4 Questions and 4 Pressure Tests To Decipher A VC's Interest In Your Company

by Larry Cheng

I have heard from a number of entrepreneurs over the past couple of months about how they wished VCs would give them a "quick no" more often.  I think it's a totally fair critique and have tried to improve in this area myself.  In lieu of a "quick no", I thought I'd give entrepreneurs 4 questions and 4 pressure tests to help you decipher a VC's level of interest.  These questions presume that you have already given the VC an initial pitch of your business, so they have enough information to at least be initially interested.  After thinking about this post, I have a renewed personal commitment to make my interest level clear and prompt so that there's nothing to "decipher".  A good working relationship should start before an investment is closed – so while I hope the advice is helpful in general, I hope that it's advice you don't have to take with me.  If you feel like you do, feel free to call me out on it – I'll respect you for it.  Without further ado…

4 Questions

1.  How quickly does the VC respond to your calls or emails? 

This is more of a disqualifying question than a qualifying one.  If a VC consistently takes more than one week to respond to your emails or calls in a normal work week, I'd say it's pretty safe to disqualify their interest in 98% of cases.  If they're responding consistently to you with positive sentiments in less than 12–24 hours, I'd consider that a positive sign.  Everything in between is a grey zone, but the more responsive the better. 

2.  Who is investing the time and resources in diligence – you, the VC, or both? 

For a productive process, it should be both.  If the nature of the diligence process is the VC asks you for information, you scramble to pull it together, and that's it – it's not necessarily a buying signal.  You want to see an investment of time and energy from a team of folks at the VC firm including a partner.  Such an investment could include: on site visits (especially if air travel is required), spending money on diligence (e.g. legal, technical, financial, etc.), clear commitment of time on diligence calls, or a partnership presentation (which is an investment of other people's time).

3.  Is the VC making progress "reportable" to a partnership every week?

Most VC firms manage a deal pipeline the same way any company might manage a sales pipeline.  When an investment opportunity progresses to a stage of real interest and opportunity, they raise it to a level internally which presumes some level of weekly reporting to the team.  Once it reaches that stage, the VC has every incentive to make "reportable" progress each week so that they don't lose momentum internally with their partners.  If you feel like a process is dragging and is slow, then you're probably not at that level or you have come down from that level and serious interest may not be present.

4.  At the end of the day, do you feel like you're chasing the VC or is the VC chasing you?

Any VC worth his/her salt knows how to go 110% after a company they want to invest in.  We all know we need to be aggressive in a competitive environment to win the best opportunities.  So, VCs know how to chase great companies.  If you feel chased, consider that the best buying signal.  If you don't feel chased, then consider a pressure test…

4 Pressure Tests

1.  Ask the VC to sign an NDA. 

I'd say this is the easiest test.  There's a widely held belief that VCs don't sign NDAs.  I haven't found that to be true.  Imagine if a VC said to their LP, "We didn't invest in Google because Larry and Sergey wanted an NDA and we declined out of firm policy."  That wouldn't fly.  The reason VCs generally don't sign NDAs is that it creates too much complexity if you're meeting with thousands of companies a year to sign NDA's for all of them.  But, VCs will sign NDA's if they're seriously interested in a company and it's important to you.  As a ballpark measure, I sign about 1–2 NDAs per month and invest in 1–2 companies per year. 

2.  Schedule a partnership presentation, or specifically outline the process to get there. 

No investment will close without you pitching the partnership.  Many VCs won't allow term sheets to be issued without a partnership presentation.  Either way, ask the VC you're engaged with to outline the specific steps and timeframe to a partnership presentation.  If they outline something very clear or even schedule a date, that's great.  If their answer is hazy or unclear, then they're not ready to put you in front of the partnership which is where they invest some of their credibility. 

3.  Ask to call references on the partner.

This is a qualifying test rather than a disqualifying test.  If a VC partner lets you call their references, then it's a clear buying signal because that's an investment of time from their references (usually their CEO's).  They won't use their CEO's time unless they have very serious interest.  If they're not ready to give you references, I wouldn't say it's disqualifying but it's a sign that there's still work to be done before the finish line. 

4.  Reject the VC (nicely).

This is probably the ultimate pressure test.  If you've asked the questions, done the pressure tests and your gut doubts the level of the VC's interest – in as kind and as humble a way as possible, let the VC go.  Just tell them that while you would have liked to work with them, it doesn't seem like they're interested, and there are no hard feelings.  Perhaps the stars didn't align this time, and you'll keep them in the loop for any future financings.  While I wouldn't recommend this as a negotiation ploy, I think it's fair game if that's how you genuinely feel.  If somehow you have misjudged the situation, and they are really interested – this should kick them into gear.  But, more likely, it will lead to a clear no which is still helpful.

VC's Mathematical Challenge

by Matt McCall

There is no doubt that the venture industry is going through a major house cleaning right now. Much of the pruning that should have been done post Bubble is finally going on now as LP's start to wake up and pull back a bit from the asset class. One of the main challenges has been the mismatch between LP demand in the category and the declining liquidity of it. The main question people as is what is the right amount of capital that should flow into the business annually to keep it healthy. Let's look at the mathematics from the exit perspective:  

Average annual number of acquisitions: 250

Average sales price: $80 million

Average annual number of IPO's: 100

Average value of IPO: $150 million

Total annual value of venture backed exits: $35 billion

(IPO's have been down below 10 recently and above 200 in healthy times but below 60 for the past 8 years)

(sale & IPO values have fluctuated but these are swags)  

Assumed VC ownership at exit: 70%

Exit Value going to VC's: $24.5 billion

Target Fund multiple: 2.5-3x

Capital Deployed to hit: $8-10 billion

This means that for the industry to continue (a la 1990's) generating IRR's north of 20% net in this exit environment, no more than $10 billion should be flowing into it during any given year. If the IPO market wakes up, this number goes up. If it stays asleep, it goes even lower. In a strong year (250 IPO's & 300 acquisitions at $200 million & $120 million avg values respectively), total annual exit value jumps to nearly $90 billion. Filter this through and the industry could handle roughly $25 billion in new capital.

Well, until just the first quarter of this year, industry fundraising has been north of $30 billion for several years and the exit markets have been significantly below even the initial levels above. Our industry stays healthy if no more than $10-15 billion per year is raised. So, we've been at 2x that rate. The LP's have hopefully figured this out and we'll see smaller brand funds and fewer total funds. 

How many funds can survive in this kind of market? Let's do the math again:

Couple of mega-mega funds like NEA, Oak, TCV & Menlo: say 5 x $2 billion each = $10 billion

Number of brand funds: say 25 x $500 million each = $13 billion

Number of next tier funds:  say 40 x $200 million each = $8 billion

Fundraising cycle: every 3 years

So, just these initial 70 funds results in $10 billion+ per year raised.  

Assuming that there will be around 300 funds around in total, this leaves about $5 billion/yr for the remaining 230 groups. Using the 3 year cycle, this results in each of these funds being under $65 million in size. If the exit environment remains moribund, then all of these number have to discounted even more to get to $10 billion in total industry dollars annually.

So, the industry has to drop from 500-600 groups to 300 groups and the LP's need to pair everyone back. No more $4 billion Mega-mega funds, no more $700-800 million brand funds, no more $300-400 million next tier funds and no more $100-150 million remaining funds. If the LP's don't do this, we end up north of $25 billion per year again and terrible returns.

Can LP's contain themselves? We'll see once conditions start to improve in the economy. In the interim, it will be ugly times for VC fundraising...

Why VCs say no 99% of the time

by Don Dodge

Venture Capital investing is a very tough game...and very lucrative if you are good at it. Part of my job at Microsoft is working with VCs, so I have learned a lot about the way they think...and why they say No to 99% of the deals they see.

This blog post by Jeff Bussgang, of Flybridge Capital Partners explains why VCs want to see every new startup...but say no 99% of the time.

"As one wise old VC once told me, "the trick in this business is to spend very little time on a lot of deals, and then a lot of time on very few deals."  In other words, see everything to be a better investor, but exert a very tough first filter so that you only spend time on very, very few deals.  In my experience, a typical VC has the bandwidth to actively "spend time" or actively work on only one to two deals at any given time and perhaps 10-20 in a year -- as compared to those 300-500 they get exposed to."

What are the odds? - VCs are exposed to about 500 opportunities a year. They spend time seriously looking at about 20 companies a year, and invest in two or three. So, they say no about 99% of the time.

We all say no 99% of the time - I would guess that every one of you reading this blog have a stock portfolio with 5 to 10 individual stocks or mutual funds. There are more than 5,000 publicly listed companies to choose from, and another 5,000 mutual funds. But, out of 10,000 possible companies you chose 10 to invest in. Why? Why did you reject the other 9,990 companies? Obviously there are more than 10 good companies to invest in. Other investors chose to invest their money in the other 9,990 companies...why not you?

We invest in people we know and companies we understand - We do this in our own personal investing, and VCs, with rare exceptions, do the same when they make decisions. We all say no 99% of the time, and we reject perfectly good companies, but we invest in things we feel comfortable with.

Find the right VC match - Don't be too quick to change your strategy or company pitch just because the first batch of VCs rejects it. It is all about finding the right VC that is interested in what you are doing and comfortable in the market space. Don't waste time trying to convince a reluctant VC. Move on and spend the time finding the right VC for you...that "gets it" the first time. There are at least 1,000 VCs in the USA. They all have different investment tastes...just like all of us do. Go for it!

Relative Value v. Absolute Value

by Larry Cheng

I have been reading a book called Predictably Irrational by Dan Ariely which has raised some thoughts I've had for awhile about why human nature tends to define value on a relative basis rather than on an absolute basis.  The first time I started thinking about this was when I would ask friends to pick which scenario they'd prefer:

1. You make $80,000 in a world where everyone else makes $50,000.
2. You make $90,000 in a world where everyone else makes $150,000.

Most people I asked that question to, after thinking about it, preferred scenario #1 despite making more absolute money in scenario #2.  It shows that in this instance, they value relative wealth over absolute wealth.  It's clearly an imperfect example because it's too theoretical, but it does start to uncover the issue at hand.  Let's take a more practical example – imagine you had to rate the "value" of the fish and chips on the following two menus:

1. Fish and Chips: $15, Grilled Chicken: $7
2. Grilled Chicken: $29, Fish and Chips: $15

My guess is if you conducted a study, the fish and chips on the second menu would be rated as a better value than the fish and chips on the first menu – despite the same absolute price.  While not using this example, Predictably Irrational does leverage compelling studies that show that a highly effective technique to sell a given product at a given price is to put another product at a higher price right next to it.  Again, this plays to our sense of relative value.  Another example - imagine you had to rate the attractiveness of the second person in each scenario:

1.

2.

Somehow I think the results would show a higher rating for the middle picture in the second scenario than the first.  In fact, Predictably Irrational talks (semi-seriously) about how if you’re going to a bar – the best advice they have to optimize your personal attractiveness is to make sure your wingman is slightly less attractive than you.  OK, one more example, and then I will in fact relate this to the venture world and technology.  This one is from the book – imagine you had to select in both cases whether you would make the drive:

1. Drive 10 minutes to save $5 on a $15 pen.
2. Drive 10 minutes to save $5 on a $500 suit.

Despite the same absolute economic savings and same cost (driving 10 minutes), a substantially higher percentage of people would make the drive in scenario 1 rather than scenario 2, because of its higher relative value.  You get the drift.

OK, this dynamic does in fact play out in the venture world more often than one might expect.  I’ve seen it in many different instances, but most classically during an acquisition process.  Consider how supportive you would be of taking the deal in the following two scenarios:

1. You have a $20M revenue software company.  An acquirer comes along and offers you $20M and says you are worth 1x revenues.  Then through your shrewd negotiating and creation of a bidding war, you’re able to walk up the price offered by that acquirer up to $100M.  You have increased their offer by 5 times!
2. You have a $20M revenue software company.  An acquirer comes along and deems the company strategic and offers you $200M.  But, then through the diligence process they uncover some issues and decide your company is “only” worth $100M – an insulting 50% less than their original offer.

In my experience, despite the same absolute value at the end, boards would more likely be celebrating in scenario 1 and angrily walking away in scenario 2.  Why?  Again, it's all about the relative value against the starting bid.

While I'm not trying to make relative value seem irrational (because I don't think it is) – it's worthwhile to recognize how human nature can sometimes inappropriately define value exclusively on a relative basis to the neglect of all other reasoning.  Perhaps we need to learn how to put aside our need to compare, and just be happy with what we've got.  In an orthogonal way, this reminds me of a quote I heard years ago, "Being rich is not about how much you have (or how much more you have), but it's about how content you are with what you have."

Be Careful about Paying Brokers to Raise Capital

by Bom Dia

There is a saying in Hollywood that "A good script gets found." The same is true in sports — if you are a good enough basketball player, the NBA will find you, whether you are playing on a Division III team in Alaska or for Duke University. I think that generally the same is true in venture capital — if you are a good startup and you make an effort, you will get an audience with at least a few decent VCs.

Therefore, paying a consultant to find you investors is usually, not always, a waste of money. Brad Feld in his blog Ask the VC had a good post about this in December 2007. I recommend reading the comments to it as well.

Personally, I feel that outsourcing fundraising to people can be of great help to a startup BUT only when those hired have relevant experience and can truly help the company. I don't agree with Brad that it is important that the founder do it themselves. I do believe, however, that the percentage of brokers/consultants that work in this area and REALLY add value is less than 10%.

Here is the major problem: almost all consultants/brokers are motivated to tell a startup that they can raise them money, regardless of whether the startup actually has a chance of successfully doing so. In other words, where the brokers/consultants really rip off the startup is in taking them on as a client when the company does not have a realistic chance of raising capital. Any fool can throw together an executive summary and email it to VCs. It takes an experienced, ethical player to make an objective appraisal and give an honest "go/no-go" to the startup before time and money is wasted. Many times the best advice to a startup is to focus on building the business and hitting milestones before looking for capital. If it is not possible to hit those milestones before raising venture capital, then the startup needs re-evaluate its business plan.

The best rule of thumb is to look at the background of someone offering these services and see if they have previously raised money for early-stage companies (perhaps for their own startup). It is not good enough just to have been in the financial services industry in general: in order to make an objective appraisal of the situation, they need experience in the early/growth stage world. Obviously, direct experience in the same vertical (e.g., consumer internet) also helps a lot, for obvious reasons, including that the broker/consultant presumably has relationships with investors in that space.

A final distinction – paying a success fee is one thing, paying a retainer is another. If someone finds you money, it is usually reasonable that they expect a finders fee or commission of some sort. Paying a retainer to a broker/consultant, however, drains critical funds from the startup and should be done only in the 10% of the cases where the broker will bring real value.

SHOOTING THE CEO

by Dr. Larry Marshall

Many investors have a systematic approach to gauging the performance metrics of a startup, and fairly formulaic methods for influencing the company through its various growth phases. One of the most painful phases is the transition from startup CEO (and often founder) to a more experienced "hired gun." This is dangerous because the founding CEO's DNA will have permeated the company's and the new hired gun will not have the same sense of ownership, responsibility, and DNA around the company. Done well, it can take a company to a whole new level, done poorly it causes cancer.

There is no doubt that the CEO of a Venture-backed startup has a target on his back, far more so than one in a public company. When a CEO misses targets and milestones, they are likely to be replaced. If they start shooting executive team members they will often be seen as shifting blame or be criticized for making bad hires--it's hard to win when you're the boss ;-)

There are generally three sure-fire ways to get fired:

1. Fail to meet plan
2. Don't follow BoD decisions
3. Make bad hires, or have a lot of exec turnover

These are easy ones to catch, but there is a fourth that's more nebulous, but it's often the question foremost in your investor's minds--can you scale?

Very few CEOs can scale from founder to IPO and beyond--even fewer should! The sign VCs watch for is lack of a decision, which is of course a decision in its own right. If you have a lot of balls in the air chances are you will have trouble deciding which one to play with--indecision; or inability to focus will get you fired and it will look very much like your company simply outgrew your ability. Typically founders like to do everything themselves, and this is a guaranteed way to NOT scale, but it's also a very lovable characteristic of founders.

Now any good entrepreneur knows you succeed by getting others to share your vision and help you succeed by doing what you can't do yourself. We also know that in order to have one successful strategy we need at least two alternates--sometimes it takes five irons in the fire to get one hot. So a certain amount of parallel processing is necessary--the critical step is quickly culling the paths that won't work and focusing everything on the one that will. It is this focus that leads to success. It's the willingness, determination and drive to bet the company on the path that you believe will win. Your VCs can help in this decision. They see a lot of companies and have a perspective on many markets--but beware, if it's not your decision then it's unlikely to be the right decision, and even if you listen to your investors, success has many generals but failure has only you ;-)

Shooting the founding CEO is a very risky move in startups because the company's DNA is invariably the founder's. If the company is too embryonic it can stunt or kill the growth or give it cancer. Generally it's better to surround the CEO with strong partners who can overcome shortcomings and build the strongest team from there--maybe the future CEO may be among them, but if not the DNA will be enhanced anyway and a new CEO can come in later if needed. My personal preference is for the first-time CEO, and to find a way to help them find success. Some of my investors did that for me, and I think it's critical that VCs do this in order to nurture the entrepreneur and grow more valuable CEOs and companies. At the same time, it's our job to create superior returns for our LPs so we had better not be teaching on their nickel unless the result is a superior one. I argue that this is more often the case than not, since the founder CEO who gets this treatment forms a far better working relationship with the investors and avoids hiding the ball but shares the problems and weaknesses so they can be fixed.

It's a shame that entrepreneurs don't get to shoot their investors, but please don't shoot me, I'm just the piano player.....

Getting Access to the Old Boys' Club (how to approach a VC)

by Mark Suster

Many VC websites have a tab that will tell you that you can submit your business plans to enquiries@vc_company.com or some similar generic email address.  But does it really work?  Can you really send your business plan over the transom and expect to get a positive response?  The short answer is "no" – don't waste your time.  I know some VCs would take issue with this and somehow I'm sure that there are some success stories with this method but trust me this is worst way to approach a VC.

Why is it a bad idea?  Most VC firms receive an unbelievable number of business plans every year.  It really is hard to process them all effectively so some sorts of filtering techniques develop.  I remember asking for advice from a law firm in 1999 (before my first fund raising exercise) the best way to approach VCs.  He told me that "most VC's will figure that if you are truly an entrepreneur you'll find somebody that knows them, develop a relationship with that person and find a way to get them to introduce you to the VC.  If you can't do that then you're probably not really an entrepreneur."  It sounded a bit like an "old boys club" to me.

It may sound harsh but in reality I think it's true.  If you can't get a warm introduction to a VC then how on Earth are you going to break down the doors to get to the VP of Sales, Biz Dev or Marketing in the organization that you're looking to sell your products to to or develop partnerships with?  If you're not assertive and creative enough to get through a VC's doors then how are you going to get the most sought after journalists to write your stories or the most skeptical buyers to part with their hard-earned cash?  And we expect you to be able to persuade potential employees to join your cause when you can't pay them properly, they'll need to work crazy hours and you'll always be 9 months away from bankruptcy.  In short, in most cases being an entrepreneur requires  a healthy dose of Chutzpah.

And when I speak on this topic in public I like to remind people that, "when I raised capital there were no easy ways to figure out who were the friends of the VC's (let alone who the VC's were in the first place) but in 2009 you have alll the social networking tools:  LinkedIn, Facebook, Twitter or even just plain old Google Search.  It's pretty darn easy.  But aside from the obvious social graph information I'm going to give you a few tips:

1. Start-up oriented, corporate lawyers.

VC's deal with corporate lawyers all the time.  We deal with them when they represent us in fund raisings and when they represent the companies that we invest in.  We spend time with them because they often attend the board meetings of our portfolio companies and we work with them when we sell our companies or implement stock option plans.  In fact, most great early stage corporate lawyers run in exactly the same circles as we do.  They are often one of the best sources of early-stage deal flow for VCs because one of the first companies most entrepreneurs do business with is their lawyers who incorporate their companies.

By the third time I was raising money in 2003 I had already learned this trick.  I called two law firms that I knew well and asked them about VCs in the Washington DC area (I was considering opening up US operations for my company and thought we'd raise US capital to do so).  The law firms were able to tell me: who the best VC firms were, who was investing money and who wasn't.  But even more precise I asked them about each individual partner – who had influence and who didn't?  Who got a lot of deals done and who was spending too much time on the golf course?  And I wanted to know who had software-as-a-service (SaaS) skills and who didn't.  I went even further to ask who was active on boards and who "dialled it in"?  (The Funded didn't exist back then).  Obviously not every lawyer is going to tell you all of this detailed of information, but if you spend enough time with enough lawyers and help them out too (introducing potential other clients) then you'll definitely pick up at least part of the story.  And most good VC law firms are good at introducing you to the VC when you're ready.

2. Start-up focused recruiters

I was recently at a breakfast for the mentoring program that I founded (www.Launchpad.LA) and I mentioned the idea of our group spending time with recruiters.  Many of the guys moaned.  I was surprised.  I've always loved spending time with recruiters.  Not just because many of them are very social people by nature but also because they know everybody.  And if they've been doing it a long time they know them in ways much better than most of them ever will. And the best recruiters definitely know the VCs.  I know that recruiters can get a bad rap because there are so many bad ones, so your job is to identify who are the best.  How on Earth do you do that?  Simple: contact the CEO's of local entrepreneurs and ask!  (see point 4 below)

3. Portfolio companies

Let's say you've identified the VC firm you want to approach and you've gathered a bit of information on them but you still don't feel you have the best person to introduce you.  The absolute best place to start is with the CEO's of their portfolio companies.  I'm always surprised that more people don't do this.  Every VC lists who their portfolio companies are so it's pretty easy to figure out a few CEO's who know the VCs (and the companies websites normally list who are on their boards so you'll even know which partner did the deal).

OK, so if the VC you want access to is Union Square Ventures you probably don't want to contact Twitter or Boxee but you could easy contact earlier-stage, less known companies.  Obviously when you do you should be respectful of their time and find ways that you can be of help to them also.  But the best approach is to ask if you can ask for a 30-minute coffee slot as you'd love to get a small amount of their time to learn a bit more about their experiences in fund raising.  If they accept – stick to your limit of 30 minutes and start a relationship that will hopefully pay off well beyond fund raising.

If you're not yet in the comfort level to start calling the CEO's you might also consider calling the other co-founders who are not CEO.  They are often listed on the websites.  Once you've had the chance to meet with 4-5 portfolio companies in a time-respectful way one would hope that you developed good rapport with at least one of them (otherwise, revisit the question – am I really the right person to be an entrepreneur?).  At the right point you might consider politely asking them to intro you to their VC.  A warm intro from a portfolio company is the single best source of lead for any VC.

4. Entrepreneurs in general

Another very obvious source of information is just to network as widely as you can with other entrepreneurs.  Founders often get so bogged down in getting their products out the door, raising money and hiring staff that they don't spend enough time networking more generally.  The best source of advice in general on how to build your company is from talking with other entrepreneurs who have recently done it or are currently doing it.

Specifically they will be able to give you tons of information about local VCs and their experiences pitching them.  You can't rely on the information of the first one or two you speak with but if you meet with enough entrepreneurs you'll be able to triangulate enough to figure out the good guys and the bad guys.

SO ... now that you know how many plans we get from portolio companies, laywers, recruiters and entrepreneurs in general (not to mention business school classmates, other VCs, professors, etc.) ... still think your plan randomly submitted has a good shot of getting you a meeting?

Partners vs non-partners – clarifying their role and importance

by Peter Lee

I was at a Dealmaker Media event the other week and was asked a question about the role of entrepreneurs dealing with partners vs non-partners at venture capital firms. Its a very interesting and relevant question for many entrepreneurs starting out who are unfamiliar with the fund raising process. Since I've been in both roles, I think I have a pretty good perspective on this dynamic.

To differentiate the roles, I'll actually split them into two groups, not based on title, but on their "authority". From my experience, it really comes down to check-writers and non-check-writers, Hopefully this distinction is fairly self explanatory but really comes down to  do they have the authority to decide (obviously with the general agreement of the other partners in the fund) on whether they will fund a startup or not and serve on the board. Rarely do even check-writers decide completely on their own – that's why they call it a partnership since there is a level of trust, influence, and sharing of responsibility.

Titles, just like in companies, often mean very different things in venture capital firms. With titles ranging from Analyst, Associate, Senior Associate, Vice-President, Principal, Senior Principal, Operating Partner, Associate Partner, Venture Partner, Principal Partner, Partner, General Partner, Managing Partner, Managing Director, etc – it can get confusing very very quickly. Basically, its really hard to tell who is a check-writer vs not. VERY GENERALLY, if forced to bucket them, the breakdown is (not 100% across firms but maybe 90% accurate)

1. Check-writers – Managing Director, Managing Partner, General Partner, Partner
2. Non-check-writers – Analyst, Associate, Senior Associate,  Operating Partner, Associate Partner
3. Can go either way – Vice-President, Principal, Venture Partner, Principal Partner

The unfortunate thing (or fortunate depending on your perspective), even VCs (not just entrepreneurs) themselves often can't tell the different when it comes to another firm unless they are very familiar with that particular firms structure and the individual's involved. It gets even more complicated because many non-check-writers at firms want to project to the outside world that they can write-checks (trying to boost their credibility and influence in a firm to the entrepreneur) even though they can't.

Essentially, if you want funding, you need to get to a check-writer (pretty obvious at this point). They will be the one who champion's your deal in their partnership and can push to get it funded – putting their own reputation on the line with their decision.

The area that is less clear is the role of the non-check-writer. Simple advice – they are valuable and can be your greatest ally or your worst barrier to getting funding, but they are often a necessary and intermediate step to get to the check-writer.

To get into more detail, the non-check-writer (typically an associate) is often the "first line of defense" for a VC firm. They are responsible for screening deals so they at least pass the initial sniff test. Unless you get a trusted referral directly to a partner in a firm, the associate is generally the one who will do the first pass and often take the initial pitch. Often due to bandwidth limitations (or laziness), the partner will just pass deals they receive directly onto their associate anyway. This initial review by the associate is important as they are the gatekeepers to get access to the check-writers. Impress them and they will convince the partner to take a meeting as they often will have the ear of the partner.

In addition to being the gatekeeper, pitching the associate can be extremely valuable to get feedback on how the partnership thinks about investments as they will have a good sense of what excites the partners in the firm. Use this time well to hone your pitch, get feedback, and prepare yourself for the next one. Often, the associate will also have a good read on the personalities and preferences of the partners that can be immensely valuable as well as fund status.

The things you want to watch out for is continuing to meet with the associate over and over again without any sense of moving forward to that partner meeting. This can be a slow and painful death….but, don't necessarily expect that you should get to that partner meeting after just 1 meeting with the associate. Often, if your pitch isn't quite ready or there just wasn't enough information to "let you through the gate" they will ask you for some additional information and another meeting to make sure. This can be a worthwhile exercise as you typically will only get 1 shot with the partner and if you screw up, its over. You'll just need to read the associate well and/or ask them directly about what additional information they need before a partner meeting might be expected. Be straightforward but realistic about the questions and diligence items that are being requested but generally, if you aren't getting invited in at least after a 2nd meeting with an associate, better to just cut bait and fish somewhere else – its likely a dead end.

Ultimately, an associate is balancing trying to find a company to "get a deal done" and making sure his filter is tight so he doesn't waste the partners time. Understand the associate's motivations, listen carefully to their feedback, and treat them professionally and you'll maximize your chances of getting through. Treat them poorly and ignore their feedback and you've likely just shot yourself in the foot. Remember, VC's judge teams (not just experience and qualifications but personality) as much or more than the business itself. Leave a bad personal impression with the associate and it will absolutely get passed onto the partner.

Going through fund-raising can be a long and confusing process – even in the smoothest of deals. The associate can be a huge ally to guide you through this so work with them and take advantage – you'll be better off....but keep your eye on the goal – get to a meeting with the check-writer and convince them as they are the decision makers in the end.

FAIL: 12 WAYS TO BLOW YOUR INVESTOR PITCH

by David Brody

While there's no shortage of reading about "how to pitch for funding", from what we can tell, a lot of what's written isn't soaking in too well. So we thought we'd try a more unconventional approach.

Our team at North has put together a collection of some knowledge (and scars) we've accumulated over the years to point out the noteworthy wipeouts, awkward moments, and empty handshakes of new venture pitching. By first revealing what doesn't work, we hope to activate the other side of the entrepreneur's brain (the one that isn't always thinking about success…).

This following excerpt is taken from our latest presentation titled, Fail: 12 Ways To Blow Your Investor Pitch. You can get a copy of the entire paper (full of entertaining reference visuals and hyperlinks) at www.dontgosouth.com.

Ready? In no particular order, here are a half-dozen ways you can fail an investor pitch (and 6 ways you can fix it). Be sure to take good notes (especially mental ones…).

The Fail #1: The K-Mart Template Business Plan

Over 500,000 business plans float around the internet attached (by a fishing line and a bobber usually) to a hopeful entrepreneur dreaming that some day their 53 page (single-spaced) doc will be downloaded by a wealthy investor who will find their idea so damn compelling that they'll call frantically asking for the ABA routing number so they can wire you a suitcase full of cash immediately.

Well, if your first move is a long winded template style business plan you purchased from the digital equivalent of K-mart, chances are you're fishing with the Rocket Fishing Rod (www.spindirect.com/product_order.php). We hate to play dream crusher, but you aren't on a TV commercial, and these ponds aren't stocked with starving fish.

The Fix #1: Sexy Materials Get Noticed

One thing that book publishers know is that in order to convert a browser into a customer, you must first capture their attention at the shelf. Don't fall into the trap of thinking that just because your business has sound financials and a good product that investors will plow through a long boring document and uncover the genius inside.

An investor's belief in your ability and your concept's strength starts with the very first time they lay eyes on your business materials. Seriously, how is one to believe that your business will inspire consumers if your materials look like they were pulled together on a Commodore 64?

The Fix #2: Talking Up Your Awesome New Product

One surefire way to lose your audience is to jump right into talking about your amazing product. Yep, without the proper context your long winded rant about the crucial need for a rapid charge system for a 14.4 volt lithium ion battery is going to fall on deaf ears.

Chances are the person you are speed pitching isn't the target consumer. Think it through, if most investors aren't currently feeling the exact itch your product scratches, you need a different approach.

The Fix #2: Talk About Solving a Real Problem

Instead of talking about your solution, start by explaining the consumer's needs. While it's essential that you bring the investor to a point where they understand your product, understanding the buyer's needs is more important. Try telling a story about a real person (www.youtube.com/watch) who needs your solution. Take the audience to a place where they can see the world through that person's eyes. Help them feel that customer's pain.

Talk up the need for big holes first and then everyone will want to hear all about your six-ton super drill.

The Fail #3: Showing Off A Feature Bloated Demo

Okay adrenaline junkies, here is your big chance to see if you can get lucky with a live demo. Chances are if you've made it this far, you're excited, so geeked up that you'll probably veer off down a path that nobody else wants to go where you'll leave the listener confused and dizzy.. We call this the tilt-a-whirl demo…a dizzying array of irrelevant features and functions. Don't worry, everything that plugs in will usually crash (www.youtube.com/watch) anyway, so be sure to have an audible up your sleeve.

The Fix #3: Weave a Memorable Story Into The Demo

While your product demo is important, how you get the audience to that point is often the true difference-maker. So it's up to you to take investors on a journey into the life of your consumer and explain how exactly they would use your solution. Help us feel their pain.

Let us experience their joy when you save the day and chop the big bad wolf in half with an axe. And don't get distracted by all the pretty things to talk about (or look at) along the way, just get to the payoff in a clear and concise manner.

The Fail #4: Touting Top-Down Market Data

Search is a multi-billion dollar market, so you conservatively project to capture a measly .001% of the search market and make tens of millions per year? Sounds pretty reasonable…if there is a multi-billion dollar market then there has to be some room for a niche player to squeeze out a little of market share, right? Wrong.

Make sure your assumptions aren't wildly off base either, or you'll be hard-pressed to last long enough in a pitch to actually get the opportunity to defend them.

The Fix #4: Build a Bottoms-Up Business Model

When you talk about the size of the market, and how you plan to capture market share, start at the ground floor with your team and work your way up. How many consumers need what you have right now? Are within range for your team to contact and have the budget to buy? Assuming you can convince a percentage of those truly addressable consumers to pull out their wallets, what kind of growth can you realistically project? Tie it back to your sales team’s individual contributions if possible.

The Fail #5: Your Business Has Users, But No Revenue

"No margin? We'll make it up in volume!" Who could ever make that mistake again? Admittedly there are still a number of ventures that don't have a real revenue model, but are media darlings. Don't be fooled, the media also loves a good train wreck. Are you able to demonstrate that there is a thirsty crowd willing to pay for what you are offering? Yep, we said pay. Or are you living a K-Fed fantasy?

The Fix #5: Show a Clear Economic Model

Okay, this is important. If it takes a complex chart and excel to explain how you make money, you've missed the mark. We love to see a simple unit economic model for each stage of the business. Oh, don't be afraid to show year to year percent changes in costs, revenues, and profit (loss) so we can get a handle on how you see things changing over time. Are your prices realistic, or based on a hunch?
Bonus points if your data is based on actual sales…

The Fail #6:  You Disappear In Sea of Sameness

"But my idea is groundbreaking." You should think this way, it's your baby. Your belief in your concept is what gets you out of bed in the morning. Unfortunately, the odds are that somebody is already working on something similar to you. And guess what, that competition probably has a nice head start.

Psst, you can develop the best, most innovative product or service, but if nobody knows about it nor is inspired to give it a try, then you're just swimming around aimlessly in crowded waters. Bottom line: if your brand isn't differentiating and motivating, it's game over.

The Fix #6: There Can Only Be One

If you're going to inspire consumers to buy your product, you have to nail your customer-facing brand.

Is it compelling? Does it stand out? Does it resonate with your desirable target? Be able to confidently describe how you can connect with your consumer because your understanding of their emotional and rational needs is unmatched. No one said pimpin' was easy. It's a competitive game. So step yours up and show investors that you know how to bring your brand to life in a relevant and inspiring way.

How LPs should deal with VC

by Georges van Hoegaerden

Last week's 20th anniversary of IBF Venture Capital Investing Conference(congrats to Alex Scott and Christina Riboldi) in San Francisco was a unique opportunity for me to witness the atmosphere between 487 Limited Partners and General Partners (also referred to as Money Managers by LPs).

My first ringing of the closing bell on Nasdaq followed by a packed premier event of the Asian American Association of Investment Managers (AAAIM) at The Harvard Club in New York, with keynotes from Julian Robertson, CEO of Tiger Management and David Rubenstein, founder of The Carlyle Group gave me some great insights into the world - and thinking - of LPs.

It is clear from these sessions that LPs (and Fund-of-funds) are misled and confused about how to improve the performance of Venture Capital (VC). The VC sector of the Private Equity asset-class has been plagued with dismal performance of less than 10% IRR (Internal Rate of Return) for the last 9-years, leading some LPs to question and reduce allocation (US: 10-15% of total assets per firm, Europe: ~4%) in a sector that deserves quite the opposite.

The emerging opportunity in technology VC

The technology sector which is my passion for the last 30-years is at the beginning, not the end of its emergence. Perhaps the top-level indicator of the innovative runway we have ahead of us is the following: more than 5/6 of the world's population does not yet use a computer connected to high-speed/broadband internet today. And all should and will, given the right technology. That's where technology innovation comes in; not just in connecting people to the internet but in deploying innovation that uses the internet as a distribution mechanism. The way we use the internet today is rudimentary, and many new technology stacks will emerge to improve its impact on everyday citizens.

Given the early days in the life-cycle of the technology sector relative to any other sector or asset-class is; low-cost to produce, low-cost to distribute and because of the internet has immediate customer impact with independently short sales-cycles. That means with relatively little money in, a massive impact can be produced, virtually instantly.

Why the VC sector is not producing

In the words of Cesar Millan, the popular dog whisperer on National Geographic, who states that the behavior of the dog is the responsibility of its owner, so should LPs demand control of the behavior of the VCs. Like dogs, VCs exhibit primal behavior that can make them great money-managers, but only when they are controlled. An issue even The Carlyle Group recognizes by including a code-of-conduct in its recently published annual report. LPs should let go of the leash after VC performance becomes apparent, not before.

-- Risk deflation
VCs sell well upwards to the LP at fundraising time, but they seem to have forgotten that they need to serve the entrepreneurs just as well. In the investment pyramid between the dollars from the LP and the ideas of the entrepreneur, the VC is simply the derivative that should serve both. Today it does neither. The money-tree report further hides the ugly reality under-the-hood as the funding stages have disrupted the equilibrium between entrepreneurs and VCs and steadily turned VC into loan-sharking.

-- Lack of relevant experience
Most VCs in Silicon Valley simply have no relevant operating experience that allows them to service the needs of entrepreneurs adequately (see sub-prime VC). And that in turn creates a massive amount of false negatives and false positives to which no liquidity mechanism (from the NVCA or Tim Draper) will suffice. Beginning in the early 2000s, the VCs have simply consistently invested in entrepreneurs that submit to sub-prime innovation and terms.

-- Lack of vision
No surprise that, according to a conversation with a chinese private equity investor at the AAAIM conference, recently 12 highly successful chinese immigrant entrepreneurs left the U.S. disappointed to go back to China because the VCs did not allow them to take the helm at their own companies. They will in China. Smart entrepreneurs simply won't submit to sub-prime VC, leaving the VC (and therefor indirectly the LP) alone in their spiraling sub-prime demise.
To echo Jessica Reed Saouaf, Managing Partner of Hall Capital Partners (with $17.5B in assets under management) who describes at IBF that the VC business today is too institutionalized with too few visionaries to create promising returns. LPs need to do a better job in sourcing, segmenting, controlling and demanding transparency so the behavior of VCs remains an extension of the LPs investment brand and integrity.

The myths LPs are being told

But the incumbent VCs are not taking this criticism without a fight, a fight to hold on to their cushymanagement fees and plush existence. From the focus of their rebuttal (by way of pump-and-dump liquidity plans, annex funds etc) you can gleam their true nature, they worry more about protecting their downside than improving their upside.
A welcome exception to the majority of followers of the auto company's plan to fixing VC are the younger VCs like Jason Green (Emergence Partners) and Paul Holland (Foundation Capital) who on the IBF panel proclaim that, unlike the NVCA they do not lie awake at night about the impending increase in capital gains tax on their carry. Instead, just like great entrepreneurs, they worry first about delivering value and returns, trusting that personal wealth will naturally follow.

Here are the most frequent myths I hear VCs attempt to imprint on the LPs that I want to debunk here quickly to prevent a further slide down the sub-prime spiral:

-- It's the economy; new fund - stack fund - annex fund
Nonsense: even the most successful startups do not achieve revenues or market-share above 10% of their total-addressable-market (TAM) during their private funding cycle. That means that 90% of the total-addressable-market is still not served effectively. With a few exceptions it is hard to imagine that a 10% decrease in market will have any affect on the success of the startup. I would argue that in a down-market the opportunities for new technologies improve considering the fact that an early adopter can more effectively compete with 90% of its competitors. So, conversion rates of companies with macro-economic differentiation should improve and so will their market-share and revenues and consequently the opportunities for great exits.

-- We are in a down-cycle, we will bounce back; new fund - stack fund - annex fund
Nonsense: the barrel of a downward spiral is cyclical too, be sure to recognize the difference. Sub-prime investments have no exits and will yield valuable fund returns, no matter what the liquidity structure is. VC portfolio choices that cannot withstand the test of time simply have no fundamental differentiation and independent future. And a GP that cannot distinguish between prime and sub-prime will never be successful.

-- Companies are cheaper to build; new fund - less money
Nonsense: I have heard LPs echo the term "Capital Efficiency", and it is a trap. Not just for the entrepreneur but for everyone in the technology ecosystem. Unlike in the past, no product can withstand the scrutiny and the power of social networks unless it is really well built, offers fundamental and disruptive value and delivers authenticity and trust. Only then will users adopt it. And since distribution is virtually immediate, more competitors will spring up to provide the noise that makes life harder. So products are actually more expensive to build and requires a different ecosystem makeup and funding trajectory for the company. VCs that look for smaller funds demonstrate further misalignment with reality and therefor exits.

-- There are not enough great ideas; new fund - less money
Nonsense: but sub-prime VC behavior and terms turns off great entrepreneurs. Only idiot CEOs and unsuspecting entrepreneurs submit to terms that hands control and destiny to underperforming VCs. Other forms of artificial arbitration such as geographic distance of 20 minutes moves the VC even further from the meritocracy it should be looking to embrace. The institution on Sand Hill Road is severely limited by its lack of peripheral vision of technology and the world.
-- New (government) regulation is strangling exits; new fund elsewhere
Nonsense: the bar has been raised for technology companies as it should. No longer can public markets be fooled by valuations that have no value. Real value jumps the hurdles of regulations with ease (as witnessed by OpenTable and Rosetta Stone). The current startup inventory, that was subject to sub-prime investment tactics to begin with, may not be able to get to the finish line. Such is the punishment for lack of independent differentiation and value.

-- The grass is greener in green; new fund - hot market
Nonsense: I have witnessed the rush to these "hot-pockets" before but hot-on-supply does not equate to hot-on-demand. Or as Julian Robertson says; "there is a difference between having a bakery and baking bread". Contrary to technology, greentech is expensive to produce, expensive to distribute, relies on long sales cycles and arbitration (subsidies, politics etc. ) that is beyond the control of the startup (and much more complicated in its regulative risk than, for example, healthcare). A dependency on government is very dangerous in meeting the time-to-money milestones for early stage companies and fund returns. I believe in the value of green-tech and energy-tech to create a greener planet, but I don't believe the current VC funding models with former technology GPs looking for greener pastures can support its early financial success within the current funding vintages. It is ironic to see VCs use the capital-efficiency slogan under the same roof as their capital intensive strategies for energy-tech.

-- The grass is greener global; new fund - new fund elsewhere
Not yet: as we move up the technology stack and specifically the investments in software, the origination becomes less relevant, I will yield to that (although I see still see an entrepreneurial quality difference), but startup investments should reside where the execution is, regardless of origination. While other geographies score well on low-cost manufacturing (and programming), real disruptive ideas and the majority of early adopter markets (driven by the frantic pace of unbridled capitalism) still reside in the U.S. So VC funds should be equipped to handle international deal sourcing (and be the first investor in) and only become truly international once the remote exits prove to justify an independent local operation. For that to happen, creation, execution and exit values need to yield appropriate dynamics. Remote execution and exit values remain sporadic today, but that may change as those markets develop and emerge as prominent technology visionaries and consumers.

How to fix VC

Optimizing VC is probably easier than most LPs think, since the issues plaguing VC have to do with regaining fundamental leadership of the investment ecosystem. Simply put, LPs need to become "VC whisperers" (to use the Cesar Millan analogy), those that can control the performance of VC so the leash can be loosened. The good news is that none of the deficiencies in VC are rooted in the complicated micro-economics of technology, contrary to what some GPs may want you to believe. But it is important that LPs hear more than the repetitive sugar-coating from underperforming VCs and keep a close eye on entrepreneurs who actually represent the monetizable assets.

-- No more "duh" PPMs
No more Private Placement Memorandums (PPM) that look remarkably like a wish-list without substance. Yes, I've seen the memorandums produced from brand-name VCs that get replicated by many other VCs in the valley. No right-minded VC would accept a business plan from an entrepreneur that looks like that, neither should you. The quality of the PPM is a direct indication of the quality of the VC fund and should help LPs clearly segment the risk associated with technology investments. LPs have invested deep rather than wide in the technology sector, hence the birth of many false positives.

-- Assess the GP's unique vision
Many of the PPMs talk about rearview mirror analyses, but the only advantage one investor has over any other is his forward looking views on the industry, or vision. So LPs need to assess the risk associated with that vision, much of which again is related to macro-economic impact rather than technology waves. GPs should be able to demonstrate that their unbridled vision in the past came true.

-- Assess the GP's relevant operating experience
To become a valuable partner to the entrepreneur the GP needs to be able to prove relevant operating experience related to the investment thesis and specifically to the segmentation. Information technology is a broad sector and experience in consumer technology differs from the application of technology to healthcare. Being able to help entrepreneurs develop a large vision with tangible baby-steps is a skill that GPs need to master to improve the size of disruption and returns. That experience needs to map directly to the investment thesis in the PPM.

-- Assess the GP's track-record for deal sourcing
Getting your hands on real disruption requires a proactive approach to finding the "diamond-in-the-rough". Many early stage entrepreneurs, hurt by sub-prime VC tactics, need help thinking bigger. The size of the disruption, rather than the cost of entry is crucial. Finding deals that can be turned in game changers is fundamental to the success of great returns.

-- Hire an expert
All this deep-diving may be too much for an LP who has nearly 90% of its assets allocated to other asset-classes, so the smart thing to do is to hire an expert that speaks the language of the entrepreneur and ensures that the needs of LPs and entrepreneurs are effectively met through an intermediate VC vehicle.

Conclusion

Crucial to the success of the technology sector is to do the opposite of what most VC funds are currently setup or guided to do. To follow Warren Buffet's advice: when everybody is investing using sub-prime tactics then now is the time to do just the opposite. Venture Capital is a sector that can produce great returns when it takes great risks, not when it becomes risk averse, and fragments and commoditizes investment dollars. Deflating the risk through sub-prime investment tactics has killed the want to innovate, and may lead to an accelerated intellectual exodus that will hurt our economy as a whole.

Apart from fixing what is broken I think the time is right to fundamentally restructure early stage innovation and make its financial support just as innovative as the inventions themselves. Facebook sets a good example of how it taunts with the institutionalized "rules of Silicon Valley".

LPs who cannot see the massive opportunity in technology should simply exit from Venture Capital. But continuing to support sub-prime VC funds is a sure way to continue down the spiral of suboptimal returns we have been stuck with for the last ten years and damage the innovative ecosystem our economy depends on.

So dear LP, go big or go home. And when you plan to go big I will make myself available to put words into action. I cannot wait to turn this page.

The Dreaded Elevator (Cocktail Party) Pitch

by Mark Suster

I was asked to speak on Fox Business network and help new entrepreneurs develop their elevator pitch.  So I thought I'd give it some thought before I turn up.  The elevator pitch is vital to an entrepreneur's repertoire and so often they are poorly delivered.  For starters, I think the term "elevator pitch" should be changed to "cocktail pitch" because it is a more realistic scenario.  You're an entrepreneur and you bump into a VC, customer, partner, potential employee, journalist – whatever – at a cocktail party, conference, airport lounge.  How do you get your points across effectively in a way that leads us to want invest, partner, join you, write about you.  [all data below totally made up] Video of me covering this topic on TV is here.

My 2 cents:

1. Be brief: Tell me what you do in 2-3 sentences – Let's say that I just finished doing a presentation at a conference.  I have 20 people politely waiting to introduce themselves to me.  You're next in line.  Be ready to pitch it to me quickly.  You'd be surprised how many people run on-and-on and never get to the point.  Remember, you're not trying to close the deal here – you're just trying to make a positive impression and follow up later.  The best people at pitching know when to gracefully say goodbye and let others speak rather than linger.  Oh … and follow up!  You'd be surprised how few people actually do contact me after telling me they're going to.
2. Define the problem – The most important thing you need to do is to convince me that somebody has a problem.  It might be that people's cell phone bills are too high, there is no good way for singles to find out what music is playing in town, website publishers can't make enough money with existing banner advertising – whatever.  But if I can't visualize the problem – I can't make the connection that somehow your product or service is likely to get mass adoption.
3. How do you solve the problem? – So you produce a new brand of coffree and I now realize the problem: 23 million US consumers have acid reflux and can't drink coffee.  Tell me about your patent-pending method developed over the past 18 months to press the coffee in a way that reduces acid and allows all these people to now consume a product that they previously couldn't enjoy.  Tell me how you're going to bring your product to market and why people will love it.  But do it briefly, please.
4. What is your target market? - Which consumers or business are you targeting?  Don't tell me that the market for services in the US is $2.3 trillion dollars.  Otherwise I know that you're not realistic and I've already started thinking other thoughts in my head and started tuning you out.  Make it real.  An example would be, "we've created a solution for people to search and find high quality janitorial services in the small-to-mid sized business market.  SMB's currently spend $4 billion / year on janitorial services alone."  OK, I know who you're targeting!
5. What progress have you made to date? – If you want to quick establish credibility with me tell me what you've already achieved.  If you're purely in the idea stage my advice is to approach me later when you're further developed.  There is nothing worse than a poorly researched Cocktail Party Pitch.  But assuming that you've gotten started, the pitch goes somethign like this: "We've designed our iPhone application to help find speed cameras in your area.  We launched 3 months ago and have signed up 800 test users.  We're trying to raise $250k to market the product more broadly."
6. Why are you uniquely qualified at this idea to be successful – 80% of my investment decision is the team.  I know that not every VC agrees but I personally believe in A+ teams more than I believe in A+ ideas or A+ markets.  I think great teams are better at finding the right idea and market over time and most good ideas / companies morph frequently.  I prefer that you have some experience in what you're doing.  VC's call this "domain knowledge" so that you're not learning about a new market on my nickel.  There is likely someone out there who knows the industry dynamics better than you do and will eventually compete with you.  So if you spent the last 4 years doing digital marketing for consumer Internet sites think carefully about launching your next product as the mobile PayPal killer.  It's a bit of a stretch.

My Advice:

1. Show energy & enthusiasm –  Passion sells.  Show energy and excitement.  Get your game face on.  Make an impression.  This is your shot and you have my attention.  Don't waste it on low energy, mumbling, limp handshakes or lack of assuredness.  I'm not saying go "over the top" in your excitement, but enthusiasm for your idea is contagious.  If you're shy or introverted I don't expect you to be something you're not – it will come across as insincere.  But at least practice your pitch enough so that you can say it with gusto.
2. Be human (no jargon, give me examples) – Most people who pitch me use jargon.  I have a simple philosophy.  If you can't explain to me what you do in simple terms I assume that you don't know what you're talking about and you're hiding behind terminology to sound more intelligent.  The most difficult of topics can be explained in human terms.  I like people to use real world examples.  When I talk about my recent investment in RingRevenue I like to talk about the problem that affiliate networks have selling high value products.  I call it the "treadmill problem".  If I want to buy a treadmill I won't click and order over the Internet when a treadmill costs $3,000 or more.  I want to speak with a sales rep to understand the 8 different models and which I should buy.  With RingRvenue affiliate networks can track calls like Interet sites track clicks.  Explaining this in "treadmill" terms I believe puts a human face on the issue.
3. Use numbers - Numbers speak.  And they help convince people that you know what you're talking about.  In the RingRevneue example the pitch goes something like this:  "The highest that a product costs in an affiliate network is $200 because above that price people prefer to call a sales rep rather than buy online.  Affiliate marketing is a large market already: $10 billion of goods sold through this channel of which the networks make fees of $2 billion.  We think we can increase goods sold through this channel by 10x making it a $100 billion channel."
4. Tell me what you want from me – In marketing or sales terminology we call this a "call to action" and I'm surprised at how few people incorporate this into their pitch.  What is your goal in telling me about the virtual reality game you built that targets teens?  Do you want me to meet you at some point in the near future?  Do you want to approach me in 6 months but just want to be on my radar screen?  Do you want to follow up with me via email to find out who invests in $250k deals in Southern California?  Close by telling me what the next steps are or how I can help.  Please don't always make it a meeting for next week if you aren't immediately fund raising.  It can be as simple as, "I just want to say hello and tell you what we do so that I can speak with you next year when we're raising money.  Do you mind if I drop you a quick email with my contact details?"
5. Be prepared for the deep dive discussion if I engage – If you're pitching me the Cocktail Party Pitch you had better be prepared for a deep dive.  I might have just been thinking about investing in a self-service retail kiosk company so the fact that you have a product like this is great.  I can cover the "Deep Dive" another time, but one bit of advice now … don't do all the talking.  I remember a friend from Australia had a saying that always stuck in my mind.  He said, "that chap is a crocodile.  All mouth an no ears."  Selling is about listening, asking questions and peppering in commentary.  The Elevator Pitch is as much about selling as it is about pitching.  So if you get beyond first base (the first 1-2 minutes) get ready for two-way dialog.

Valuation optimization vs maximization - what is the real goal?

by Peter Lee

One of the most confusing and misunderstood concepts to entrepreneurs is around valuation – not only in how it is determined (that is an entire post itself which I won't try to tackle right now) but more importantly, what should the goal be?

I think for entrepreneurs who haven't been been through fund raises already, the first and obvious reaction is the get the highest valuation possible and if you do, you'll have "won the battle". I guess it makes sense that this viewpoint is commonly held – in many other areas of negotiations, auctions, grades, sales deals, etc, the goal is to get to the extreme (either lowest or highest) and the closer you get, the better you did. It's how they got to where they are now – by winning and excelling in everything they did. They view the "valuation negotiation" with a VC just another competition to win.

So, why isn't this the right approach for entrepreneurs? (and the answer is not because I'm the VC writing this and I'm trying to convince you to take a lower valuation – but good try!). The reason is because a) the funding is a financing event, not an exit (the exit is when its decided whether you win or lose) and b) the prior valuation has a significant impact if and when another financing round is required. The exception to this is if this is definitely the last financing round the company will need before exiting – and even this has it pitfalls when it comes time to exit (see my earlier post about entrepreneur and investor alignment specifically regarding exits and the VCs need for high returns and a multiple on their investment).

For the entrepreneur, the financing event and resulting valuation merely puts a number on the company value which then affects the percentage ownership the founder has in the company – but this doesn't translate to real money that the owners can walk away with (I'm sure those of you who were at startups during the dot.com bubble but didn't exit before the crash can relate to this quite well…). Its paper wealth. Funny-money. Remember 100% ownership of nothin' is still nothin'…

Valuation becomes a real issue for those companies that need to raise another round of financing (this may be where many of the entrepreneurs who raised money in the last 18 months before the market crash last fall start to perk up…). A high valuation (which 12 months ago seemed like a huge success) is now feeling like a huge albatross – a heavy burden on the company that may stifle their ability to raise money from an outside investor. This occurs because the prior round investors want to be rewarded for putting money in earlier through getting a higher "step-up" valuation in the next round. The new investor is often wary of companies with valuations too high as their expectations for a smooth round getting done is put at risk as they worry about spending a lot of effort for a down round that gets resistance or just gets done by the insiders (prior investors). In a startup, momentum is very important on how the world perceives your succes. When things continue to be on the "up-and-up" across all areas of the business – great team is built out, revenues increase, customer base grows, metrics improve….and valuation continue to rise round-after-round, everyone is happy.

Now, just to be fair, on the other side of the table, it isn't in the best interest of the VC to drive to the lowest valuation possible either. This is because if the founder/entrepreneur doesn't have enough of an ownership stake in the company (especially after several financing rounds), there is a real risk that the founder may leave if he feels like the reward for staying isn't big enough vs doing something else (starting another company, taking the big corner office at a cushy large company job, etc) – remember, being an entrepreneur is hard work and people need to be rewarded for their commitment.

Somewhere in the middle between a valuation so high it risks future financings and a valuation so low it dis-incentivizes (I know this isn't a word but it should be….) the founders is the optimal valuation. For the entrepreneur and VC, the goal should be to find a fair valuation for everyone. The entrepreneur/VC relationship is a long-term one, often 5+ years. Raise these concerns with the VC and get it on the table so both of you see each other's perspectives and motivations. Its a good initial step in a very long journey that will ultimate be in both of your best interests. Remember, "winning the war" is the goal – exiting the company so that both you and your investor makes money through an exit. The fund raises and valuations are just a step along the way towards the final goal.

What to do if your VC leaves their fund

by Healy Jones

This is my follow up post on what to do if the venture capitalist who invested in your startup leaves their firm. (For the first post on what it means when your VC leaves click here.) My first thought for you, as a startup CEO in this situation, is "wow, you've just become an orphaned deal and you might be in trouble." But all is not lost, and there are steps that you can take to make the situation better; perhaps even a positive. The amount you freak out depends on your particular situation. 

Your situation when the VC leaves

Let's hope that you've picked your VC wisely. Some venture funds have good internal information and responsibility sharing on existing investments. These funds also force rank their investments across the entire portfolio. I think that many of these funds will handle partners leaving much better because they have real understandings of which investments will be supported, regardless of which partner works with the portfolio. Why don't all funds do this? Because it is a huge amount of work to develop these rankings and keep them up to date. While I was at Atlas we did this exercise several times, and it required the attention of every investing partner, principal and associate, plus the CFO and several members of the administrative staff for two of full days, plus hours of preparation time. And it wasn't fun. But I think that the exercise gave the fund a much better, more rational understanding on how each portfolio company was performing and the key value drivers and risks faced by each. If you are a portfolio company that is doing well at a fund like this then you will be handled with care during a partner transition. I still suggest you think about following some of the steps I list below, but you are going to probably end up being in good shape.

However, if your fund seems disorganized and doesn't seem to know who will be managing their investment in your startup after your partner leaves (for example, if you first hear that your partner left in the media/news and not through someone from the fund contacting you), or if your startup is not exactly … kicking ass then you need to be very pro-active.  

Is this the only fund that invested in your startup, or is there a syndicate? This is one of the reasons why you, as a startup CEO, should want to syndicate your early financing with more than a single venture firm. If there is a syndicate you may be in better shape. Hopefully that other fund will continue to be supportive - if so this will make raising follow on financing from new investors much easier. And hopefully this other member of the syndicate will be able to help you meet near-term capital needs.

I am operating under the assumption that you have a good view into what your cash needs will be, and that you know when you will need to raise additional funds for your startup. (If you don't have a fresh financial plan get it together ASAP!) You should be less concerned if you have 12+ months of cash runway.

Steps you can take when your VC leaves

Figure out what is happening at the venture firm. Did they just raise a new fund? Then you may be in better shape, because this is a strong sign that the fund will continue to exist as an entity and that the remaining partnership should be stable. If the firm’s most recent fund is on the old side and they do not have plans to raise a new fund soon then you should be a bit more worried. In this case, the next step becomes very critical.

Hopefully you have an existing syndicate partner and this other venture firm can continue to support you. Call this partner ASAP and develop a plan of attack with them. Do they know what is happening at the other fund, and have they worked with the new partner before? You want this other firm to continue to aggressively support your startup. You need them to be willing to step up and invest in your next round. You may wish to talk with them to see if they are interested in trying to buyout the other fund - occasionally this can be accomplished at bargain basement prices. This syndicate partner may also be interested in proposing/leading an aggressive financing round in your business, with the purpose being to remove the other fund from the cap table. This is called a "wash out" and it is not for the faint of heart. 

Again, I hope that you've got a well build financial model and you know when you will need to next raise cash. If you feel worried about the level of financial support that you will get you may want to consider taking steps to decrease your cash burn and increase the company's runway.

I believe this is my most important tip: I would try to schedule at least half a day (if possible a full day offsite) with your senior management team and this new partner. You should be prepared to re-pitch to this new partner. They will need to be "reminded" of how big of an opportunity you have, how great your team is, all the progress that you've made, etc. Remember that this partner did not do the same level of diligence on your company, and that they have not been sitting on your board closely watching you evolve as a business.  Try to help them get all the diligence that your original partner had at the time of the investment in a very short period of time. This is really hard; diligence really can't easily be crammed. But the better you do, the more educated of a partner you’ll get- and in theory this will lead to a more supportive partner.

Don't forget to provide some customer diligence to this new partner. VCs get excited when customers pound the table and say how much they need the product/service. In an ideal world you'll connect the new partner with a customer who they already know. I realize this may be pretty hard to pull off, but maybe when the venture firm did the original due diligence on your firm they introduced you to potential customers? If you closed on any of these customers they are the greatest people to have speak with the new partner. You may have to set these calls up, but I think they will be worth the effort.

You should have a voice into which partner will take over managing the investment in your company. Have an opinion. Figure out which partner has the time, experience and desire to help your company. Also take into account who the "power" partners are at the fund. They may have more pull and thus have a better shot at making sure you get the resources you need from the fund.

In summary, when a partner leaves and your deal becomes an orphan you could be in serious trouble. But there are steps you can take to increase the probability of having a smooth transition. You need to get serious mind-share from the new partner. You'll need their support at their fund, and you'll want them to be a productive member of the board of directors. This will require work - put in the effort!

What happens when your VC leaves their fund

by Healy Jones

I don't know if you've noticed, but the venture capital industry is undergoing a bit of a contraction. The WSJ recently noted, "Not since the dot-com bust has the industry experienced as much turnover as it is now. Since the end of 2007, the number of venture-capital principals, who make investment decisions and are directors of start-up companies, has tumbled by more than 15%, according to the National Venture Capital Association." There is a ton of discussion about how the shrinking of the venture industry will impact "innovation in the USA," and "what does this mean for new companies chances of getting funding." However, there is another group of startups that is being impacted by this personnel exodus - funded companies. What happens when you are a startup that has raised venture capital and the VC who sits on your board leaves their fund and your company becomes an "orphan deal."

Well, you should probably freak out a bit.

Let me explain. Everyone knows that there is a lot of rational, thoughtful analysis and diligence work that goes into a venture partnership making a new investment in a startup. However, there is also a bit of passion that goes into any given investment. Fred Wilson recently blogged on this topic when he discussed the leap of faith that goes into any new investment. This leap is mainly taken by the partner who is leading the investment. That partner stands up to the venture firm's partnership and says: "I believe in this. Here is my work and here is my thought process, and here is why I want to risk our investors' money in this business and with these founders. If the going gets tough, it will be on my back to figure out how we save this investment." 

The lead partner knows the startup better than all the other partners at the fund. When the startup hits the inevitable bump (or two) on its road to world domination, it is that partner's job to pound the table at the fund and say "we need to continue to support this management team." It is much easier for the partner who made the initial investment in the startup to provide this level of support because the partner: 1) was supportive of the company during the first investment, and assuming the startup has been doing well, has probably also been providing positive updates to the partnership; 2) has seen the team in action, and (assuming the team is good) has developed confidence in their ability to execute; 3) understands the product development timeline and why it will work for the company’s eventual plans; 4) because of the time spent around the startup for the past months/years knows the market well enough to speak very confidently about the fact that there is a real need and addressable market; and 5) knows how and where the company will burn cash and how this will generate leverage in the business model and returns for the investors. (I have updated this post to include this sixth point) 6) Limited partners (the investors in venture capital firms) do not give real deal "attribution" to partners unless they were the one who made the initial investment. Regardless of the reasons why, this does not provide the proper motivation to a different partner taking over responsibility for the investment in the orphaned startup. Being an active board member and managing an investment takes a huge amount of time and effort, and if the new partner isn't going to get real credit for managing the investment to an exit then they are less likely to be as supportive as the original partner.

The other partners at the fund just can not offer this same level of support/advocacy because they haven't spent as much time with the company. If your venture capitalist leaves their fund, you need to get a new advocate within that fund ASAP. Usually you'll get a call from your VC explaining that a new partner will be managing the investment in your company. You need to reach out to this partner quickly and get them to fall in love with you just as your original partner once did.

I would not take this lightly. Some business school professor should do a study on the percent of follow on rounds that are supported by venture firms after the investing partner has left vs. the average when the partner is still around. I bet there is a statistically significant difference… I am very much suggesting that you may not get the same level of financial support in your business from that fund as you had in the past. If you are going to be raising additional capital this is a big deal.

Over the next 18 months venture funded companies will struggle as they try to get financing from funds where their partner has left. Some will get that support. Others won't… and trying to get a new venture fund to support your startup after your existing venture capital firm has passed on investing is as close to a kiss of death as you can get in the early-stage financing world. Who could know more about your company than the fund that is currently an investor? There is no bigger red flag for potential new investors in your startup than the current investors not having enough faith to make a follow on investment, even if this pass is due to a change in investment professionals at the fund.  

Tomorrow: the steps you should take if your VC leaves their fund. There are things you can do to land on your feet and help manage a smooth transition with your investor…

Do Young Venture Capitalists Have an Advantage?

In venture capital, success breeds success. Entrepreneurs and investors tend to knock on the doors of the venture capitalists who have repeatedly grown tiny start-ups into billion-dollar companies.

But are newer, younger venture capitalists actually better at the job? Some limited partners, who invest in venture funds, say they are, because they are more plugged in to ever-changing technologies and closer in age to 20-something entrepreneurs.

"The top firms might not be who you think they are," said Judith Elsea, co-founder and managing director of Weathergage Capital, speaking Friday at the International Business Forum venture capital investing conference. "The industry and the people in it are maturing," she said. "Some of the people who were venture gods in the 1990s are ten years older than they were. Maybe they've stayed relevant and active or maybe they've migrated out of their space to another great opportunity, but many times people don't migrate that well."

Experience and past success are, of course, advantages in any industry. But technology might be different, Ms. Elsea said. "Technology is so dynamic it just moves on, and it takes a lot of work to have your networks refreshed and changed. A lot of people don't jump innovation curves. It's awfully hard to stay at the top of your game for a very long time" in the venture industry, she said.

Top venture firms develop brand names for themselves, but many investors say the track records of the individual partners are more important than those of the firms. And often, even if a star partner stays at a firm, the younger partners are more actively involved in finding and investing in new companies. That means investors in venture funds must look deep into firms to see who the younger players are.

"If you look at the old guard and their success, I agree entrepreneurs are attracted to their firms, but you have to look through those brands and identify where are the true visionaries, where are they spending time, and how as an L.P. do you get exposure to the true essence of innovation?" said Jessica Reed Saouaf, managing director and co-head of private equity investments at Hall Capital Partners.

That kind of research distinguishes smart investors in venture funds from those that do not do their research, limited partners said. The old adage "You never get fired for buying IBM" has an analog with big names in the venture business, Ms. Elsea said. But the question becomes whether the limited partners "are sophisticated enough to know I shouldn't be buying IBM anymore," she said. "There is some education that goes into this — some of the L.P.s are living in a world of the 1990s, not today."

Since the life of a typical venture fund is ten years and the rising stars could very well move from one firm to another within that time, Bronwyn Dylla Bailey, research director for SVB Capital, researches firms' succession planning and whether they incentivize new stars to stay at the firm. "Younger entrepreneurs want to partner with someone who's a better cultural fit, closer in age and has a fire in the belly and excitement over innovation, and will stick with the entrepreneur in the five to fifteen years it's going to take before the company exits," she said.

More venture capital firms halt their fund raising

By Galen Moore

Two more venture capital firms — Wellesley-based Venture Capital Fund of New England (VCFNE) and Lynnfield-based Velocity Equity Partners — have suspended efforts to raise new funds, following Prism Ventureworks into the VC fundraising doldrums.

Unlike Prism, which last month said it still had funds remaining for three to five new investments but would not seek to raise a sixth fund, Velocity and VCFNE said they would no longer be investing in new companies out of their current venture funds.

Both Velocity and VCFNE said they will continue to defend portfolio companies by reinvesting in them with reserve capital. Once the last startup leaves the nest, the last remaining partner may have to turn out the lights. But Gordon Penman said he and the other partners at the long-standing VCFNE are hopeful that won't be the case. "We've had some success in the portfolio and the best is yet to come from the existing portfolio," said Penman, who is also an attorney at Brown Rudnick LLP. "Once the current environment changes, we're hopeful that we'll have the track record to raise another fund.” Their fourth fund, worth $25 million, closed in April 2002, Penman said.

Both Velocity and VCFNE had participated in the federal Small Business Investment Companies (SBIC) program, which co-invests government money with certified venture capital funds.

New venture

Founded in the early 1980s, VCFNE brought on a new managing director in 2005 and intended to raise a fifth fund without SBIC participation. Rashid Ashraf, who had been a founding partner at Blue Sky Ventures in Framingham, had planned to take the VCFNE mantle from veterans Harry Healer Jr. and Kevin Dougherty. Instead, Ashraf has left VCFNE to take a founding partner role at a new firm, Arrowpoint Ventures, with former Kodiak Venture Partners partner John Abraham and former Castile Ventures partner Marcia Hooper.

Healer and Dougherty plan to help guide the firm's fourth-fund investments to liquidity, and are expected to retire after that, both Penman and Ashraf said.

VCFNE failed to raise funds because of bad timing and because the firm was trying out a new model, said Ashraf. By attempting to raise a much larger fund  — over $100 million — without SBIC assistance, he said, VCFNE represented an uncertain proposition to limited partners, or LPs, those who provide the capital that VC firms invest in startups.

Ashraf's new firm, Arrowpoint, is in a holding pattern as its founders wait for the right moment to raise a $150 million fund, which is expected to be targeted toward early-stage investments in infotech, medical device and wireless companies. Potential LP investors, such as pension funds or endowments, are already over-allocated in VC and private equity, Ashraf said. That makes it better for a nascent fund to wait.

"Even though all three of us have been VCs, when it's a new team, you're considered to be an emerging manager," he said. "To go out and not be able to raise (a first fund), I don't think sends a very good message to the market."

A failed fund-raise can tarnish even an established firm, said Bill Asher, a VC finance attorney with the Boston law firm Choate Hall & Stewart LLP. "The real issue is whether your existing limiteds are going to support you on the next fund," Asher said. "If that's not happening then you're in real trouble."

But perception is not absolute, he added. If the economy improves, limited partners will be looking for VC firms with good track records. Even firms that may be struggling now could recover well if in the next couple of years they're able to sell off portfolio companies for a good return.

Limited partners are likely to be impressed with anyone who can make returns in the coming two years, said Kevin Delbridge, a senior managing director at Boston-based fund of funds HarbourVest Partners LLC. "For those that can prove themselves in this environment, there's probably a story there," Delbridge said.

That's what Velocity hopes to do. "Right now, we're focused on the portfolio," said managing director David Vogel. He declined to answer questions about the size of the firm's current fund, which is its second, or about the date of its founding.

He said the firm found a higher-than-usual bar to fundraising in this environment, but is looking forward to the exit of some of its portfolio companies. Last month, Velocity participated in an $8 million reinvestment round for CiDRA Holdings LLC, a Wallingford, Conn., maker of industrial flow measurement components. "We intend to do more of the same," Vogel said.

The Death of Venture Capital as We Know It

by Penny Herscher

A massive shakeout of venture capital firms has been predicted for years but it is finally going to happen over the next year because of a perfect storm of timing.

There are countless books, a few movies and mountains of silicon valley gossip about the good times of venture capital. Huge returns from the Internet bubble bred too many people who thought they were smart because they were rich and it seemed as if new funds were popping up all the time, staffed by VC wannabes from investment bankers to millionaires from companies like Netscape, eBay, and Cisco. As one of my investors said at the time "everyone wants to be a venture capitalist, even the landlord".

But that era came to an end 9 years ago now, and 10 years is the critical period for the venture capital industry because funds are 10 years in length so I predict the decimation will start by the end of this year (although some like Venture Beat are already counting the corpses).

The perfect storm will create an inability for all but the best firms to raise money - and funds need to keep raising money to stay alive - but they face a tempest:

1. The 10 year look back will not look good for all but a very few by the end of this year. With the exception of a handful of funds, the great returns came off funds that started before the tech bubble burst. It burst in 2000 so by 2010 the look back will not include liquidity events in 1998 and 1999. Even some of the best firms don't have great returns over the last 10 years.
2. Major LPs (limited partners like pension funds and endowments) are having to balance their portfolios away from alternative investments. Imagine you manage an endowment or pension fund that has a restriction on what percentage can be invested in alternative investments (like venture capital) . But the equities portion of your portfolio has dropped by 40% so now your venture capital portion is over your limit. You can't invest more in venture capital even if you want to participate in a new fund.
3. For years now about $2B a year in new money was flowing into the venture capital world from new LPs. This was new family money diversifying, or countries bringing a portion of their sovereign wealth fund into venture - but now if you are a newly wealthy South American land owner and have a $100M that you are being advised to invest in higher risk/higher growth you'd look back at the 10 year returns of venture capital and say "no thank you".
4. The IPO market is broken so smart investors know that the rates of return for venture capital will continue to be depressed. Being acquired just doesn't carry the same multiples as an IPO - especially now when buyers are taking advantage of the difficulties small companies have raising money in a recession.

Even the best funds are working harder than they have every worked before to raise their new funds. NEA has closed on over $2B of their $2.5B raise, Oak Investments will succeed in raising their $1B plus fund because the same small group of partners has been repeatedly successful over more than 20 years - as will the best of the best like Sequoia, Benchmark, Sutter Hill, Kleiner-Perkins et al when their time comes.

But we're seeing a significant flight to quality as the funding so far in 2009 is down almost 40%. LPs will be ruthlessly selective and this will weed out the new, the small and the weak.

The coming contraction will cause the startup industry to return to fundamentals. Good ideas into vibrant new markets that take 6-8 years to blossom not 2-3. Some in the valley think this will lead to less innovation but I disagree. I think we'll get a higher quality of company because great new companies don't come from the spray-and-pray approach - they come from creative, hard working entrepreneurs working hand in glove with nurturing investors and customers over a considerable period of time.

There are about 700 venture capital firms in the US according to the National Venture Capital Association. I readily admit I'm opinionated and think that probably less than 10% of these are really valuable to entrepreneurs (my friends who are partners in the best firms listed above would say the quality list is less than that!). As I've posted before - all venture money is not equal - pick your investors very carefully.

I predict decimation - but I realize as I conclude that I am not using the word correctly because it comes from the Latin for the destruction of one tenth - but I wonder if one in ten will be left standing? Will there be as many as 70 US venture capital firms two years from now?

And you may ask who cares in these tough times? As long as critical breakthroughs in new technology - from clean energy to bio technology to the way we communicate - come from innovative small companies as they often do today we all care.

How Tranching An Investment Can Affect Investor Ownership

by Mark Peter Davis

In my post, Investors Tranche Fundraising To Reduce Risk, I address one of the key considerations that drives VCs to decide whether to tranche an investment, or not.  While tranching an investment is always better for reducing risk, it's not always better for maximizing ownership.  

A VC may or may not be better off by tranching their investment.  Ultimately, the determining factor for determining whether a VC should capitalize a company in one round or several when seeking to maximize ownership is the percentage of the company's lifetime capital requirement that the VC will be providing.  In a nutshell, the greater percentage of the company's total required capital that the investor provides, the more capitalizing the company in first round will increase ownership.

The Logic Behind This

If the investor plans to provide all of the company's required capital, they have an incentive to do the entire investment in the first round, when the valuation is lowest (valuations tend to increases between tranches).  The simple logic here is that it enables the investor to maximize their ownership of the company.

In contrast, a venture fund that can only provide a portion of the company's required capital is poised to own more of the company if the financing is tranched.  This is because by breaking the total capital invested in the company into tranches, the investor's capital can represent a greater percentage of the company's first investment round.  Since the remaining capital will be invested in subsequent rounds at a higher valuation, the investors capital will be diluted less than it would have been if all of the capital was invested in the first round at the same valuation.

In sum, majority investors want to buy as much stock as they can in the company at the lowest average price - subsequent rounds increase their average share price.   Minority investors want subsequent investors to pay a higher price than they did to reduce the extent to which their ownership is diluted.

An Example

The table below illustrates an example of how this math works.  Note that the numbers I picked are not indicative of the average deal structure - I simply chose numbers that make the math easier to follow.

I use the term "majority investor" loosely below to describe an investor that provides the majority of the invested capital.  Conversely, the minority investor provides only a small portion of the invested capital.

What you'll notice is that the minority investor owns more of the company in the tranchedscenario and the majority investor owns more of the company in the one-round scenario.

Making Sense Of This

This math leaves majority investors with a bit of a quandary.  They have conflicting incentives.  The majority investor is both incented to tranche the investment to mitigate execution risk and incented not to tranche the investment to maximized ownership.  How these investors ultimately decide to proceed is likely to be a function of their perceptions of execution risk and their risk tolerance for the investment (which is driven by where the investment sits in the life cycle of the fund and how much of a cowboy they are at heart).

Some have argued that the inherent incentive alignment partially supports the model of having smaller VC funds.  That's another dicussion for another day.

Early Exits

by Mark Macleod

Back in January, I wrote about the oncoming era of the "small exit". I felt then (and still do) that the combination of capital efficiency, the bad fit between traditional VC and today's young startups, the sheer number of startups vs. amount of available capital (especially here in Canada) all pointed towards small exits. Vancouver-based Basil Peters has written a book on this topic which I recently had the pleasure of reading.
His book Early Exits covers his considerable personal experience as a founder, VC and now angel investor. His thesis for the book is as follows:

"Today, the optimum financial strategy for most technology entrepreneurs is to raise money from angels and plan for an early exit to a large company in just a few years for under $30M."

There are many reasons why this message likely resonates with today's tech entrepreneurs:

- VC is getting harder to find. Funds are getting bigger and only want to do deals that require a lot of capital

- Its easier to generate "small" exits than big ones but small exits don't interest VCs

- Putting a few million in your pocket as a founder can change your life

- As VC has gone through some challenges we are seeing more and more the impact and scope of angel investing
Basil lays out a compelling case for early exits. We all know that taking VC is no guarantee of success. In fact, Basil has shown that VC-backed companies have considerably longer time to exit and lower rates of success. There is no question, that his message is anti-VC. And since this comes from a former VC, we should take note.
Basil covers many important considerations for entrepreneurs and angels as they plan for their exits. Some highlights:
- Founder shares should vest over time with 1/2 vesting on exit (since up to 1/2 of the value creation comes here and all of it is realized here).

- Aligning on exit strategy can be the single biggest factor in determining whether founders actually realize the value in their shares.

I agree with both of these points, especially the latter. I have seen the complete paralysis and disfunction that comes from having stakeholders that are not aligned.

For someone who has spent the last 10 years raising VC, Basil's book and message will not have me abandoning this market. The fact is: not all startups *should* raise VC. However, you don't have to choose your path right away. You don't have to decide between a big swing for the fences raise lots of $ strategy vs. an angel-fueled early exit play.

To me, the ideal strategy for most startups (especially in the web, where I spend most of my time) is to raise modest amounts, keep burn low, be positioned for the early exit, BUT if you feel you can and want to make a big play, then have the team, technology and traction that will enable you to fund it and go for it! In other words, have your cake and eat it too! This also enables you to go down the VC path should you choose to from a position of strength as you will have more of the elements that they look for in a deal. The best time to raise VC is when you don't need it. So, building a business that does not depend on it can only help you if you decide to take VC down the road.

I definitely see the potential for early exits. This is in fact one of the big reasons why I scaled back from doing one startup at a time to taking on several: So that I could help finance, grow and sell startups that may never be big enough to need a full time in-house CFO. And will never be big enough to work with great M & A advisors that can increase their exit value.

If you have not done so already, I highly recommend you read Basil's book. You can get it here.