Venture Capital Selection Tips and Guidelines

Preliminary Considerations

Have your business plan reviewed by someone with expertise before you present it to investors. The reviewer might be an entrepreneur, an executive with an entrepreneurial bent, a venture capitalist you won't be approaching, or someone who specializes in preparing business plans.

Consider making the entity a limited liability corporation or a limited partnership; this allows the pass-through of profits and losses (avoiding the "double taxation" that occurs regarding a C corporation) and it allows corporate investors (unlike a Subchapter S corporation).

Selecting a Venture Capital Firm

Ideally, you want a venture capitalist:

  • Who is interested in early-stage companies and already has investments in your industry.
  • Who has a preference and the know-how for investments in your industry: one who knows your market and your industry.
  • Who has a successful record of growing smaller companies.
  • Who can offer sound business advice, moral support and contacts in the business and financial community in addition to venture capital.
  • Who has co-invested with quality venture-capital firms and underwriters.
  • Who gets along with you well.
  • Who has a good reputation.

One source book for venture-capital financing is Pratt's Guide to Venture Capital Sources (Venture Economics, Needham, Mass.) Also, lists of venture capital companies are available from:

The National Association of Small Business Investment Companies
1156 15th Street, Suite 1101
Washington, D.C. 20005
(202) 833-8230

The National Venture Capital Association
1655 North Fort Myer Drive, Suite 700
Arlington, VA 22209
(703) 528-4370

On the Web, lists of venture capital firms can be found at:

http://www.capitalventure.com/cvvclinks
http://www.entrepreneur.com/listings/vc100/0,5946,,00.html
http://inventors.about.com/od/venturecapitol/

Note that venture capitalists will generally refuse to sign confidentiality agreements--but they will maintain confidentiality as part of maintaining their reputations.

What Investors Look For

Frequently the investor is looking for the following:

  • A company that can become highly profitable and dominate the industry.
  • A company that can go public or merge within four to seven years at a high price/earnings multiple.
  • A complete management team with a strong leader.
  • Principals with proven entrepreneurial, management and profit experience in the industry.
  • A strong innovator, technologist or marketing person.
  • A team with complementary and compatible skills.
  • Principals with unusual tenacity, imagination, commitment and integrity.
  • A significant competitive lead and other market advantages.
  • High-value-added goods or services.
  • Exclusive contractual or legal rights.
  • No dominant competitor.
  • A market growing at 25% or more per year.
  • Clearly defined customer and distribution channels.
  • The opportunity to achieve positive cash-flow and break-even sales.
  • Gross margins of 40%-50% or more.
  • A 10% or greater profit after taxes.
  • First-round capital requirements of $1 million to $10 million.
  • An opportunity to recoup 5 times the investment (or more) in five years.
  • Anti-dilution and initial-public-offering subscription rights. (Though often the entrepreneurs want to avoid these, as will be discussed later.)

Some items that particularly excite investors:

  • Evidence of market acceptance (orders, letters of intent, beta sites etc.).
  • Focus by the entrepreneurs and a market niche for the venture.
  • A proprietary or exclusive position created by intellectual property (licenses, patents, copyrights, proprietary technology etc.), or a substantial market lead and the lack of dominant competition.

Here are the ranges for compounded annual rates of return that investors often expect, based on the stage of the venture. However, these ranges may well vary depending on the what the investor perceives as the degree of risk involved.

  • Start-up 50%_70%+
  • First Stage 40%_60%
  • Second Stage 30%_40%
  • Third Stage 10%_30%

Generally, the usual negotiation ranges are 50_70% or more for the investor who provides all the required funds when the venture is a start-up. However, on start-ups, if the entrepreneurs provide 10% of the investment they may be in a position to keep 50% of the equity; if they provide 1/3 of the investment they may be able to retain 2/3 of the equity.

Some factors that may persuade an investor to take less than the usual range are:

  • Previous profit responsibility by the lead entrepreneur and above-average profit.
  • The presence of a complete management team.
  • An entrepreneurial team with detailed, current knowledge of the target market and substantial previous experience in getting orders from the venture's prospective customers.
  • A demonstrably strong position for the venture's products or services in terms of patents, exclusive markets or substantial lead time.
  • The entrepreneurs taking personal loans or second mortgages on their houses to invest money in the venture.
  • The entrepreneurs offering collateral (mortgages on real property, liens on the company's equipment and machinery, patents or other intellectual property rights) to protect the investor's investment.
Oral Presentations to Investors

The oral presentation to the investor should:

  • Be rehearsed; key facts, figures and other knowledge should be memorized.
  • Be concise; venture capitalists are frequently pressed for time.
  • Analyze the opportunity and market for the company's products or services and why those products or services can establish a market niche against the competition.
  • Stress the unique skills and backgrounds of the management team that qualify them for their projected roles in the company.
  • Discuss the history of the venture.
  • Provide a brief view of projected sales and profits over the next five years and the key assumptions behind those projections.
  • Address potential risks and problems, showing that the management team has the ability to think through the tough trade-offs and devise alternate action plans.
  • Give each key person on the management team an opportunity to speak.
  • Offer a succinct list of who owns what shares in the company and who has paid what.
  • Offer a summary of the details of the proposed deal, including the price and shares (or a range of them).
  • Indicate the name and telephone number of the person the investor can call with questions.
  • State how the investor may ultimately cash out (IPO, purchase by the company over time, purchase by a company ESOP or ESOT, purchase by the company according to a formula, sale of the venture to another company, finding a replacement investor, liquidation).
  • Include a short, exciting, written business summary (1,000 words plus charts) addressing these points.
  • Generally include well-designed, professional prototype or actual product brochures, and pictures of the product.
  • Let the investor know you are also approaching other venture-capital sources.

Be prepared to answer all conceivable questions about the venture.

Whenever rejected, try to determine the true reasons for the rejection--it will be useful for the next time.

Negotiations and Agreements

Despite any claims to the contrary, everything is negotiable. The essential negotiables are:

  • The basic valuation of the company, and how much equity is relinquished for the money the investor puts in.
  • Who will pay the legal and accounting fees necessary to complete the deal?
  • What type of stock or debt will be issued? (Common stock, preferred stock (entitled to set dividends), convertible preferred stock (convertible to common stock), convertible debentures (loans convertible to common stock), loans with warrants (options to buy stock).) Investors may want to purchase convertible preferred stock, while the entrepreneurs may prefer to issue common stock or debt plus stock.
  • Will the management remain as it is? Investors may want a management change if they believe the company's team is lacking in some skill or if they believe someone else on the team should be president.
  • How many directors' seats will be allocated to the investor?
  • How will voting control (of stock) be allocated?
  • Will investors have a right of first refusal on subsequent offerings? Will the original shareholders?
  • Will there be stock-vesting agreements where the entrepreneurs do not own all of their stock initially but acquire ownership over three to five years?
  • Will there be employment contracts, non-compete and proprietary-rights agreements with the entrepreneurs? Investors often insist on this.

The management team should decide these issues in advance. On price per share paid by the investor, the entrepreneurs should decide what they would like to get and what they will accept.

Logical persuasion is generally the best negotiating tactic.

The investment agreement should:

  • Specify the amount, timing and type of the investment (stock, convertible preferred stock, notes, warrants etc.)
  • Provide terms that will motivate the entrepreneurial team if they perform as planned.
  • Provide down-side protection to the investors by giving them control of the venture if it is in danger of failing.
  • Provide and protect opportunities for the investor to realize capital gains and liquidity.

The following are usually burdensome conditions to be avoided if possible:

  • Participating preferred stock. In the case of liquidation, investors are repaid first (purchase price plus accrued dividends) plus any remaining assets are divided on a pro-rata basis with the common-stock shareholders (usually the entrepreneurs).
  • Anti-dilution "ratchet-down" provisions. The investor is issued additional common stock if the company completes an subsequent sales of stock at a lower price. If the investor holds convertible preferred stock, the conversion price is adjusted to equal the lower sales price.
  • Anti-dilution "weighted average" provisions. Here the conversion price is adjusted based on a weighted average of each stock issuance. Less drastic but still a problem.
  • "Demand" registration rights. Investors can demand that their shares be registered for a public sale (typically within three to five years). Underwriters often object to this, which can make going public difficult or impossible.
  • "Piggy-back" registration rights. Grant investors the right to include their shares in any stock registration. Again, underwriters frequently object.
  • Mandatory redemption of preferred stock. Here the company must buy out the investor if the company fails to complete an IPO (or meet other goals) within a specified time period. Raising the cash may cripple the company.
  • Co-sale provisions. Investors can tender their shares if the founders sell additional stock before an IPO. This causes conflicts with later-round investors and inhibits the ability of the founders to cash out.
  • Investor-only sales. If management doesn't find a buyer or take the company public by a certain date, the investors can find a buyer for their stock alone.
  • Dilution financing. Dilutes all existing stock when current shareholders won't commit additional funds. This may leave the entrepreneurs with too little to keep them motivated.
  • Key-person insurance benefiting the investor. Key-person insurance with the proceeds directly payable to the investor, rather than to the company.

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Methven & Associates
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Phone: (510) 649-4019 Fax: (510) 649-4024
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Copyright 2004 Bruce E. Methven, All Rights Reserved.

The foregoing article constitutes general information only and should not be relied upon as legal advice.