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As published in American Venture Magazine,
March 2002
How to Obtain Early-Stage Venture Capital Funding in
a Horrible Market
By Todd T. Pietri
I don’t envy entrepreneurs trying to raise early-stage venture capital
money in this market. The major stock market indices are directionless.
The overall economy, while showing marginal improvement, leaves much to
be desired. More importantly for our investment focus, business investment
is anemic. Given these uninspiring economic trends and the portfolio problems
at the typical venture firm, many VCs have lacked the confidence and time
required to invest in fledgling enterprises. The numbers make this reality
clear. According to Venture Economics, venture capital investment is down
from $21.4 billion in Q4 2000 to $7.3 billion in Q4 2001, a 66% year over
year decline.
Historical perspective offers comfort, though, as venture capital investors
invested $37.7 billion in 2001, which far exceeds the $19.8 billion invested
in 1998 -- a record year at the time. In addition, many VCs are reaching
a turning point with their portfolios, as they have largely shut down
their losing investments and have stabilized the ones worth keeping. With
a perception that the darkest days are now behind us, VCs should have
the time and energy required to focus on new deals.
However, entrepreneurs must recognize that VCs have changed their standards
for new investments. The majority of my venture colleagues currently want
to invest in later-stage deals at what used to be early-stage pricing
because the risk reward calculus makes so much more sense for investors.
While some pre-revenue companies are receiving backing, they are increasingly
rare.
The question for entrepreneurs is how to approach the private capital
markets in the most intelligent way. I will assume you have the basics,
including: a proven management team; a profitable and scalable business
model; a compelling, quantifiable value proposition; a proprietary technology;
and customers with real pain and the money to pay for your solution. I
am also assuming you aren’t targeting a crowded, over-funded market
or plan to burn through a ton of money in a short time.
If you possess these fundamentals and have avoided the major deal killers,
here are some insights you may find useful as you seek capital:
- Be prepared for a long capital-raising process: Plan for a 4 to 18
month institutional capital-raising process. Four months is very rare.
The key is to survive the lengthy process, so reduce your cash burn
rate as much as possible and then reduce it some more.
- Build the confidence and trust of venture firms over time: In this
market, initial meetings rarely lead to heated due diligence and term
sheets over a short period of time. Instead, initial meetings spark
interest and identify issues that need to be addressed. In the ensuing
months, as you meet major milestones, you should regularly communicate
the positive news to the interested VCs. Over time, you will build trust,
confidence and rapport with your potential investors, which is a solid
foundation for completing a financing. In addition, VCs are much more
likely to invest in a very early-stage company if they have watched
you deliver on your promises over time and feel comfortable with you.
- Close small amounts of angel money on a rolling basis and charge for
your consulting services to stay alive: The best structure for angel
money is a convertible note with a modest discount (10%) to the institutional
round. If you can’t charge for your product yet, charge for your
services to generate cash.
- Prepare two financial models: Venture firms have bifurcated into groups
that want to make large investments and those that concentrate on small
financings. You need to target both to improve your odds of success.
For example, we are working with an early-stage company that has both
a $3.5 million plan and a $10 million plan. We are interested in the
$3.5 million plan, but they are also talking to larger firms that want
to see the $10 million plan. In either case, you need to have a plan
with growth expectations and headcount increases based in reality. In
our case, we also like to see a round size large enough to get you to
profitability or last you two years, even if you miss your forecast
drastically.
- Paying reference customers are your lifeblood: The mission in life
for an early- stage company is to secure marquee reference customers.
Talking and visiting with these customers is the most important due
diligence activity for a venture capitalist. The more sophisticated
and knowledgeable the customer is about your offering and market the
better. Ideally, you should have a minimum of six paying, installed
reference customers.
- Form meaningful strategic alliances: When you are a small, early-stage
company, you have to borrow the credibility of established players.
Strategic alliances serve this purpose and position you for growth.
- Prepare a detailed new business pipeline: Every opportunity you are
tracking should have a deal value, an estimated closing date, and a
probability of closure. The revenue line in your monthly financial model
should correspond to this detailed monthly pipeline. You should be conservative
in your forecasts because over time VCs will pull out old forecasts
to see if you are meeting your numbers.
- Market size is critical: Venture investors are looking for large markets.
In fact market size is a gating factor for most venture firms. Of course,
the definition of “large” varies from VC to VC. Many VCs,
but by no means all, would find a $500 million market size with 30%
percent annual growth interesting. Investors that can tolerate smaller
markets, which is increasingly rare, will adjust valuations downward
to factor in the smaller market size.
In any event, make an honest first cut at sizing the potential market.
Take your universe of target prospects and separate them into small,
medium and large opportunities. Estimate the average deal value for
the different categories and multiply these values by the number of
prospects in each category. This result is your total market size. You
then need to estimate the annual market size by calculating the percentage
of the total market that will turn over every year.
Also, adding up the annual revenues of all known competitors is another
helpful exercise for sizing the existing annual market.
- Communicate realistic valuation expectations to investors: No one
is going to work on due diligence if the entrepreneur signals unreasonably
high valuation expectations. For enterprise software deals currently,
.5 to 2 times current year revenues is the reasonable range. If you
are pre-revenue but have a product and beta customers, we don’t
see many valuations greater than $2.5 million pre-money.
- Connect genuinely interested venture investors with each other: While
in some rare cases it behooves the entrepreneur to play VCs off one
another to get the best price, in this market it is more important to
just close the round. In most cases, the lead investor will need to
form a syndicate to share due diligence work and fill out the round.
When you have more than one firm sincerely interested, connecting them
at an opportune time -- for example when you close a big deal or partnership
-- can be the catalyst that generates a term sheet and builds the momentum
required to fill out the syndicate. No one wants to spend a lot of time
and effort on due diligence if it is going to be a long struggle to
round up other investors.
- Think through your exit strategy: A venture firm we respect once offered
a useful analogy for thinking through an exit strategy: If you died,
would anyone show up for your funeral? In other words, after you build
your company up to a reasonable size, will anyone care you exist? Remember
that good companies can be bad investments. A VC firm can fund an early-stage
company that grows into a profitable $20 million annual revenue company,
but it may be impossible to exit if you exist in a vacuum. Think through
the following questions. Would your strategic partners or customers
suffer materially if you disappeared? Will the major players in and
around your market see your customers, core competency, technology and/or
management team as strategic necessities they must own?
It goes without saying that the entrepreneurs, not the VCs, are the heroes
of this economy. We respect entrepreneurs who are building a business
and trying to raise capital in this environment. While very few companies
have all of the ingredients discussed in this article or will be able
to follow all of these guidelines, a preponderance of these qualities
and a credible plan for shoring up the weaknesses will go a long way toward
helping you close your round.
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