A VC’s Expectations, a Startup’s Needs

An industry insider explains what he looks for — and what entrepreneurs should demand before inking any funding deals

With banks tightening their lending and IPOs (initial public offerings) few and far between, established businesses are turning to private-equity lenders for expansion capital. What do those lenders look for to distinguish a great company from a good company? What are the qualities of a stellar management team? What do venture-capital firms look for these days?

Smart Answers columnist Karen E. Klein took those questions to Bruce R.Evans, managing partner of Summit Partners, a private-equity lender with offices in Boston, Palo Alto, and London. What follows are Evans insights about the VC industry’s priorities, and also his tips about what an entrepreneur should be looking for when courting an investment partner.

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According to Evans, the five "building blocks" of a great investment:

Management: The most important piece that we consider when looking at an investment is the management team. In a great company, we find that at least some of the team is already in place, perhaps the CEO and one or two other key team members. We like to work with the company to add to and round out the team, rather than going in and replacing the CEO. The exception we sometimes run into is a technology company whose founder wants to become the chief technology officer and needs help recruiting a CEO.

Product/Service: We like situations where the company’s customers rate their offerings as superior in their sector. In the tech sector, we’re looking for software, communications technology or services, semiconductors and electronics, and information services. Outside the tech sector, we consider everything from health care to life sciences, financial and business services, industrial and consumer products.

Market: We try to understand a company’s market share and how it fits with their plans for the future. It’s nice to find a company with a sizeable portion of market share, but it can be a growing company serving a fragmented or underserved market that gives it plenty of room to expand. We’re always looking down the line three to five years, trying to understand what will be happening then.

Historical and Projected Financial Performance: Since we deal with established companies, we look at their recent and projected future performance. The companies we fund tend to have annual revenues between $5 and $200 million. The key metric, for us, is that the company be profitable or growing at a rate that will make it profitable in the near future. Companies that have good cash-flow characteristics show us that they have bootstrapped their way through to profitability.

The Deal: We always evaluate how large the investment opportunity is for us. We have the Summit Accelerator fund that is looking for $2 million-to-$10 million investments and the private-equity Summit Venture 6 fund that makes investments in the $10 million-to-$250 million range. We look at what the company needs, what the shareholders want in terms of liquidity, whether they need the money to pursue a growth strategy or working capital to build a plant, buy equipment or expand geographically, or if they want to launch a new product line or pursue an acquisition opportunity.

Sometimes, a firm does not have capital needs, but the founder is overexposed with equity in the company and needs to diversify his investment portfolio by selling some portion of the company. Other times, a founder is looking to sell the company outright. That’s when we will buy 60% to 80% of the firm and let him continue to run the show and have a minority ownership interest that he can phase out over time if he chooses. Our involvement can also be a way for an early investor or ex-employee to get liquidity before the company goes public or is sold.

What an entrepreneur should look for in a VC:

Stability: With the down economic cycle, many VC firms are going through some generational leadership changes. Senior members may choose this time to retire or exit. You don’t want to partner with an investment firm that will not be in business in the next three years or five years or seven years. Make sure that your VC firm has plans for an orderly transition for its senior members and a "next generation" poised to step in and take over. There are firms where the founder stays around for many years without a succession plan, and when he leaves, the firm blows up. Don’t be afraid to ask about long-term plans.

Success Record: Look for investors that have some experience in and around your industry, but don’t expect them to know your products or markets as well as you do. When you are an experienced, competent CEO, you know how to run your company. Rely on your investment partners to help in ways other than day-to-day operations.

Outreach: If you’re hoping to approach a venture-capital firm with your opportunity, it’s best if you find a personal contact. An introduction from someone we know, someone we’ve worked with in the past, gets you in the door with additional credibility immediately. But that’s not required. We have firms that contact us cold, from our Web site. The key for entrepreneurs is to do some research so they understand what the investment firm’s strategy is and how their company might relate to that strategy. It’ll save you a lot of time if you’re not a good match for a particular investing company.

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