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What VCs Don’t Tell You and How to Snag the Strategic Investor

To secure funding, an entrepreneur needs to appreciate the goals and strategies at work on the other side the table.

By Gabor Garai BusinessWeekOnline

Here’s a guide

Venture capitalists tend not to be very forthcoming when entrepreneurs ask why deals are rejected, beyond the maddeningly vague, "It’s not for us." The reality is that there are a number of forces at work behind the scenes dictating investment decisions that are key to determining when, where, and how investments are made.

In my last column (see BW Online, 8/18/03, "How to Snag the Strategic Investor"), I examined the key factors that guide corporate venture investing, and how they are influenced by the long-term needs of the corporations providing the cash. Venture-capital firms are focused a bit differently, based on a division of labor and investment between the professionals running the fund and the institutions (pension funds, university endowment funds, investment banking pools, etc.) which provide the bulk of the investment funds. It’s important for entrepreneurs shopping for cash to appreciate the motivations of these "end users," as it were.

DOING THE MATH. First, entrepreneurs need to understand the investment structure of venture funds. The funds are managed by professionals, who are usually former entrepreneurs or investment professionals. In smaller funds, they typically invest from their own money between 5% and 10% of the fund’s total assets. This means that, for a $100 million fund, these individuals are putting up $5 million to $10 million — a significant amount. The remainder of the assets come from institutions.

The fund’s managers are compensated in two ways — from an annual management fee typically amounting to between 1.5% and 2.5% of the assets, and something called "carried interest," which is an amount based on the fund’s value appreciation. The management fee is used mostly to cover ongoing expenses like rent and staff salaries. Also important to remember is that the fee is usually paid for five years, after which it declines to perhaps 1% to 1.5%. Thus, the fund’s managers have an incentive to make things happen within a five-year window.

It’s in the carried interest that the managers can make the "big hit," since any increases in fund value are typically divided 20% to the managers and 80% to the investors. Returning to the hypothetical $100 million fund, let’s say it is worth $200 million after five years. In that situation, the managers would receive $20 million of the $100 million of appreciation and the investors $80 million. If the fund’s value soared to $500 million, the managers would rake in 20% of a $400 million gain, or about $80 million — not a bad bonus for five years of work.

CREDIBILITY CRUNCH. On the other hand, if the fund stays even after five years, it would actually be worth $12.5 million less than when it started, since it will have paid $2.5 million annually in management fees, or $12.5 million over five years (assuming a 2.5% management fee). In that situation, the managers would receive no "carried interest" and, like the institutional investors, would lose a portion (12.5% to be exact) of their initial investment. Moreover, the managers would have little credibility in subsequent efforts to put together venture funds — and might even have to give back some of their management fees.

Clearly, the incentives for managers to succeed are very attractive, and the penalties for failing to deliver an adequate return are severe.

It’s important also to understand the viewpoint of the institutions putting up the bulk of the funds. They invest in venture funds largely to help achieve a diversification strategy. Institutions typically invest in stocks, bonds and real estate, which may well provide small but steady returns, so they view venture funds as an opportunity to get some some oomph into their overall returns. Or, if their other investments are down, it’s hoped the venture fund will be countercyclical and provide an overall positive return.

HERD MENTALITY. In order to achieve sizable returns for the institutions, the venture fund has to do extremely well. Because the managers are receiving both the 2.5% annual management fee plus 20% of any gains, the math works out that a fund must achieve a 45% to 50% compounded rate of return in order for the institutional investors to realize a 30% compounded rate of return on their investment. It’s also important to understand that institutions often come to investment funds with extra baggage in the form of political considerations. University endowments, for example, may prohibit investments in companies that have any connection with child labor or gambling.

In addition, institutions will want to know, especially if things don’t go well, that the fund’s managers "did the same things as everyone else" — in other words, that he or she invested in industries popular with other investment funds. If one fund takes it on itself to venture into a new industry that others are avoiding, such as a promising but unproven technology, and the investments do poorly, it could be criticized and possibly even sued. This helps explain the so-called "herd mentality" for which venture capitalists often have been criticized.

What does all this mean for entrepreneurs? Here are several potential lessons:

&#149 Approach venture funds that have been recently formed, rather than those that are two or three years old. Because venture funds tend to have five-year time horizons, they seek to make as many of their investments as possible in the first few years; institutional investors expect that the proceeds of most of the portfolio will be distributed five years to seven years after launch of a fund. Companies seeking funding that come along in the second and third years will be expected to show extremely sharp growth potential.

&#149 Investigate as carefully as possible the goals a venture fund spells out for institutional investors. Ideally, you would like to see the documents it uses to make its pitches to prospective investors. If you can’t obtain them, study the fund’s Web site very carefully for clues as to investment goals, political issues, and other such factors.

&#149 Seek out fund managers who will be receptive to what you are trying to achieve. For example, if your company has complex technology, seek out funds managed by technical types.

&#149 Figure out how your company fits into a trend or industry that venture capital firms have deemed to be "hot." They follow the crowd, no doubt about that.

&#149 Check the fund’s risk tolerance. Is it a seed round, B-Round, or later round investor?

As in all kinds of marketing, it is key for the entrepreneur to understand the VC firms’ goals, preferences and interests and sell accordingly.

Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.

http://www.businessweek.com/smallbiz/content/sep2003/sb20030916_6904_sb020.htm

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How to Snag the Strategic Investor

Venture-capital firms and corporate investors each pump cash into startups, but their goals are likely to be very different
What is it that professional investors want from young companies? The highest possible return on investment, we are told. But that oversimplifies the matter, because the fact is that professional investors are driven by their own individual agendas — ones that may not be readily apparent to entrepreneurs.

Gabor Garai BusinessWeekOnline

It is often said that the most important challenge faced by any business owner is understanding his or her customers, which is true enough — so far as it goes. But entrepreneurs must also understand the complex factors, influences, and priorities that motivate their distributors, wholesalers, retailers, and other links in the marketing chain moving products through to customers. Entrepreneurs also must adjust the incentives they provide to make sure all parties’ needs are in harmony.

THE CORPORATE VIEW. The agendas driving professional investors also vary widely. Begin with strategic investors, which are typically large corporations, and have much different agendas than those of venture-capital investors. Thus, entrepreneurs must adjust the investment pitches they make to each if they are going to stand a chance of winning funding. In this article, I will examine the corporate investor’s perspective, and in my next column, the venture capitalists’ outlook.

Corporations that invest in young companies typically do so through a venture arm established for that purpose. These units are staffed by professionals trained in the ways of the venture-capital world, but their view of that mission differs from those of counterparts in venture-capital firms — and it is a much different perspective than entrepreneurs often imagine. Simply put, they must report to a corporate hierarchy whose goals are reflected in its investment strategy.

Entrepreneurs seeking investment funds from corporate investors tend to view them as huge bureaucracies that want to invest in nimble young companies providing the latest in technology or marketing. The entrepreneurs’ biggest worry is that the corporate investor will somehow steal the new technology. Meanwhile, the opportunity many entrepreneurs see is the possibility that corporate investors will eventually buy out their startups. This view of corporate investors colors the entrepreneurs’ approach to obtaining investment backing. They tend to focus on legal issues — protecting their intellectual property, establishing guidelines around the corporate right of first refusal on possible acquisition, setting up terms for technology licensing, and so forth.

DIFFERENT PERSPECTIVE. The corporate venture investor’s view may be much different, however. Corporate investors may be less interested in gaining access to a particular technology than they are in tapping the entrepreneur’s envision. Also worth noting is the change that has taken place since the late 1990s, when there was a high probability that corporations would acquire the companies in which they invested. These days, that is less likely to be the case.

So what is it that the corporations want? Typically, it is something more subtle than what entrepreneurs suppose — to take possession, one way or another, of their ideas and technologies. The corporations want most of all a window on the future of a particular industry, and they figure that a young company with leading-edge products or services is going to provide the best view of those emerging horizons. In addition, the corporations assume that the young company’s management is likely to include the leading thinkers and doers — people, in other words, who are in contact with other brightest lights of their industry.

Corporate investors want to join the clique, as it were, to which leading-edge entrepreneurs belong. When they invest in a company, corporations typically negotiate a seat on the board of directors or advisory board, but the people they send to those meetings will more often than not turn out to be a marketing guru or technology visionary, rather than a nuts-and-bolts technology expert. Again, the reason is that the corporation is seeking access not to specific technology, but to ideas. The corporation isn’t necessarily after something proprietary, but rather wants access to people who can point it toward emerging opportunities.

THE RIGHT PRESCRIPTION. As one example of how this process works, a pharmaceutical company in recent years has invested in several medical-services outfits. The pharmaceutical isn’t interested in any technologies these growing businesses are developing, but is rather trying to understand how the system of providing medical services around the world — a system in great stress in many countries — is going to evolve in coming years. Once it understands the new thinking and emerging paradigms, the pharmaceutical outfit figures, it will be able to target its efforts at creating better-selling drug products.

So, how should entrepreneurs adjust their pitches and expectations to the real corporate investment agenda? One answer: They need to be looking at the kinds of things that are important to their companies besides money. One good way to do that is to take the lead from the corporate investor. Get to know key people in the corporation. Try to obtain introductions to industry players who may be outside normal operating channels. In other words, try to get a window on the industry’s future, but do so from a different angle. Obtaining corporate investment isn’t necessarily a one-way admission ticket to a new world.

Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.

http://www.businessweek.com/smallbiz/content/aug2003/sb20030818_0688_sb020.htm

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