VENTURE CAPITAL

Venture capitalists (VCs) are fund managers who invest other people's money in private companies. The people and institutions that provide the money are called the limited partners of the venture capital firm. In exchange for managing the money of the limited partners, the VCs typically receive a 2% of the fund as an annual management fee and a 20-30% carried interest (a.k.a. carry) in fund's returns. If the VCs invest a fund of $100M into 10 companies and are able to sell their equity after 6 years (though 10 years is more typical) for a total of $800M, the VCs will have realized a 700% return on investment (ROI). At a 2.5% management fee and 25% carry, the VCs would receive about $18M over 6 years (for salaries and expenses) and a carry of $175M. The limited partners would receive about $620M at an average internal rate of return (IRR) of 35% per year. In fact, a few long-standing venture capital firms consistently give their limited partners a 35% rate of return, significantly beating out the public markets over the long-term.

During the 90's, VC funds swelled to unheard-of proportions. It became common for a VC firm to have over $1 billion under management. With larger funds, the average size of each deal also increased, making it difficult for companies with small initial capital requirements (<$5M) to justify the attention of many VC firms. Yet, not all companies qualified for larger investments, particularly those that lacked good management, a credible business strategy, solid IP, etc. Venture capitalists who continue to fund such raw startups may only do a few per fund, maybe only one each year. These ventures require considerable coaching, and one of the venture capitalists may need to step in as interim CEO.

BEING A VENTURE CAPITALIST

From their vantage point, VCs have an informed perspective on the industry's future. The large respected firms have first- or second-hand knowledge of most of the startups looking for financing at any given time. As Directors, VCs sit in company board rooms, where the good, bad, and ugly are discussed without the layers of PR varnish the rest of us try to see through. Seems everyone either wants a piece of a VC or wants to be a VC. On the surface, it would seem that VCs have it made.

Yet, VCs must answer to their limited partners and have the unenviable responsibility of making money for the LPs regardless of the economic climate. VCs must stay ahead of the trends, but not too far ahead, and pay heed to changing demands on technology, business models, and management. While the most experienced firms will survive an economic downturn with a few bruises, many VCs lose their jobs either due to bad luck or once their incompetence comes to light. In certain circumstances, VC can face personal bankruptcy. There's nothing grand about being a failing VC, regardless of the prestige the title carries. It's not a job to be coveted lightly.

VENTURE CAPITALISTS AS PARTNERS

Venture capitalists do more than just provide money to companies. They also serve as valuable advisors, capable of guiding a company through many phases of growth. The best venture capitalists have hands-on experience turning startups into mature companies, allowing them to better relate to entrepreneurs. They have extensive networks and can help recruit employees, executives, directors, customers, and other investors. One entrepreneur indicated that he could have gotten financing on better terms from angels but instead chose to accept an investment from a highly respected venture capital firm.

Evaluate VC firms based on the companies in which they have already invested. There may be opportunities for your company to work with other companies in the VC's portfolio. At the same time, be careful of approaching VCs who have already invested in a competitor. Not only are they likely to turn you down, but you may also find that news of your activity has leaked to the competitor.

VENTURE CAPITALISTS AS INVESTORS VCs have a reputation for taking advantage of entrepreneurs, demanding majority equity stakes and the right to fire the founding CEO on a whim. Indeed, VCs are savvy investors and know the value of their money. When they have a strong bargaining position, which is almost always, they will negotiate for more equity and control than the founders are happy to relinquish. However, VCs are not so blind as to rob entrepreneurs of all incentive to succeed. If you were dealing with an experienced VC in your field, many entrepreneurs would advise you to accept an offer even if the terms seem a bit harsh. As long as you have an experienced corporate attorney on your team and have reasonable expectations, you should be able to negotiate acceptable terms.

Venture capitalists' terms frequently include clauses that tax the founders and other shareholders in the event of missed milestones. For example, if a company fails to finish a prototype or secure a license by a certain date, the company must issue additional shares to the VCs (or accordingly change the preferred-to-common conversion ratio), giving the VCs a larger stake in the company without additional investment. On the bright side, such terms really motivate management to succeed.

Identifying good venture capitalists is not always easy these days. Because of the rapid proliferation of funds, there are many venture capitalists distributing other people's money who are not necessarily qualified to do so. Eventually, the ones who poorly invested their first fund may find that they cannot raise another and will leave the industry. Taking money from a poorly respected firm may prevent you from being able to raise money later on from the good firms. When selecting a VC, look for those with a successful track record of co-investing with other reputable VCs.

Some firms have a reputation for stringing a company along for months, professing a deep interest but without offering a term sheet and telling the company not to talk with other VCs. When such a firm finally decides not to follow through, the entrepreneur is left out in the rain, having lost valuable time. A company should agree to exclusive negotiations for a specified period only if a VC has put forth a term sheet. Otherwise, the company owes a VC no loyalty and should hold multiple discussions in parallel.

In other cases, venture capitalists develop reputations for being difficult and controlling. For example, when a company goes on to raise a second round of financing, an existing VC shareholder may insist on providing the additional funds. This type of deal is known as an "inside round" and only makes sense if the insiders are willing to match or beat terms offered by outside investors, who are in the best position to objectively establish fair value. Of course, if the company's current VC investors are unpleasant, other VC firms may not want to come onboard.

MEETING THE RIGHT VC

Venture capitalists receive thousand of plans each year, more than they can process, are focus on those that came in from trusted sources. More importantly, VCs often specialize in particular industries and, at any one time, are likely to prefer a company with a specific business model, technology, disease focus, etc.

Before you seek out venture capital you should have:

  • A well-written, organized business plan.
  • An Executive Summary, no more than 1-2 pages.
  • A qualified scientific advisor.
  • At least one business-savvy individual, ideally on your management team but possibly on the Board of Directors.
  • An experienced and respected corporate attorney.
  • An option or rights to key intellectual property.
  • If applicable, a list of people who have agreed to join the company once it is financed.
  • Answers to every question about any aspect of your product, technology, customers, competitors, business model, etc.
  • Confidence to say, "I don't know, but I can find out", when appropriate.

After assembling all these pieces, you may find that you are already connected to VCs. At least your corporate attorney should be able to put you in touch with a few firms. A reputable technology licensing office can also have enough influence to get you in the door. Find an opportunity to meet CEOs of other biotechnology companies, possibly through your scientific advisors, technology transfer office, or local biotechnology industry organization. As fellow entrepreneurs, CEOs of small companies may be willing to give you advice and put you in touch with their VCs.

Once a VC has seen a deal, a clock begins to tick. The deal becomes "stale" over time. Do not blanket the VC industry with copies of your business plan. Most VCs may not even respond, but if you approach them after six months, they will assume that there is something wrong if you are still looking for money after all that time. Focus on several VCs at a time and if things do not work out after a few weeks, move on to new firms that have not yet heard of you. Even so, VCs are well connected and exchange information, so even the new firms may already know that you have been looking for capital unsuccessfully for some time.

Good VCs create trends rather than ride them. Still, if proteomics companies are making the news, venture capitalists will take notice and may consider that sector hot. To assess how "hot" your idea will sound, read biotechnology trade journals such as BioWorld and In Vivo. A university tech transfer office may subscribe to these publications. If nothing else, keep track of the latest news on BioSpace.com and sign up for the email bulletins issued by Venturereporter.net

PRESENTING TO VCS

An experienced businessperson on your team should lead the presentation since the central topic is usually the business model. A scientific founder's role should be limited to discussing the technology and science. Keep in mind that both the people and the idea will be subject to careful scrutiny. At no time should members of the presenting team interrupt each other or the investors.

Keep it simple and clear. Too much glitz makes it look like you are masking a bad idea. The VC should already have a copy of your business plan and will probably have questions. You might simply be asked to introduce yourself and your idea informally before the VC starts asking questions. The presentation may become conversational, but never let down your guard because you are always being judged.

Though one should always put one's best foot forward, do not hide anything significant from the venture capitalist; they will dig deeper and discover if they had been initially misled. The success of one venture is not worth ruining one's entrepreneurial career by acquiring a reputation for dishonesty.

WHAT VCS LOOK FOR

Visit the websites of a few dozen venture capital firms to read what most of them want. By the tenth site, you will be able to recite the clichés by heart:

  • Experienced management team • Large and growing market, >$500M.
  • Proven technology or concept
  • Intellectual Property
  • Little or no competition.
  • Attractive business model.
  • Multiple exit opportunities: Sale or IPO -- preferably within 5 years.

The management team is the most important element. Venture capitalists would rather invest in a great management team with a poor technology than a great technology with a poor management team. The rationale behind this philosophy is that a bad management team will mismanage a great technology whereas a great management team will figure out a way to make the company successful regardless of the starting technology. Investors won't like a scientist without business experience insisting on being CEO just because the company was his idea.

The VC's goal is to earn at least a 35% return overall for his fund, which might mean shooting for a 55%-65% return in case a few companies fail. A 55% annual rate of return means that the VC must expect a $3M investment will be worth $30M in five years. A company should appreciate these targets if they hope to appeal to a VC's bottom line.

"NO" DOES NOT MEAN "NO"

Venture capitalists hate missing a great deal. Consequently, their rejections are rarely absolute. They fear misjudging a company that will later make money for other firms. Bessemer Venture Partners has even compiled an amusing anti-portfolio of missed opportunities (www.bvp.com/port/anti.asp), proof that VCs are not without humor.

In the rejection, The VCs may say that your company's focus does not fit with their current strategy. However, "No" really means "Not now". They may suggest that the company strengthen its management or further develop an area of the business plan. Follow their suggestions and, when you think you have made important progress, make another pitch. Be politely persistent.

Because VCs may be indirect ("The venture is promising but too early in its development for our firm, so please let us know when you are raising the next round."), some entrepreneurs may not recognize a VC's way of expressing disinterest. Entrepreneurs must be very careful not to misrepresent one VC's comments when speaking with other investors. Prospective investors can easily pick up the phone to figure out what their peers at other funds were really thinking when they turned the entrepreneur away.