Getting the First Round of Funding: the Venture Capital Process

by on October 6, 2008

in Business, Social Media, Social Networking, Strategy

This week I attended the excellent MassTLC unConference. Among excellent sessions on effective use of Twitter, how to generate free PR, common startup mistakes, and others the unConference was a stellar event. One of the sessions I attended was about the process and best practices on raising the first round of funding for a startup. It was run by Steve O'Leary (of General Catalyst Venture Partners) and James Gershwiler (of Common Angels: "Boston's Largest Network of Technology Investors" .) The session was incredibly informative for someone who's new to the process of getting their startup funded via VC or Angel money. This is going to be a long post, but the information I found to be invaluable and interesting since it came directly from active investors and VCs.

The first thing to understand is what the differences are between 'VCs' and 'Angels.'

VCs are companies that raise money from 3rd parties (individuals, institutional investors), manage this money in a fund, and deploy this money in hopes of a return on the investment. These funds have a term like any loan (usually < 10 years.) VCs expect returns on their investment relative to the pool of money the manage in the fund, usually in the range of 10-20% of the pool. A 'small' VC fund is about $200 million: a VC of this size would expect a return of $10-$20 million on their investment. So it's critical that you choose a fund that matches your company's mission: if your vision is to grow to be a $2 million company don't shop for VCs that have multi-billion-dollar funds under management.

Angels are usually individual investors but can also be hybrids (syndicates of individuals.) Some have money under management, some do not; however, the money is usually theirs, not a 3rd party's. Angels tend to be cashed-out entrepreneurs with expertise in their fields. They usually invest in people they know, businesses they understand expertly, or in referrals from trusted sources. Angel investors generally make much smaller investments (< $10 million in most cases) but may band together to invest larger amounts of money. Certainly there are some Angels with vast resources but most invest much less than $10 million individually. As a rule of thumb individuals have less money than institutions.

The panel discussed 'qualifying questions': these are the things that VC and Angel investors need answers to immediately before considering an investment. They are (in no particular order here):

  • What's the size of the company? How big (meaning how big a valuation) can it get?
    • a VC would most likely invest in a company that can meet their requirements for returns (remember: rule of thumb is 10-20% of their fund size and within a timeframe that they receive these returns in time to pay back fund's investors!)
  • At what stage of funding is the company (none, angel, VC round A/B/C)?
    • VCs usually expect to take 20% of profits
    • VCs usually have an expense/load amount - that is, their 'paycheck' - of about 2%. This is what you must pay them regularly just like you would pay an employee.
    • Different VCs have different risk profiles - some invest in only early startups which have much higher risk (thus potential for higher reward); some invest only in late-stage startups which are less risky. Generally, a VC's risk profile is related directly to the size of the fund(s) it manages.
    • Order of liquidation if company fails: debtors, VCs, other investors
  • What expertise does the company have?
    • Having advisers - non-paid individuals that are helping you out since they know you and have connections - that are respected as experts in a field is a huge help. They cannot write the check but they can make it much easier to get your foot in the door of those that can.
    • Early-stage VC investors are usually experts themselves in specific fields; they know if an idea is viable. Late-stage investors are usually generalists with access to experts as needed. They are more focused on financial outcomes.
  • What's the company's overall business strategy?
  • Where is the investing firm in the life of its fund?
    • Later investments are 'harder' for VCs since they are under more pressure to succeed (they're closer to having to pay back the money they borrowed to invest.)
    • Example: a VC that's 6 years into an 8-year fund is less likely to take a risk than one that is just starting a fund.

The panel then discussed how to 'pitch' your idea, company, or service to investors. Everyone who reads this has most likely heard stories about this. And what everyone has heard probably involves some drama and horror. So it was very interesting to hear feedback directly from actual investors to cut through the myth and misinformation that surrounds this feared, mystical, and often hallowed process.

So, what do investors look for in a good pitch? First, they are always on the lookout for a 'Big Idea' that addresses a big or untapped market opportunity. Less competition == more possibility for success. Also, a successful pitch will show that the company will have more than one revenue stream.  Always be sure that your company shows potential for more than one revenue stream, at least three unless your idea is 'revolutionary'. And trust me, it most likely is not (sorry!) For example, one investor said he would 'never' invest in anything related to the blogosphere - it's a monolithic revenue stream that does not scale. If a blogger stops blogging, revenue stops too. One can only blog so many hours a week until they drop dead. And they do. Even Arrington is going to have to slow down at some point. Another thing is that investors realize is that the business plan that a company uses when they pitch invariably changes as the company moves through the funding process. Can the company cope? If so, how? Do they have a strong enough vision and understanding of their markets to make relevant changes without blowing the scope of the product or its time to market? Can the company deal with very frank discussions about changes in their product or service without causing collapse or a deleterious change in direction?

The discussion then turned to the 'Elements of the Pitch.' It involves five areas of risk and return: people, the problem, market size, competition, and the company's 'go to market strategy.' I will address each of these in turn.

First, and most important by far - all investors present wholeheartedly agreed on this point unanimously - are the people involved in the company. Credibility is king and nothing trumps it. If you've never sought funding or had entrepreneurial success before the funding process is most definitely going to be much more difficult for you. Having a set of trusted, successful advisers on board is key. One investor said something along the lines of: "You want to find that one guy that you'd invest in no matter what he did. You just KNOW he'd find a way to make money regardless of what it was. If this guy starts a hot dog cart I'd be the first one to give him money..." If you aren't that guy (or girl) find someone who is and ask them to be an adviser.

Secondly, the investors want to understand the problem, and be sure that you do, too. "What pain are you trying  to solve, or 'what's the pain you fix'?" This is where the company's product or service enters into the mix. If you are looking for early funding, expect that the investors will be experts in your product's industry. If they are not, you are doing it wrong. Why? Because someone from the investment firm WILL sit on your company's board. The relationship must be both beneficial and reciprocal. Expert investors that sit on your board can be HUGE resources that could help your company land critical customers, crush the competition, or avert catastrophe. Or they can be enormous drains that can hamper your ability to execute, or worse, drive the company in the wrong direction. Remember that once you take funding you are ceding some control to the investor and their goals must be the same or at least in line with your company's. You better be able to work with this person! Also, one big question that comes up frequently is, "does the product work?" If it's theoretical do you have expert proof of its viability?

Next, what is the market size you are entering? Is it an emerging or mature market? Is it's growth explosive (social media) or flat (RAM)? Can you prove it? How well do you know the market you are in?

Analysis and understanding of your competition follows as the next important element in your pitch. The worst thing you can do is state, "...the only competition we have is ourselves. Our product is so revolutionary there just are not any other competitors." All the investors knowingly laughed out loud at this. It supposedly happens all the time. "Trust us," they basically said, "EVERYONE ALWAYS has competition. And you better know who they are, what they do, how they do it, and where they do it." You must also prove that you understand your past, present, and future competitors. If you are in a highly-regulated market (like pharmaceuticals or mission-critical systems) then regulatory agencies become your competitors and you must intimately understand them and their requirements.

Finally, the pitch has to address the strategy your company has for getting to market. What's your company's sales model and distribution plans? How will you reach your market? The more efficient your sales model is the more likely you are to get funding. A sales model that eats up 40% of your budget or is very labor-intensive will be eyed with extreme suspicion. Efficiency and speed are key here, as is the ability to prove ROI.  Better to have multiple models that drive those three (or more) revenue streams I mentioned above. As part of this strategy, you should at least think of your exit plans if the need arises. Profitability is something you ought to be mindful of but there are reasons to remain unprofitable for as long as possible.

Other things like time lines (different stages of development, deployment, growth, etc. shown over time) and current status reports are also helpful. The worst thing you can do is to shop 'every investor in town' with the same pitch. Most likely the first one will have a ton of excellent feedback. Use it. Retool as needed. It's exponentially more difficult to get funding from an investor or VC once they've shown you the door. Some have one-shot-only policies as a rule. Even if they do not the burden of proof weighs very heavily on your shoulders if you approach them again. Best to use your least-likely choice as a sounding board and incorporate their feedback before pitching to the one(s) you really care about.

An insightful listener asked about the effects the current market woes are having on investors and their willingness to take new risks. One investor said the new conditions were "GREAT!" He said almost everything (goods, labor, real estate) is cheaper in a slow market and therefore it's a great time to grow a business. Another voiced some concern in the three- to five-year window because of longer funding-to-exit times the industry now faces due to the new rules of financial markets. The mean time before first funding to exit in 2001 was 2.1 years. Now, it's eight. IPOs are more difficult because of consolidation and restructuring of the financial markets. It's better to have the mindset of "what's the likely path of being acquired" rather than "how do we go public." IPOs are much more difficult to pull off these days.

Hopefully this shed some light on the process of getting your company its first round of financing, even if it is just a reinforcement of what you already know. Kudos to MassTLC for getting all of these people in one place at one time - it's rare that you get access to investors or Angels in a situation where you are able to ask questions without being there for a pitch.

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