Darren Herman: When To Approach a VC

I am about as passionate as anyone regarding entrepreneurship. I work and play amongst circles of entrepreneurs and always offer guidance to any aspiring business-minds who are trying to hatch their killer idea. Most of the time, I am lending advice to early to mid-stage startups about strategy, product development, or finance. While my strong point is not finance, I certainly understand the process at which an entrepreneur must go through to execute on a funding strategy and ultimately, close the venture deal.

I’ve decided to take some time to write a check-list that an entrepreneur should follow in order to have the most efficient and effective funding strategy. This list is not the end all and be all of how to get venture capital dollars, but will certainly help in your approach to working with VC’s.

To round this posting out, I realized that what I’ve got to say is just one side of the equation. So, I’ve asked some extremely active VC friends what they look for in a company. Raj Kappor (Mayfield Fund), Nick MacShane (Progress Partners), Brad Feld (Mobius Venture Capital), Alan Kelley (SJF Ventures), and Keith Benjamin (Levensohn Venture Partners) all have added their two cents into this article with some original answers (thank you guys very much for taking the time to do so!).

Like I said above, this list is not the end-all and be-all. Some of the items on this list may look extremely obvious, but trust me, I’ve learned over the past ten years to never assume in business. Things you take for granted in your work will sometimes be left out in others.

Ladies and gentlemen, the list we’ve all been waiting for… Things to have completed and polished before you go to a venture capitalist for financing:

Executive summary & business plan are written
Financial model and projections are tested
30 second and 3 minute pitches are polished
You’ve had a referral to that particular VC
Very strong senior management team and/or founding members
Starting to gain traction with your customers (vendors, customers, etc)
You are starting to appear in the press (or are currently already written about)
You’ve raised a friends/family and seed round and going for at least $1mm
Your business is for-profit and has a large exit opportunity
The market you are moving into is large enough to support a $100mm+ company
Customer testimonials and references
Your founding team and management team have no skeletons in the closet
Your books and paperwork are clean and filed and can move quickly thru due-diligence
You have put together an outline of the VC’s you’d like to approach in your geographical area and they all are being approached at the same general time (to leverage term sheets)
You’ve checked and made sure that the particular VC you are going to approach invests in your market
You’ve done due diligence prior to meeting the VC by speaking to their portfolio companies to see if the style the VC utilizes is the style that is comfortable with you
Your pitch team knows how to interact with each other and not step on each other’s toes during presentations
You’ve gone over your presentation enough to speak to it intelligently and to do it without a PPT (incase the computer doesn’t work or that particular VC doesn’t want to see it)

Some analysis of the points:
Time is money and not just for the VC. Your time as an entrepreneur is as valuable as anyone else. If you spend 15 hours courting a potential VC when it’s not really in their investment strategy to fund your company, you’ve just wasted 15 hours of building your business or raising funds from another VC.

Your founding team is crucial. Most of the time, one person cannot start a business themselves so they must rely on other proven business executives or entrepreneurs. Early on, there usually isn’t enough money to compensate them for their salary so you must convince them to come on board with equity or other compensation packages. If you cannot convince a world class founding team to join, why should a VC pour millions of dollars into your company if not one else believes in it.

The hardest thing for an entrepreneur to understand is when they are no longer effective in the role they are playing and must step aside and let someone with more experience take over. In most cases, the founding entrepreneur is the lifeblood of the company and assumes the roll of the CEO. If the entrepreneur has little experience in this role in the past, there will come a time (70%) that they will be replaced and it could get contentious. The most effective entrepreneurs realize this and are willing to step aside and grow the business in another functional area. There are too many startups that have upset founding teams so they usually move-on after a few years.

Even in 2006, there are still the Napkin Deals. These are the “famous deals” that get done in a steakhouse or in Starbucks where you meet with a VC early on in your companies’ history and they give verbal agreement to invest at the table with writing on the napkin. This particular type of deal is few and far between so do not get your hopes up when seeking funding.

The points above (and miniature analysis) are all from an entrepreneurs perspective, but what do the venture capitalists themselves have to say? Alan Kelley, the Managing Director of SJF Ventures weighed in with some great insight, “Venture capitalists, especially those on the East Coast, rarely feel pressure today to invest in a hot new company before customers validate market demand. Most venture capitalists believe that the risk / reward profile for investing in concepts is usually unattractive, and they know that competing venture organizations are unlikely to finance companies in their infancy.

It's a real challenge for start-up companies today to find seed capital outside of their circle of family and friends. Even angel investors often want to see traction in the marketplace before they invest.

When businesses are the end users of a new product or service, a handful of enthusiastic customers can prompt an early-stage venture capital fund to back a company. Venture capitalists tend to trust that a small sample of business customers is often representative of a larger universe. Before investing in companies with a business-to-consumer model, however, venture organizations sometimes want to see tens of thousands of users.”

Nick MacShane, Senior Managing Director of Progress Partners talks about what he looks for in a startup. "We visit with 4-5 new companies a week. Many entrepreneurs walk through our doors are long with ideas, but short on focus, discipline and a sound understanding of how to present their ventures to the investor community. Those businesses that stand apart, and are fundable, have any or all of the following:

a grasp on what "need" they are filling in the marketplace;
an objective view on whether or not the team in place is the most
appropriate to take the venture to the next level; and
a clear, strategic and logical road map on what to do with the funds once/if they are received."

Nick makes an excellent point about what the logical road map is once the funds are received. Many entrepreneurs give the answer of, “grow the business” but that is as generic as vanilla ice cream. You need to be very detailed here as investors like to know how their money is being spent.

For Raj Kapoor of the Mayfield Fund, it’s all about the opportunity and the team (amongst many other things). "I'm willing to invest in a startup with a great idea that requires a seed investment of under $500k up to a later stage company requiring $10M - the key is that the opportunity is compelling and that the team is superb. I'm looking for a very strong founding team as a key criteria."

Why a strong team? Because either they’ve done it in the past with another startup or they’ve worked in a corporate setting and have the knowledge of how to maneuver in tight situations and work logically.

Keith Benjamin of Levensohn Venture Partners weighed in on the subject with a sort of opposite point of view, one of which becomes very prevalent when you send your business plan unsolicited or wonder why certain VC’s do not call you back, "With few exceptions, we do not meet entrepreneurs unless they are referred by somebody we know and respect. Ideally, an entrepreneur can find angel and seed investors with a strong network of VC contacts."

Brad Feld of Mobius Venture Capital offers up some case studies that he has blogged about on his blog, Feld.com. These are invaluable to entrepreneurs and show insight why he pulled the trigger to invest.

Why Did We Invest in NewsGator? http://www.feld.com/blog/archives/000083.html
I'm Hot on FeedBurner - http://www.feld.com/blog/archives/000343.html
My Newest Investment - Judy's Book - http://www.feld.com/blog/archives/001339.html

Conclusion
At the end of the day, it’s about execution. If you’ve got a fantastic idea, a stellar team, and have the passion and belief that you can execute on the particular startup, chances are you will succeed. Never lose sight of how important execution is and always focus on getting things. Horizontal movement is detrimental to your company, especially in the early days. As Jerry Garcia says, “Keep on Trucking” – always execute vertically and move towards your end goal. Running backs in the NFL never run horizontally because you can only score a touch down when you run straight ahead. Keep that in mind.

Comments

Darren, thanks for taking the time to write this great post. I think its really helpful for newbies like me.

When you talked about going "vertical" instead of "horizontal", exactly what is horizontal? Can you give an example?

Posted by: David Chen | October 30, 2006 at 11:29 AM

Darren, great post!

I'd love to see a follow up post digging into phase 2 of working with VC's. For example, the pros and cons of raising more or less money. Your thoughts on valuation and when it is important/not imporant.

Posted by: Seth Besmertnik | October 30, 2006 at 10:03 PM

Good overview Darren. The one thing I would add is that there are a lot of VCs (and not just the innovative one's) that are adjusting the model slightly to come in a little bit earlier to some deals. In Boston, I've seen a half dozen deals this year where a VC came in at $250-500k -- often alone -- to seed an idea. This is partly a reaction to the fact that a lot of software companies can get started for less, and that with exit valuations where they are those VCs need more of the company at the end.

However, by and large all of these deals were with:

- Founders that the VCs already knew (although not necessarily big shots or folks that had made them money)

- In an industry that they already understood (more comfortable with tracking seed stage and picking a winnner)

Posted by: Nabeel Hyatt | October 31, 2006 at 10:22 PM