Aug 212011
 
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11 Things Venture Capital Investors Look For

I get a lot of questions about what venture capital (VC) investors look for when they are considering investing in a venture.  Many of the characteristics I’ll cover here are also applicable to what “angel investors” look for in prospective investments, as these days, a significant percentage of such investors have been at it a while and have reached a level of investing sophistication that is hard to differentiate from that of venture capitalists.

I won’t go into a huge amount of detail on each of these desired characteristics, but I thought it would be nice to at least have many of them covered in the same place.  I will also throw out the caveat that not all venture capital investors put the same amount of emphasis on the same set of desirable venture characteristics, and this list is not meant to be comprehensive.  However, in my experience and that of my client companies, the eleven venture characteristics discussed below usually play at least some role, and often a significant one, in the investment screening decisions of venture capitalists and more sophisticated angel investors.

1.       Strong Management Team

Pretty much every venture capitalist I know will agree with the old saying, “I’d rather have an A team with a B idea than vice-versa”.  The reason for this is that startup ventures and even those a little further along in their development rarely go exactly as planned.  There is always “execution risk” in any venture, but the earlier the stage of the business and the more cutting-edge the technology being exploited, the greater this risk becomes.  In such situations, it is very helpful to have a team that has been around the block and has a track record of success of maneuvering in such dynamic environments.

2.       A Growing, Sizable Market

The target market should be sizable and growing.  Venture capitalists typically are not looking for “small” opportunities.  They are looking for ventures that are targeting markets which show promise of significant growth for at least five or ten years into the future and which are of a size ($1B+, minimum) that will allow their prospective investment to enjoy considerable returns.  So, if you are looking to corner the market on widgets in your small town, or if you are looking for working capital or even growth capital for your business in a mature, low-growth industry, don’t bother contacting venture capitalists.  The one nuance to this is if you are doing something to “revolutionize” a low-growth industry in a segment that has reasonable size, you may then be able to stir up some interest from VCs.  Also, clearly there are VCs and angels that will look at opportunities in small, highly targeted segments, particularly for some very specialized technologies, but these are fewer and farther between.

3.       Strong Margins

As I’ve pointed out elsewhere, strong gross margins allow you to make a lot of mistakes and still be around to fight another day.  They also allow the potential to make tremendous net profits and investor returns if the company grows as planned.  For these reasons, venture capitalists like to see strong gross margins (60%+) in their prospective investments.  That said, it is widely known that business opportunities with such high gross margins are not easy to come by, so VCs and other investors are willing to look at businesses that don’t quite reach that benchmark, particularly if there are other positive characteristics that make the venture attractive.  Sometimes, for example, while strong gross margins would be a “nice to have,” it is much more important to the venture and the investor that the business achieve critical mass (for example, a large number of subscribers) quickly to become the leader in the market and attract the interest of potential acquirers.  Every situation is unique, of course, but all else being equal, strong margins currently or at least projected at some point in the future, raise the attractiveness of a potential investment.

4.       Exit Potential

The potential to exit the investment is very important.  There are very few VCs that want to be in an investment for “the long haul”.  In fact, VCs typically raise their money from institutional investors and wealthy individuals, in order to invest it and obtain the best return they can in a certain period of time.  They are what are called “closed end” funds.  So there is an investment horizon and as managers with fiduciary responsibility to their investors for the money they have raised from them, VCs do not have the luxury of not considering how they will exit from the investment.  While the situation for angel investors who are investing their own money is distinct from that of VCs investing money on the behalf of others, their “exit mentality” is usually similar.  For these reasons, both VC and angel investors will typically strongly consider how they’re likely going to be able to get out of a particular investment, before they will invest a dime.

5.       Proprietary Technology

The focus on proprietary, patented (or patent-pending) technology will vary depending on which industry or industries the venture capital investor is focused on.  In some industries, this may be much less important and in other industries, such as biotechnology, proprietary technology and such things as FDA approval may be extremely important.  Regardless of the industry, most all VCs, knowing how competitive any new market environment is, will want to see what many refer to as your “special sauce”.  What is it that you do differently or have that’s unique, that will allow your venture to excel in the marketplace?  The answers to this question can vary widely.  They may relate to operational advantages, marketing strategies and tactics, or financial advantages you bring to the table.  They may also come in the form of technology or business processes that you’ve patented that will give you an advantage in the marketplace.  Whatever they may be, you must show up to the table with some “special sauce” elements of your business, or you are not likely to get too far in obtaining VC or sophisticated angel investment.

6.       Big Upside Potential

Venture capitalists are not looking to hit “singles,” to use a baseball metaphor.  They know from experience that of every ten investments they make, one, if they’re lucky, may be a “homerun”.  They may also have a “double” or “triple” in there as well, but the rest likely will not go anywhere too exciting.  So when they are looking at any individual investment, if they don’t think it can be that one “homerun,” why would they consider it?  They must believe that if all goes well, your venture can become a homerun and serve that role in their portfolio.  If they can’t believe that in the beginning, how can they expect to get behind it if all doesn’t go exactly as planned and your venture needs some more investment along the way?  They must be able to believe and you must be able to make a strong argument that your business has the potential to be an extraordinary success.

7.       Good Use of Investment

Venture capitalists are not making investments for the fun of it.  They are not going to write you a check for five or ten million dollars and just hope they you have a good idea what you’ll do with the investment.  You need to meticulously plan how you intend to grow your business and how you will deploy the capital being invested.  How much will go to capital expenditures (“CAPEX”)?   How much will go to marketing?  How much will go to working capital?  How much will go into upgrading and expanding the sales force?  When will you need the next round of investment?  You need to have this all very well planned out and be able to demonstrate precisely how you expect to utilize the funds being invested.  All investors know that nothing will go exactly according to plan, but by providing detailed forecasts on the expected growth and uses of capital for your venture, you can demonstrate to prospective investors that you are not “shooting from the hip”.  Put yourself in the place of the venture capital investor; which venture would you invest in – the one that had a detailed plan on how they were going to use your investment, or the one that was “winging it”?

8.       Reality-based Projections

A pet peeve of almost every professional investor I know is when a management team shows up with (or sends in) financial projections that they appear to have pulled out of thin air.  Everyone is aware that it is impossible to predict the future, so pro-forma financials are inherently flawed and inaccurate.  This is not, however, an excuse to pick revenue and cost numbers arbitrarily!  All financial projections will be driven by a series of assumptions.  When you build your financial model, you should make sure that your assumptions are well-explained and justified.  It is also important that you project a range of possible outcomes.  You can get very fancy with this and use such techniques as Monte Carlo Simulation, but usually if you are able to provide potential investors with a “worst, expected, and best case” estimate of possible outcomes, that will suffice.  In terms of how to justify your assumptions, it can be a bit challenging, particularly if you are pioneering a new market.  Even so, it’s important that your assumptions and financial ratios are consistent with industry standards in the same or similar spaces, unless you have very good reasons for projecting more optimistically.

9.       Market Traction

If you are a pure startup, in seed funding mode, it’s likely a bit tough for you to show market traction.  The reality though is that most of the venture capitalists I know these days have larger funds and are looking to deploy larger amounts of capital in each deal, so they’re not doing much, if any, seed funding.  Many angels still look at seed funding deals, of course.  In any case though, most of the “risk capital” investors I know and work with would still like to see you demonstrate at least some market traction, if at all possible.  Market acceptance and adoption are such a significant portion of the risk equation for any prospective startup and investor, that if a company has managed to get a few initial customers, it may help to mitigate at least some of the concern related to this issue.  It is OK if they are non-paying “beta sites,” however, it’s even better if they are customers who have been willing to pay for what you’re offering.  If they’re not paying customers, but they are larger organizations that any prospective investor knows would have done significant company and technology due diligence before even trying your product and service, that can serve as evidence of market traction as well.

10.   Scalability

Scalability refers to the ability to take your business from a one or two-person show and a small handful of customers, to a larger, efficient and even more profitable enterprise.  Will what you are doing “scale” well?  Will it allow you to enjoy economies of scale and/or economies of scope?  Or will you be constrained by certain inputs that are hard to obtain in large quantities, like a certain type of skilled worker, for example?  Venture capitalists and sophisticated angel investors understand that in order to have “homerun potential,” your venture has to be able to expand without an enormous amount of operational risk and with the possibility of taking advantage of certain “economies” that can lead to extreme profitability.  Ask yourself, is my venture scalable?  If it’s not, consider how you can make it more scalable.  Regardless of whether you obtain VC or angel investment, having a more scalable enterprise, is likely to benefit you significantly as you grow your business.

11.   Vision

It’s often not enough to just send your business plan in to a potential investor, or even to show up and present a prospective venture that is attractive along many or most of the dimensions covered in this article.  In addition, you must have a vision, and it must be a big and clear one.  Prospective investors place strong importance on any potential investment having a founder(s) with vision and passion.  It’s especially attractive when the team is trying to “change the world” in their particular industry or niche and when the strength of their belief is palpable.  This passion must of course be balanced with a solid understanding of “reality,” but a “we will not be defeated” attitude can carry a lot of weight when there may be a few other noticeable flaws in the venture and the plan.  As stated elsewhere, early stage investors know that no startup venture goes exactly according to plan, so belief, passion and a “never say die attitude” carry a great deal of importance in the assessment of the venture leadership and management team.

So there you have 11 things that venture capitalists and sophisticated angel investors look for in prospective investments.  It is not meant to be an all-inclusive list, but it does cover many of the most important characteristics that VCs and angels assess when they are screening potential investments.

I look forward to your thoughts, comments and ideas.   Please leave a comment below or in the top right corner of this post.

Paul Morin

paul@companyfounder.com

www.companyfounder.com

 

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Mar 312011
 
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Raising Capital – 7 Potential Funding Sources and What They Look For

Raising capital for your business?  Here are seven potential sources of capital you should consider.

# 1 Self-Funding

Self-funding is where you either fund from savings or from ongoing cash flow that perhaps you have from another venture.

In terms of what you are looking for as the sole investor in the business, I’d say the most common motivation is control. You do not want to give up equity ownership in your business, so you decide it’s better to risk you own capital, or to take on debt, than have other equity players in the business. This is typically the approach taken when the amount of capital required is not too large (relative to your resources) and you have a relatively high confidence level in the success of the venture.

# 2 Friends and Family

This is where your friends and family hear that you’re getting a new venture off the ground and want to get in on the action. It could also be the case that you go to them with your idea and convince them that it would be a good idea to invest.

While this is one of the most common sources of funding, it is also one of the riskiest. This is the case because you are risking more than just a business relationship; you are also risking a personal relationship. It is very important that you are completely up-front with prospective family and friend investors. You owe it to them to tell them that, while you will do everything in your power to make the venture successful, they could very easily lose all the money they’ve put in. It is also important that you have a clear, written agreement with these investors, as you would with any other investor, regarding the terms of the investment. You need to cover whether it is a debt or equity investment and the exact investment terms and conditions. There are several potential “gotchas” with these investments, from a tax and other regulatory perspective, so make sure you have competent legal counsel.

# 3 Credit Cards

This approach involves using whatever credit limit you may have on credit cards to fund your start-up and early stages of your business. This is a much more common source of capital than most realize or would be willing to admit.

The “investor” in this case is still you, as you have full responsibility for repayment of whatever credit limit you may utilize for funding.  This is the case even if you open business credit cards in the name of the business because many creditors will require a personal guarantee from the owner or company officer.  The credit card company typically will charge a higher interest rate than most other (credit, at least) funding sources. The credit card company is not looking for any equity ownership in your business, rather they just want the amount they lent you paid back with interest. This source of capital needs to be used responsibly and not on frivolous purchases. Remember that even if your business is not successful, you will need to pay back these debts, or risk ruining your credit record.

# 4 Home Equity Credit Line

This source of funding involves taking a loan, in the form of a credit line, against the equity you have in your home. This was very common at one time; it is less common in times when homeowners don’t have a lot of equity in their homes.

In this case, your home is the security for the loan you are using to buy, start, or grow your business. It starts to get a bit more serious here, as your home is the security and is directly at risk. That said, this is a very common source of capital for entrepreneurs. Again, as with the other forms of personal funding of your business, you’ll want to be very careful to make sure that you are making expenditures that will create and/or increase future earnings, not making frivolous purchases.

# 5 SBA Loan

This is a bank loan that is guaranteed by the SBA. The SBA’s guarantee of all or a portion of the loan makes it possible for the bank to lend to borrowers to whom they may not otherwise lend, or at least not with interest rates at such low levels.

This is a very common source of funding for early stage companies. In reality though, from the perspective of the entrepreneur, it is not all that different than other forms of asset-based lending. The entrepreneur still has to have a very good credit record and has to have sufficient assets to secure the loan. Do not think that by getting an SBA loan, you will not be on the hook if the business fails; you will. The main advantages for entrepreneurs of SBA loans are that they may get approved for certain projects or loan amounts that they may not otherwise, without the backing of the SBA. Also, it is likely that on an SBA loan you will have an appreciably lower interest rate than you would on a non-SBA-backed loan.

# 6 Angel Investors

This type of funding occurs when through your contacts or those you make, you manage to get in front of a group (or one) of wealthy individuals that invest in early-stage companies. Such investors are typically called “angels” or “angel investors”.

Angels tend to be relatively selective about the types of ventures they invest in. That said, there is a very wide range of sophistication among angel investors, along with which the level of selectivity varies widely. You will want to make sure you have concise investor pitch that flows. You will want to make sure that all angel investors from whom you will receive funding meet the Accredited Investor standards. For this reason, and in order to make sure the terms and conditions of the investment make sense, again you will want to make sure that you have competent legal counsel involved. Don’t even consider doing a deal with angel investors without having a good attorney watching out for your interests. Also, although in the beginning of your venture it may be tempting to take money from whoever will give it to you, do your due diligence on all prospective investors and make sure they are people you think you can work with and communicate with. This will be particularly important when all does not go exactly as planned. As you know, it hardly ever does.

# 7 Venture Capital

In order to obtain venture capital funding, you present your business plan or growth plan to professional early stage investors known as venture capitalists. This source of investment is appropriate for a relatively narrow segment of the startup company population and very few companies end up being funding by venture capital.

It is important to remember that venture capitalists are professional investors.  It is key to know what venture capital investors look for.  They raise money from what are known as limited partners, usually pension funds and other institutional money managers, then invest that money to earn as much return as possible for their investors. The venture capitalist then shares in the gains they are able to achieve. They are also paid a management fee for their efforts during the life of the fund, which is typically 7-10 years. So as you can see, venture funds are designed to invest, grow and harvest in a finite, relatively short period of time, thus they must choose their investments very carefully. For this reason, venture capitalists are typically interested in companies that are further along, that are already on a reasonable growth trajectory and need money for expansion and further growth. They usually like technology companies that have a proprietary (patented or patentable) product or business process. Unless you have something truly exceptional in the techology space that’s a bit further along, other than with a few venture capitalists that are willing to look at seed deals and deals outside the technology space, you are not likely to find success seeking funding from these investors.

Conclusion

While this list of seven potential funding sources for startup and early-stage companies is by no means exhaustive, it gives you an idea of several of the most common funding sources and what they’re looking for in their investment targets.

Let us know your thoughts, comments and questions, which you can enter below or in the top right corner of this post.

All the best as you work to start and grow your venture!

Paul Morin

paul@companyfounder.com

www.companyfounder.com.

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Aug 062010
 
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I’ve always been quite surprised by the percentage of entrepreneurs who think the way they will grow their businesses will be through raising money from venture capitalists.  For most companies, nothing could be further from the truth.  Venture capitalists look for very specific types of companies, almost always based on some sort of proprietary technology, run by a stellar (not just good) management team with an impressive track record, with a very large potential addressable market.  VCs have these criteria in place because they correlate to ventures that are successful and have a reasonable probability of hitting the return on investment targets VCs have.  A very small percentage of companies get funded by venture capital – a single digit percentage of the companies that VCs look at, and a much lower percentage of companies that submit business plans to VCs get funded, and a yet lower percentage still of the overall population of companies attract capital from VCs.  For most companies, the bottom line is that VCs are not interested, and quite frankly, most company owners probably should not be interested either.  Before you invest considerable time and other resources into pursuing venture capital, you should take a look at the websites of a few VCs and click on the link that says “portfolio companies”; unless your venture closely resembles the types of companies in the VC’s current portfolio, you should spend your time seeking financing elsewhere..

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