the VC asked me and my team to make a presentation to his firm. I noticed he wore the gold “beaver” ring, signifying he had graduated from MIT.

I brought three others of our team and since I guessed my father’s friend was an engineer, I decided to have our “chief technical guru” make the whole presentation and prove how smart we all are. Our guru went at it for 45 minutes and filled his talk and white board with dozens of obscure abbreviations and advanced techno-jargon. When he finally took a breath, one of the VC’s interrupted and asked for a “pit break”. Five VC’s left for the break and only one, the most junior, returned. A week later we got a letter. They turned us down. They’re too dumb to recognize our potential.

VC’s:
We’re interested in making money, not trying to understand every facet of new technology. New, but professional, management teams split up the presentations, use slick visuals and stress: how unique the opportunity; how tempting the market; how safe the entry; and, how huge the return. If I want to be overwhelmed by technical data, I’ll rent a Stephen Hawking CD.

Scenario #7
Since we’re almost finished, I thought I would “fess up” to one area where we may just take a teeny, tiny advantage – on rare occasion – and, of course, only in limited circumstances.

We’re financial experts and “survive in the streets” by negotiating deals. When we prepare to offer an investment, we spend a lot of time establishing our “valuation” of the deal. That is simply, what we think the whole opportunity is worth and how much we’re willing to spend for what percentage. We all agree on the numbers and set up a meeting with the entrepreneurs.

We enter fully-prepared. I usually start-off by innocently inquiring: “We think we might be interested. Tell me how much money do you need and, assuming we do a straight equity deal, what percentage ownership are you willing to part with?”

As many times as this has happened, I still get amazed. Their team has not considered how to answer this basic query. Further, there probably isn’t a real financial guy on their team and they’ve adamantly refused to pay for sophisticated legal and knowledgeable financial counsel. After an awkward silence, the CEO usually blurts out something like: “Well, we know we need at least $3,000,000. What do you folks think is fair?”

In that one sentence, they have just “given away the store”. Next I respond: “We’re prepared to give you this check for $2,750,000 (reaching in my pocket and putting it on the table in front of them) on Monday in exchange for 90% of your stock”. They’ll mumble and caucus, groan and caucus, complain and caucus until they “reluctantly agree to 82%” and we close.

For years after they’ll tell how greedy and vicious we were, never understanding it was their own fault for not being prepared for a tough, “knock-down” with highly-experienced negotiators. And, think of their awe if they knew the percentage we’d internally agreed upon before the meeting was 43%

You can’t send little kids out to play hardball against the Yankees and expect to win … but, with a lot of preparation you may be able to score a couple of runs. We come complete with an impressive amalgam of well-connected, powerful business associates and can help fledgling companies avoid making similar, dumb mistakes.

… That’s the end of VC stories for today.

Entrepreneurs: Thanks. Maybe we just learned something.

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For more information, please visit Dick's TNNW Bio.





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VENTURE FINANCING - REALITY VERSUS RUMOR: Understanding VC's