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Realistic Expectations for Start Up Venture Capital

In 1998, an entrepreneur with a back-of-the-envelope idea for a better switch for the telecommunications industry walked into our venture capital firm, InterWest Partners, and promptly won full backing from day one.

by Gil Kliman, M.D.
InterWest Partners http://www.interwest.com/ in EntreWorld.org

Now, before all of you founders get too excited, keep in mind that the entrepreneur, Jagdeep Singh, had built other companies and was well known in venture capital circles. What’s more, his product enabled information to move faster on the then rapidly growing Internet. He was on the front end of what is usually an 18-month window of opportunity for getting new products into the rapidly changing information technology market.

Singh also arrived in our office at the crest of the biggest venture capital boom in financing history, the one that began in the mid 1990s with the rise of the Internet and took hold in force in late 1999 and 2000. Not only did his company, Lightera, secure full venture funding, but within one year he was able to sell the company to a public acquirer for $463 million. However, that was during the peak of the dot-com and telecom boom, and it is a different world for entrepreneurs today.

Real Start Ups, Real VC Funding

Despite all of the qualifications to the Singh story – and the subsequent near shut down of venture capital funding to companies following the bursting of the Internet bubble – the fact remains that even in today’s post-bubble environment, early-state companies can and do get VC money.

I know. I’ve been a company founder myself, having launched Aris Vision Laser Centers, a pioneer in laser eye surgery, with two partners way back in the pre-bubble world in 1995. Before being merged, our company had won both angel and venture backing. These days, I’m on the other side of the desk, having joined InterWest Partners in Menlo Park, California, in 1996.

Today, the good news for entrepreneurs is that the bad news is behind us. There is a lot of venture money out there, which isn’t invested, because many VC firms sat on the sidelines for the last three years. Venture capitalists are always looking for good companies with good ideas. True, they usually invest a bigger chunk of their funds in later-stage companies. But now, perhaps more than ever, they are receptive to start ups.

What we at InterWest define as a start up is a company that hasn’t previously received venture funding – although it typically has secured money from other sources, such as individual investors called "angels" or the government. Others may consider these to be "early stage" businesses rather than start ups. About half of the 10 to 20 companies in which we invest each year fit this description, perhaps a higher percentage than at many other VC firms.

Walking the Walk

Our statistics indicate that early-stage companies aren’t necessarily at a disadvantage. In fact, in the industries in which we invest, information technology and life sciences, ideas from newcomers are often the ones that fuel growth. In IT, for example, the sky is the limit when it comes to innovation. The industry isn’t regulated and thus is wide open, save for the fact that the entrepreneur must get to market (as did Mr. Singh) in a timely manner, because the market changes rapidly.

In life sciences, the reverse is true. The market is highly regulated and fairly static, driven mainly by the aging population. Innovation comes in the form of new techniques for combating age-old diseases. At InterWest, for example, we recently invested in IntraLase, an eye laser company that has a new way to treat nearsightedness, a condition which has been around literally as long as civilization itself.

While innovative technology is a key ingredient, it is also critical for the start up founder to be credible to the venture capitalist. An unknown and unproven entrepreneur is at a disadvantage compared with those who are known in VC circles for having built previous companies that were sold or taken public. Therefore, the early-stage entrepreneur can—and must—correct for that deficiency by properly positioning themselves and having realistic expectations about the VC industry and what it takes to get funded.

Some Fundamentals

Early-stage entrepreneurs must understand that venture capitalists are looking for a distinct profile when it comes to all companies they fund. At InterWest, our minimum investment is $5 million, which means that we would only bet that money on a very large upside opportunity. We are generally seeking companies with the potential for annual revenue of at least $200 million (and upwards of $1 billion) that can be worth $500 million or more within five to seven years.

That, in turn, means we want companies whose products offer a distinct advantage in the market, either because they are completely novel or because they are dramatically better, faster or cheaper than the existing standard. We look for products that solve important near-term problems for customers, not a "nice to have" improvement. Put another way, we like to invest in pain pills, not vitamins.

Just as importantly, we expect the entrepreneur to have tested for whether customers will buy, either through market research or early sales to flagship customers. Just because a product is innovative, we’ve learned, doesn’t mean it will sell.

During the dot-com heyday, for example, the idea for pets.com appeared to be a winner. After all, if customers were buying books online from the wildly successful amazon.com, why not pet food? Well, it turned out that customers weren’t willing to buy pet food online – for whatever reason. All of which has assured pets.com a place in the annals of the dot bombs, providing a definitive answer to the oft-asked question, "Will the dogs eat the dog food?"

For Start Ups Only

Start ups and later-stage companies alike are subject to the above fundamentals. However, for the start up, there is more baggage with which to contend – and ultimately to overcome.

The lack of credibility is the big one. If you, unlike Mr. Singh, haven’t founded a previous company that caught the attention of the VCs, you must do the next best thing, which is to surround yourself with people who have. Choose advisors and investors who are known to venture capitalists – and you will catch a bit of the glow.

The way you’ve funded your company prior to seeking venture backing is also a factor. Raise enough money to allow some proof of principle of your idea, either from angels or the government, and spend it wisely. That tells us in the VC community that you are able to attract money—and, perhaps more importantly, people—to your side. Hopefully, you’ll also be able to demonstrate value creation with those resources.

Don’t, however, get caught up in the valuations assumed by angels, which are frequently optimistically out of line. Try to get a sanity check that the valuation at which you raise angel money will still hold up if you have to talk to venture capitalists in the future. When you approach VCs, be prepared to work with them to produce and accept a fair – and often lower – valuation than you might have expected.

Finally, just because you are the founder of a start up, don’t sell yourself short. You might be seeking VC funding, but you are also in need of expertise from investors who will be by your side for a long time. An unfortunate fall out from the days of the Internet boom is that a lot of inexperienced financiers were able to set up shop and call themselves VCs. Stick with those who have proven track records in your field.

Nothing’s Easy, Just Doable

Surely when it comes to securing venture capital, nothing has ever been easy, especially for the early-stage company. But these days, the landscape is better than it has been in years – if hardly the free-for-all of the late 1990s.

The early-stage company shouldn’t expect the overnight successes of those years. You need to be realistic. It may take as long as six months from first approaching a VC to get an answer. But the good news is that the bad news is behind us. VCs are eager to invest. They are on the prowl for ideas from all venues – including the start up. As I’ve said, it’s a good time to be starting up.

Editor’s Note: Venture capital has been important for the growth of some companies, but it is also true that this type of financing is appropriate for a very small percentage of firms (less than one percent). Further, statistics show that the portion of venture capital investment in start up and early-stage businesses has been declining since 1995 and accounted for less than five percent of total VC deals in 2002. As the author notes in his article, his firm invests in a higher percentage of early stage companies than most of venture capital firms. When you’re thinking about financing your company, make sure you think through all of the different funding options and work to achieve the type of financing that is right for your business.

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Author’s Profile

Gil Kliman, M.D., 44, is a Managing Director of InterWest Partners, a leading diversified venture capital firm headquartered in Menlo Park, California.

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