In-Depth

Fishing for Venture Capital

Researching VC firms, getting ready for their questions and practicing on B-list players clear the way for landing the right investment partner.

• By Edward O'Connor
• September 01, 2006

Luring venture capital is a lot like fishing: You need to know what kind of fish you're after, the best time for fish to bite and, most importantly, how to get them to bite. While last month we covered the basics of venture capital (see Part I, "What Makes Venture Capitalists Tick," August 2006), this month we turn to the tactical, offering practical advice on everything from choosing your target to the best ways to reel in your catch and seal the deal.

Step #1: Know Your Bait
How do you determine your best VC prospects? One technique is to see the world through the eyes of your fish: the ideal equity partner. Take a hard look at your firm as an investment target, and ask yourself the questions investors are likely to ask (an exercise you'll need to perform anyway to prepare yourself for the pitch phase).

Here's a list of potential questions to get you started:

What differentiates your firm from its competitors? Be sure to look at this question from all angles, including management team, products or services, historical or planned market and financial performance, and go-to-market strategy and tactics.

What are the problems -- strategic, operational, in development, delivery, and in marketing and sales -- that your firm has encountered, and what have you done to resolve them? Has your firm done everything it could to address them? What challenges remain and what will be done to reverse them?
What are your firm's strategic plans for growth? Is the strategy cogent and attainable? What is your intended path to investment exit? What challenges do you foresee and how will you handle them?

How much capital do you need to execute your strategic plans? What historical and competitive benchmarks can you cite to support your case? Is the amount of capital sought appropriate to achieve it? Is it in line with your historical financial performance, or are you stretching for big bucks when your market position indicates that your appetite outpaces your aptitude and resources?

What will you give? How much of an ownership stake in your firm are you willing to give up in exchange for equity investment? How much of a strategic and an operational say in your firm are you and your management team prepared to cede? Are you and your management team prepared to exit the firm, should the equity firm decide that it's in the firm's best interests that you do so?

Answer these questions as if they were posed by your target equity investor and do so until your management team can respond in a confident, detailed and bullet-proof fashion.

While you're doing this self-assessment, refresh your understanding of environmental factors. These include the macro-economic environment, market conditions in your geography, competitive context and what the big players are doing in your sector. Avoid the tendency to get too highfalutin' here: The issue that matters is not really the big picture, but how the prospective equity investor views the big picture.

Step #2: Identify Your Catch
Now that you understand the lure you're working with from an investor's perspective, it's time to familiarize yourself with the market of equity investors. You can do this yourself or hire a firm or individual to do it for you:

• Start a list of firms by searching the Internet, consulting phone books, checking with regional chambers of commerce, and asking friends and associates for references to equity investors in your region or those in other regions that invest outside of them.
  
• Identify successful firms in your sector or in adjacent sectors that have had equity investment. Identify the lead investor and supporting investors, and put the supporting investors on your list. While a lead investor isn't going to want to place two big bets in a single sector, a supporting investor might be willing to get behind another company in a bigger way.
  
• Conduct due diligence on all firms on your list. Focus on their management teams, investment criteria, portfolio companies, news articles and press releases about successful exits, and sectors in which they invest.
  

Once you narrow the long list of equity investors down to, say, 30 firms, make a short list of about half as many that are most likely to invest in your firm. Do this by considering environmental factors and preparing your investment apparatus. This entire research process should take you only a few weeks.

Equity investor Web sites tend to reveal little about what specifically the firms want to invest in and how they actually work. You need to learn to read between the lines and test any hypotheses about your short-listed targets before you approach them.

Not only do you need to understand the sectors in which firms say they invest and those in which they actually do invest, you also need to understand their perspective on the sector. This means the upside and threats they see, the sort of strategies that they think work and the attributes of successful firms in the sector where your firm plays.

Few firms uniformly think alike; rather, it's the partners and principals in the equity-investment firms that matter. So narrow your due diligence on the prospective equity investors down to the partners and principals in your short list of firms that seem to think most in accordance with your own views. It's likely one of them will consider your pitch and, if the equity investment is made, it's one of them that will sit on your firm's board and will be the main person you'll work with during and after the investment.

How do you pare your list? Fortunately, again, the Internet is extraordinarily helpful: Consider the companies in which each of the partners or principals have invested and on whose boards they sit. Identify the sectors that are harmonious with the one in which your firm plays. Search on the seemingly most amenable partners or principals in all such equity-investment firms to find blog, seminar or conference, or article references that will help you get to know how they think as it relates to your situation.

Do as much of this research as you can to get the best understanding of these various equity investors-personally and professionally-in order to break your short list into two categories: A-list and B-list targets. Even though your A list will be your preferred investors, you're going to start with the B list first (more on why later).

Step #3: Prep Your Lure
Before you start contacting either A-list or B-list equity firms, you first need to know what you're going to say to them. As you're doing your own due diligence, you'll begin to compile the sort of information that you will need to stitch together for presentation. Doing so is by far the most time-consuming part of the process. Items to prepare include the 20-second verbal presentation known as the "elevator pitch," an executive summary of the business plan, a list of reference customers and a presentation of 10-20 slides. This information is almost universally sought by equity investors.

The Tackle Box In terms of information to prepare, most equity-investor Web sites list what they need. You should plan... ...An executive summary of a business plan as well as the plan itself. These should clearly, succinctly state and substantiate the following: the nature and focus of the business as well as a summary of the sector the business stage and strategy, products or services and competitive differentiation the management team's experience for this business and the corporate governance structure a detailed description of the technology and its competitive advantages the business model, target markets, go-to-market strategy, plus the historical and projected financial performance a "capitalization table," which reflects the percentage of ownership of your firm by all stakeholders while indicating the pre-investment valuation based on the criteria that are relevant to your sector the amount of investment being sought and the intended use of funds that aligns with the strategy an indication of the firm's strategic exit trajectory and timeframe, and the specified path to achieve it ...To prepare a list (on a separate sheet of paper) of five to 10 reference customers with their contact information. ...A formal presentation -- ideally 10 to 15 colored slides -- to the equity investor and a demonstration of your product or service. ...To craft a 20-second "elevator pitch" about your firm -- what it does and how well it does it, how it will dominate its target market, how much investment capital it needs and what its exit trajectory is -- that you and everyone on your team knows by heart. -- E.O.

Now that you've gotten everything together, it's time to practice stating and explaining everything about your firm. From the top-line summary to the most granular details, make sure that you and every member of your management team can articulate the inner workings, market potential and growth trajectory of your firm.

In the course of due diligence, your prospective equity investor will want to talk with every member of the management team to ensure that your stories are consistent. Your junior people are not immune to this probing, so be sure that every employee can summarize the firm's strategy. Nothing derails a due diligence exercise like learning things from an employee that contradict the management team.

In the materials you develop and prepare for your target investor, there are several common mistakes to avoid. They include:

• Don't over-sell but do over-deliver: Make sure your milestones are achievable and your financial projections are realistic.
  
• Be confident -- not peremptory -- in your assumptions and presentation: Assume your targeted equity investor has seen better plans and that he's smarter than you about the market, business models that work, as well as the particulars of your plan. This is likely not true, but it's best not to come off as cocky.
  
• Be cautious -- not paranoid -- in your representations: Demonstrate that you are an expert in your sector and your business, but qualify things properly-such as your firm's strengths and weaknesses, and the likelihood of your firm's success in achieving its strategic objectives.
  
• Be attentive to detail but keep in mind the big picture: Dwell on the key issues that matter about your firm (capabilities, potential) and to your investor (opportunity, exit), and support your points with valid data.
  
• Be aggressive but not hasty: Your target equity investor is in no hurry to write a check without covering all of the points in its due-diligence checklist at least twice. Don't be perceived as being in too big a hurry yourself, but do state reasonable timeframes for each step in the process and follow your target's lead on tasks and timeframes.
  
• Be perceived as a partner -- not a time-sink liability -- to your target equity investor: There's give and take in any working relationship, and this one is very important. Make sure you always leave the impression of someone with whom this principal is going to want to work.
  

Note that you needn't be deferential, afraid or in awe of your prospective equity investor. But it's a business relationship. So make sure that your numbers are correct. Avoid one of the most common mistakes: Do not over-value your firm. Learn what the right multiple is for firms in your sector -- a multiple of earnings, discounted cash flow, etc. -- and how other firms in your sector have been valued on a sale.

Plan accordingly, and don't set unrealistic expectations for yourself where the only justification for the valuation is your gut feeling as opposed to what the industry standard is and what is indisputably fair. Be fair to your firm and to your prospective equity investor in establishing-and justifying-a proper valuation of your firm that will be used in setting its worth before and after the equity investment (also called pre- and post-money valuation, respectively).

When your investment apparatus -- business plan, investor presentation -- is complete, and you and your team can fluidly present and explain it in summary and in-depth (rehearse again and again on some third parties), then it's time to go fishing.

Step #4: Reel 'Em In
Among the first things to note on equity investor Web sites -- besides all the pictures of happy, thoughtful people and big buildings -- is that firms seeking funding to submit their business plans either on the Web site or with an e-mail message to some address. Don't do it! Your submission will likely be reviewed by a very junior person who simply checks submissions for pre-defined criteria. If all of the criteria are not met on this initial pass, the submission is deleted and the submitter is rarely notified.

Rather, in your network inquiries to identify particular people at each of your target equity investors, you will have found someone who knows someone who knows the most promising investment professional there. Now is the time to line up the introductions, whether through that person or, ideally, from the executive in one of his portfolio companies with whom you spoke. If you can't get the introduction, let your fingers do the walking.

Start with the last equity-investment firm on your B-list and, with a firm determination to be brief -- respect his time -- get the guy on the phone. Chit-chat for a split second. Then segue into your elevator pitch. If he's interested, tell him you'll e-mail your executive summary or business plan, whichever he wants to see, and while you're on the phone, schedule a time in a week to 10 days to get back on the phone or to have a meeting about it. If he's not interested, scratch the firm off the list.

Work your way up your B-list until you find a taker. Landing a meeting with this big fish is your formal dress rehearsal. What you learn in this meeting will be very important for your intended meetings with your A-list firms. Most importantly, ask a lot of tough questions to gauge how well the equity investor understands your market and about the equity firm's investing process and investment resources.

Grilling Your Equity Partner Sample questions for a meeting with your equity partner: Does he understand the market, your sector and the place and potential that your firm has in each? Is he up on your competition and levers as well as inhibitors to your intended growth? Specifically, how will his firm help yours to achieve its objectives? What other portfolio companies have he and his team similarly helped, and will he broker a call or meeting for you and your executive team with them should you both choose to go forward together? What is the status of their investment fund--how much? How many deals done in the past two years? What’s the amount of the average round and when was the last time they closed a round? What is the average timeframe for an investment to be made in a prospective portfolio company? Where do they stand on the issue of follow-on rounds, if needed, for working-capital bridging (mezzanine) or growth-capital purposes? How do they traditionally exit investments? How much equity do they seek in firms such as yours and based on what valuation? -- E.O.

Your equity investor counterpart will ask you what other firms you're speaking with, to which you should reply that his firm is among the first. Depending on his reaction -- an "OK" could signal indifference, a "don't talk to any others" could signal envious interest -- you will get a sense of where you stand. Don't fall into the trap of being fished for with salesmanship tactics that they might employ to get you not to cast your line elsewhere. This posture takes some getting used to, but you will get comfortable with it. The right equity investor will respect your strength. Not only are you executing this fishing excursion in a responsible fashion, but you're laying the groundwork for future success with the equity investor should the firm decide to invest in you.

Repeat this exercise, working up your B-list until you find a firm that's very interested. When you've done that, jump to your A-list and go for the big fish.

In all these meetings, ask this essential question: Would this equity investor put up all the money or would it seek to syndicate the investment? If it's the former, you have a clear path to funding if you don't blow it or if the firm doesn't walk away. If it's the latter, do what you can to fast track your conversation to the point that the firm brokers a meeting with its co-investors.

When you have found your likely investor, then you're in a position to make your final pitch that will result in the equity investor's offering you a "term sheet," a list of terms for its making an investment in your firm either on its own or with other firms. This is often a happy time, even if the terms are less in substance or more in procedural restrictions than you might have hoped.

Don't despair or respond hastily -- everything is negotiable. Mull over which terms you and your management team can and can't live with, and be optimistic that you can persuade your equity investor to see things your way. After all, you have lead the firm up to this point.