What To Expect From A Venture Capitalist

I’ve got a venture capitalist who wants to invest $5 million in my company. What should I expect in terms of how he will want to interact with the company?

************

by: Guy Kawasaki in Forbes.com

http://www.forbes.com/smallbusiness/2004/01/27/0127artofstartmidas04.html

Guy Kawasaki, the latest addition to our columnist lineup, is an entrepreneur, an author and the chief executive of Garage Technology Ventures, a venture capital investment bank for tech firms. Guy will provide expert answers to all your questions about starting a business.

************

As long as things are going well, a venture capitalist will leave you alone. Understand a venture capitalist’s life: He’s on as many as ten boards that meet at least quarterly and sometimes once a month; he has to raise money to invest and keep about 25 investors informed and happy; he’s looking at several deals a day; he’s dealing with five other partners. He doesn’t have the time to micromanage you–and if he thought he’d have to, he probably wouldn’t have invested in you.

The more important question is, "What can I expect out of a good venture capitalist?" The answer to this is: five hours per month of mindshare during which he opens doors for you with prospective customers and partners and interviews candidates for high-level positions at your company.

How can I identify the venture capital firms that have new funds with a maturity sufficiently far out so they align with my liquidity time frame?

You’re thinking too much. The timing of a fund is hardly ever a factor. Besides, the firm is going to pick you and not vice versa, and there is no way to predict a liquidity time frame.

Do entrepreneurs have to accept the valuation proposed by the venture capitalist who wants to invest into our business?

Whatever the first offer, ask for a 25% higher valuation because you’re expected to push back. In fact, if you don’t push back, you may scare the venture capitalist if he thinks you’re not a good negotiator. It would be nice to have some arguments to show why you believe your valuation should be higher–saying that this book told you to push back isn’t sufficient.

At the end of the day, though, if the valuation is reasonable, take the money and get going. You’ll see that you either make more money than you ever thought possible or your organization will die. In either case, valuation and owning a few more percentage points seldom makes a difference.

For a rough approximation of your valuation, circa 2004, you can also use Kawasaki’s Law of Pre-Money Valuation: for every full-time engineer, add $500,000; for every full-time M.B.A., subtract $250,000.

If this is too unscientific for you, then use services like VentureOne or VentureWire for information about current financings.

How can one protect an idea since few investors will sign an NDA (Non-Disclosure Agreement)?

You’re right: Few investors will sign one, and even if they did, simply hearing your idea better not make it copyable. I’ve never seen a case where an entrepreneur told an investor about an idea, and the investor ripped it off.

Investors are looking for people who can implement ideas, not simply come up with them. Ideas are easy. Implementation is hard–and where the money is. Quite frankly, few investors are capable of implementing an idea–that’s why they’re now investors–but I digress.

Here are the fine points of using an NDA:

* Never ask an investor to sign one to have a first meeting or in the first meeting. No one who would sign one this early is an investor you’d want.

* If you’re asking for an NDA to merely discuss your idea, keep your day job because you’re clueless. I’ve been asked to sign an NDA to hear about selling books online!

* Freely circulate your executive summary and PowerPoint pitch. These documents should entice investors to go to the next step. They should not reveal your magic sauce.

* Ask for an NDA if an investor is interested in your deal and wants to learn more at the bits and bytes or molecular level. It is reasonable for an interested investor to ask for this in the due diligence stage. This is most relevant for life sciences and material sciences companies.

* You should feel pretty safe once patents are filed to discuss your magic sauce under an NDA–not that you’ll have the time or resources to sue for patent infringement.

The bottom line is still that the best protection of an idea is great implementation of the idea.

What is the order of approaching the tiers of venture capitalists: tier one, then two and three or the other way around?

You’re thinking way too much too. Pitch almost any firm you can get into. After trying to raise money for nine months, you’ll realize that all money is green. Plus, it’s also not at all obvious who is a tier one, two or three firm.

When do I stop trying to find/negotiate a better deal and take what’s offered?

It’s a good idea to stop looking and negotiating if you can’t meet payroll. If the deal that you’re offered is within 20% of what you wanted, take it. Focus on building your business, not finding the best deal. In the long run, the quality of your business determines how much money you’ll make, not the deal you cut years before with an investor.

Should I worry more about dilution, the real needs of my business or the amount the investor wants to put in?

Here’s the priority: the real needs of your business, the amount the investor wants to put in, and last and least important, dilution.

What is the internal rate of return expected from tier one, two or three venture capitalists? How firm do they stand by that projection?

First of all, it is unlikely that a venture investor will admit that his firm is not a tier one firm. Even if he did, he isn’t saying to his partners and investors, "Since we’re not a tier one firm, let’s just try to get 10%."

All venture investors are looking for a very high return on your specific investment, not a return that matches their target average. (Remember, they know there is a high likelihood that your company will flame out.) But your question misses on another point. Although venture firms are ranked against each other by their internal rate of return performance, venture investors do not evaluate individual deals by calculating prospective IRRs. Not even VCs are so arrogant to believe they are that visionary.

Practically speaking, investors look at cash-on-cash returns–that is, if I put in $1 million today, what can I reasonably expect to get back in four or five years? ($5 million would be a five times return.) Expectations for cash-on-cash returns vary by the type of investor and the sector of investment, not by the prestige of the firm. For an early-stage, high-tech investment, you had better be able to convince the investor that there is a realistic plan for returning five times to ten times his money in three to five years.

About Guy Kawasaki

Guy Kawasaki is the CEO of Garage Technology Ventures , a venture capital investment bank for high technology companies. Previously, he was an Apple Fellow at Apple Computer. Guy is also the author of seven books. He has a BA from Stanford University and and MBA from UCLA as well as an honorary doctorate from Babson College. He is currently on the board of BitPass, a micropayments systems company for online content.