FINDING THE RIGHT VC

At the end of the 20th Century, entrepreneurism had reached epidemic proportions, and venture capital firms, established and new, competed for the best investment opportunities. In the first few years of the 21st Century, the epidemic has abated and VC firms have become much more selective in their investments. In the current economic environment, it is tempting to assume that any money is good money. That can be a risky assumption.

By Kenn W. Webb, Davis Munck, P.C.- American Venture Magazine

Public perceptions about the investment climate tend to be overstated. It is a misconception, for example, that “anyone with a good idea” could be funded at the peak of VC investments in late 1999 and 2000, according to Guy Hoffman, Venture Partner with TL Ventures in Dallas. Conversely, it is also a misconception that no one is being funded today. “Venture capital financings are occurring each and every day. The VCs have merely tightened up the definition of what constitutes a good deal. If you take out the 2000 ‘bubble’, VC investments are still on a positive curve,” says Hoffman.

Positive signs can also be seen in a report released August 5, 2002 by Thomson Venture Economics and the National Venture Capital Association, which indicates that $1.8 billion was raised in the second quarter of this year for VC funds, a slight increase from the $1.7 billion raised in the first quarter. Moreover, a majority of the funds raised in the second quarter focused on early and seed stage investments, rather than later stage investments. Despite the fact that VC funds returned more money to their limited partners than they raised in new funds in the second quarter, the VCs are retaining ample resources to support their near-term investment strategies. The Thomson-NVCA report calls this the “rightsizing” of funds, which should generate goodwill among LPs and may aid future follow-on fundraising efforts.

Thus, while entrepreneurs may no longer be able to play one eager VC against another to negotiate favorable terms, many VC firms have substantial “dry powder” (money from a fund still waiting to be invested) and are willing to invest it in the right circumstances. Even in today’s economy, companies with good business plans and talented, experienced management teams have a realistic opportunity to obtain VC funding.

An early stage company can benefit in a number of ways from being funded by a venture capitalist. In addition to providing capital, a VC firm can be a valuable advisor to its portfolio companies. Indeed, venture capitalists typically are not passive investors, and VCs that lead deals expect, to varying degrees, to be actively engaged with their portfolio companies. Thus, in order to reap the greatest benefit from its fundraising, an early stage company should analyze the strengths and weaknesses of its potential VC investors.

No VC firm claims to be all things to all people. In other words, no VC has the professional talent, capacity, experience and available funds to be the best option for all early stage companies seeking funding. Entrepreneurs expect VC firms to do extensive due diligence prior to making an investment. The converse should also be true: Entrepreneurs should fully understand what a prospective VC investor brings to the table before accepting the investment.

Obviously, compromises must sometimes be made if the search does not uncover a willing VC firm that is a perfect fit for the entrepreneur. Nevertheless, regardless of the amount of capital sought or the timing of the transaction, any early stage company seeking funding from a venture capitalist should gather as much information as possible about the VC before accepting a term sheet. A consideration of the following factors may be useful in that process.

Factors to Consider

Availability of Funds. Does the VC currently have funds available to make the investment (and potential follow-on investments)? As the economy has worsened over the last few years, VCs have earmarked a greater percentage of their available funds to support their existing portfolio companies. That leaves less money available for new investments. An entrepreneur should therefore ask a prospective investor not only about the total dollars available for investment, but also about the percentage of the available funds expected to be needed to support the VC’s existing portfolio.

Entrepreneurs should also be comfortable that a VC is willing and able to close an investment without unnecessary delays. However, the entrepreneur should be aware that the average time between the initial contact and funding is currently approximately six months. A few years ago, when the supply of funds available for investment exceeded demand and competition among VCs for the best deals was intense, the process often took two months or less. Today, start-up companies that expect to burn through their available cash within 60 days may be better served by seeking financing elsewhere.

Relevant Experience. Most early stage companies look to their lead investors for advice, through the investor’s representative on the Board or on a less formal basis. The quality of the advice is affected dramatically by the extent of the VC’s relevant knowledge and experience. TL Venture’s Guy Hoffman says that his firm will make an investment only if they feel that what they can offer will “contribute to the company having an unfair advantage over its competitors.” According to Hoffman, “The most important factor is track record—has the VC invested in successful companies at a similar stage of development?”

Another factor that should be considered is whether professionals within the firm have experience with, and therefore understand, the company’s business, industry and market. In Hoffman’s view, this domain expertise, while significant, is somewhat less important than the VC’s track record with similar-stage companies. A firm’s industry focus can easily be determined by reviewing a list of its prior investments, which usually can be found on the firm’s web site. Ideally, of course, an entrepreneur will have determined whether his or her company fits a VC’s investment profile before making the initial contact with the firm.

A VC’s general business and transactional experience may be useful to the entrepreneur in a variety of circumstances. For example, a venture capitalist with extensive marketing experience may be extremely valuable to a start-up company in performing crucial market analyses and developing a solid marketing strategy. Similarly, an entrepreneur who does not have a strong financial background may benefit greatly from the venture capitalist’s experience with complex financial modeling and analysis. A VC may also be able to assist in negotiations with third parties such as strategic partners or vendors.

A technology start-up may also want to determine whether a VC has professionals on staff that have technical backgrounds that will allow them to have more than just a layperson’s understanding of the company’s products or services. This factor, however, is probably secondary to the factors described above. A VC firm with a relevant track record and domain expertise can engage its own advisors as needed to develop the necessary technical knowledge and understanding.

Relationships. Does the VC have other relationships that may benefit the company? Does the VC’s portfolio include, for example, investments in companies that may become customers, vendors or business partners of the company? If necessary, can the VC introduce the company to qualified attorneys, accountants or other advisors? The entrepreneur should determine what the experience of the firm’s existing portfolio companies has been in this respect. A venture capitalist with an impressive Rolodex will benefit the company only if he or she is willing to use it on behalf of the firm’s portfolio companies.

Capacity. Does the VC have the bandwidth and the motivation to serve as an effective strategic partner? What is the firm’s ratio of professionals to portfolio companies? More specifically, what are the key individual are other commitments, and might they interfere with his or her ability to help the company? The entrepreneur should be comfortable that the individual professionals at the VC firm, particularly the individual who will serve on the company’s Board of Directors, will be able and willing to devote the time and energy necessary to be a valuable asset to the company. The entrepreneur should discuss these issues with the venture capitalist. He or she should also contact the VC’s other portfolio companies to discuss the extent of their post-investment contact with the VC and their general impressions about the firm’s willingness to be an active partner rather than a passive investor.

The entrepreneur may also want to discuss with other portfolio companies the extent to which professionals within the VC firm, other than the company’s primary contact, have become involved. Professionals within a VC firm may have complementary skill sets and relationships. The extent to which venture capitalists are willing to devote the time and effort necessary to assist the firm’s portfolio companies, other than the ones on whose Boards they serve, varies among VC firms.

Assistance with Recruiting. Closely related to the relationships and capacity issues is the extent to which the venture capitalist can be expected to participate in recruiting talent for the portfolio company. While a venture capitalist can be an extremely valuable Board member and strategic ally, the company’s success will ultimately depend on the quality of its own management team. For many companies, one of the primary benefits that a VC firm can provide is helping locate and recruit talented management and technical personnel. The willingness to perform this function varies among VC firms, as the recruiting process can take significant time and effort.

Ability to Attract Other Investors. Some VC firms are frequently the lead investors in financing transactions, while others prefer to be co-investors. Among those who lead transactions, some firms have better track records than others with respect to attracting co-investors and investors in follow-on rounds of financing (i.e., their investments are seen as “smart money” by the VC community). Conversely, the participation of a “nonstrategic” investor in an early financing round may discourage some VC firms from participating in later rounds.

Staying Power. Although it is tempting to focus only on the amount and terms of the current financing transaction, it is important for an entrepreneur to understand the VC firm’s track record of making subsequent investments in its portfolio companies. The unwillingness of a first round investor to make a follow-on investment may be a kiss of death for the entrepreneur’s ability to raise funds from other VC firms in later rounds. In part, this is a question of availability of funds. Does the VC have adequate funds to provide follow-on support to all its portfolio companies, and to preserve its historical ratio of total investment to first round investment?

Hoffman offers one caveat when evaluating staying power: “For any specific company, a VC may have a good reason—such as a significant disagreement with management on philosophy—for not making a follow-on investment. An entrepreneur should look at the VC’s entire portfolio to discern the firm’s record of making follow-on investments.”

In the current environment, it may also be useful to determine whether a VC firm has made follow-on investments at a price above the first-round price, given the stigma attached to a follow-on investment made at a lower price, a so-called “down round”. Again, however, there may be legitimate reasons for a down round in individual cases.

The willingness to make follow-on investments is not the only measure of staying power. An entrepreneur should discuss with a VC’s existing portfolio companies whether the VC has remained an active advisor after the closing, and whether the firm has remained actively engaged with the company in bad times as well as good.

The Process

Entrepreneurs may find that gathering the information described in this article is not as difficult as they might expect. Surprisingly, however, many entrepreneurs do not take advantage of the opportunities for learning about their prospective investors. “In my experience,” says Hoffman, “nine out of ten entrepreneurs don’t research VCs at all. That’s amazing to me, given how readily available the information is.” In fact, Hoffman sometimes questions whether a start-up company that has not done its research on Hoffman’s firm can be relied upon to do adequate due diligence on its prospective customers, employees or other business partners.

The best starting point for finding information about a VC firm is the firm’s own web site. Most VC web sites contain a wealth of information on the firm’s existing portfolio, past portfolio, investment philosophy, investment criteria and the qualifications and experience of the firm’s professionals. They also typically contain links to web sites of the VC’s portfolio companies. Using these sources in combination, an entrepreneur will generally be able to determine the VC’s record of making follow-on investments, other firms that have co-invested with the VC, the typical size of the firm’s initial and follow-on investments and other valuable objective and measurable information.

Some of the more qualitative factors described in this article are not as easily evaluated solely on the basis of the data included on these web sites. The entrepreneur should contact several of the VC’s portfolio companies to discuss these issues. Obviously, some portfolio companies will be more willing than others to engage in detailed conversations. Regardless of the extent of the conversation, these conversations will, at the very least, reveal whether the company has had a positive experience with the VC.

When performing due diligence on a VC firm, the entrepreneur should focus on the individual professional within the firm who will be the company’s primary contact. Although, ideally, the entrepreneur will be able to draw on the talents of a number of people within the firm, the company’s relationship with its primary contact will be the principal determinant of the value of the relationship. For this reason, another portfolio company’s experience with one professional within a VC firm may not be particularly relevant to an entrepreneur whose relationship will be with a different professional within the same firm.

Finally, one of the best ways to obtain information about a VC firm is simply to ask. “Most VCs I know are straight shooters,” says Hoffman. “You would be surprised at how frank they can be about their views on a company’s business plan and prospects, and about their own firms, particularly after they have developed a rapport with the entrepreneur.”

In fact, the ability to develop a rapport with the VC fairly early in the process is itself an important consideration in finding the right VC. Open and honest communication between the entrepreneur and the venture capitalist is the key to a successful, long-term relationship.

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