“Start-up Fundraising In 15 Steps ”
by Oliver Gajda
In this article you will find 15 steps and an introduction, no more, that will help you considering venture capital and how to go about getting some. These is by far not an all inclusive overview, but merely scratches the surface of the ever changing world of high growth investments and entrepreneurship.
Step 1: Setting the Stage
Step 2: Moving ahead
Step 3: Ambitions
Step 4: What to avoid
Step 5: Business plan
Step 6: Executive summary
Step 7: Slideshow
Step 8: Pitching
Step 9: Closing in
Step 10: Due diligence
Step 11: Aligning interest
Step 12: Deal Structure
Step 13: Valuation
Step 14: Investor
Step 15: Exit
You might consider building your own business, for different reasons and at different times in your life. You might think about it already as a student with a great and world changing idea or later in your career as an employee embedded in corporate life or, as often the case, in between jobs in order to bridge support your standard of living. There are many things to consider before launching into the life of start-up entrepreneur, including income security and working hours, but once thrown into the deep end you will have to keep going. Indeed, running your own business is not that difficult, you might find, if only you have cornered a market in which you can produce an adequate margin to live on. But let us be more ambitious and think about growing your business, make it a household name across borders. In most cases this will include financial hurdles that need to be overcome through an injection of external capital.
After reading through the posts you might feel better prepared to approach investors or less. In both cases I would advise you to consult further information. If you have contacts and friends that have been through this process before or failed at it, consult them too, they will be some of your best sources of information. It is important that you consider both the good and the bad experiences, because every business is unique in its idea and its management. Therefore, there can be no one-fits-all solution, there is no one-stop-investor either, and no single advice from anyone will be able to capture your situation accurately.
Most importantly, venture capital is not for everyone. Indeed, the venture capital industry is undergoing structural changes, with less and less dedicated professional early-stage funds and a lot of semi-professional angel funds and accelerator programmes opening up. The former were not all great and the latter are not all bad. There is no saying if this is for the better or for the worse, but it means that the investment rounds available for start-ups are smaller than they used to be, which is reflected also in the diminishing cost for creating a so called web 2.0 company and the decrease in capital intensive start-ups.
Do your homework and identify an investor that you can and want to share a long term goal with. Understand what motivates them, also under pressure. Do not settle for second best. Read on to get some more ideas.
Step 1: Setting the Stage
Any ambitious entrepreneur will at some point or another encounter the need to enter into fund raising negotiations in order to take their company to the next level. No matter with whom you will negotiate, you can prepare your success by making an effort to understand the different forms of financing, their benefits and their risks and downsides. This cannot and will not be done here. The aim of this blog is to help you to understand what it means to opt for venture capital and to prepare you effectively for meetings and negotiations with investors. The execution depends on yourself and the people you talk to.
To start, let us quickly outline a few obstacles you may need to take on. You must analyse your own strategic position. This will be based on your personal understanding of your business idea, its market potential, as well as its financial and social value. You will base your business strategy on your own judgement, plus that of a few friends or mentors. Write things down, put them into a clearly structured document or, even better, a number of clearly structured documents: these are your business plan, your business presentation, your executive summary, and last but not least your elevator pitch. In order to find out how clearly structured you have drafted your documents. I suggest you take the opportunity to test them on friends or business partners in order to gain:
- open and frank feedback on the strategic strengths, weaknesses, opportunities and threats;
- a first insight into how potential investors or business partners could perceive your idea; and
- a foundation in presentation and relationship building skills, which will be key later on.
Something else that is advisable but unfortunately too often not exercised is the on-going improvement of your materials and public presentation skills. This is not only true for start-ups but also for established companies. This skill set will help you to capture the imagination of your own staff, suppliers and other business partners as well as investors. Think of the impact every public product launch delivered by Steve Jobs for Apple had. First impressions count, therefore, you should also:
- Take ample time to sharpen your documentation and your elevator pitch. Frequently!
- Repeatedly practice presentation skills and methods, pronunciation and enunciation of difficult terminology or foreign language parts.
To become good at selling your idea by giving a pitch is different from running through an executive summary, a presentation deck or a business plan. Only practise can prepare you. Firstly, the person you are presenting to makes all the difference as to what and how you will make your presentation, because every investor has his or her own preferences and dislikes. Have different volunteers help you with that or imagine different people, if this helps. You need to be on top at all times!
Unfortunately for some, but fortunately for others, documentation and presentation are not all. The presenting entrepreneur needs to understand their businesses, its shortcomings and its advantages in detail. They need to be able to communicate the relevant aspects, both positive and negative, clearly and comprehensively to the opposite party if and when needed. While many entrepreneurs and start-up managers have a good understanding of their customers’ or suppliers’ needs, often from their own professional experience, they are often inexperienced when it comes to talking to investors. As a result, many fund raising road shows are going nowhere – either because the entrepreneurs fail to sell a perfectly good idea or because the idea is not of interest to investors. You should, of course, avoid both scenarios.
It is actually not that difficult. You need to understand what kind of capital you need and from whom, by when and what you need it for. Assuming you know the what, there are many possibilities for young and growing companies to obtain financing, including family, friends, fools and fiends as well as business angels, banks (overdrafts, short or medium-term loans), factoring and invoice discounting, bootstrapping, leasing, public support programmes (regional, national, European) and, of course, professional venture capital investors. If you look around, you will probably be able to spot a few other sources that you can tap into.
The financing forms providing private capital at an early stage assume the highest risk, especially private persons and business angels, but do not necessarily get the highest rewards. It is the venture capitalist, who is able to provide large amounts of capital necessary to really push an early-stage company into the market, who also expects the highest returns. Therefore venture capital is not right for every company or every entrepreneur – overall, venture capital prefers highly scalable growth companies, often with technology focus.
Furthermore, venture capital is rarely the first external source of funding for any company these days. In general, a company will have used a variety of other financing sources before it approaches venture capital investors for the first time. But when is your business ready for venture capital? Simplified, unless your business offers the prospect of above average (read exorbitant) growth in turnover and profits within five to seven years – indeed, three to five might be a more realistic period to think of – it is highly unlikely that you will receive venture capital.
On top, you will need an experienced, ambitious and hardworking management team as well as a realistic but visionary business idea. But let us take this step by step. Going forward we will quickly consider different investors, define venture capital in a little more detail, define your idea, produce your relevant documentation and guide you towards a pleasant but hard working – and hopefully successful – fund raising experience.
Step 2: Moving Ahead
Finding sources of money is fairly easy, getting it is the difficulty. Before you spend long hours putting together your pitch for the venture capitalist you have read or heard about, let us consider the alternatives. For your start-up business, support is readily available from a variety of organisations. These include start-up coaches, accountants, lawyers, business consultants, friends, the chambers of commerce, business information centres or incubators, government support programmes and so on.
Depending on the stage of your start-up, your primary financing sources are family and friends, which usually come with limited resources and emotional attachment and which is risky if you should fail. Nonetheless, this is probably the starting point for you unless you have enough cash on your own bank account. Business angels are a great source of funding, but make sure you pick one that understands your business and its industry, has plenty of contacts, the willingness to get involved and share but no urge to be in charge.
If your business idea is straighter forward and revenue is on the doorstep, banks (overdrafts, short or medium-term loans), factoring, invoice discounting or preferable payment terms from suppliers and bootstrapping could be a very good solution to overcome funding gaps. However, these will in nearly every case not support stellar growth of your company. Lack of funding can also be tackled by reducing cost and expenditure, for example the purchase of second hand information technology, leasing and sharing of facilities. In some cases public support programmes (regional, national, European) can be used to drive the development of a specific technology or the exploitation of a new market. Still, most of these come with a bureaucratic burden, which needs to be managed.
Not all of these might be useful to you at the current development stage of your business and it is advisable to be aware of what is available in your city or region. Talk to relevant people you already know (business and corporate lawyers, for example, are often a great source of contacts), then look at the offer that best suits your needs. Of course, if your business will be the next success story we will be reading about in the Wall Street Journal, than a professional venture capital investor might be someone to consider. Call you contacts use them to get an insight regarding suitable venture capitalists out there and get a personal introduction, if you can.
To simplify your work, I would advise carefully considering at least the following points before committing your business to any particular source of funding.
Define your roll-out plans. Do not be shy. Start talking about the roll out plans of your venture with business partners (if you have any) or other parties of interest as early as possible. Clearly define the preferred outcome of the company or technology development and focus on the most promising business activity. It is easy to envision different scenarios, but focus will help you in executing your plans with relevant support. Investors are not interested in opportunities as such, but in those opportunities that can be executed and achieved within an agreed time-frame by you and your team.
Spell out the consequences of potential follow-up. Be very clear about the situation your business is in, the relationships that could support it and the abilities and limitations that define it. Ask yourself:
- Which of your business partners are willing and capable to support the deployment phase?
- Who has the intellectual property rights and the know-how and how can these be managed within your venture?
- What is the business model you favour? Is it a direct sales concept, a reseller model, a services model in some form, including varieties such as Software as a Service, based on licensing and royalties, franchising, etc.? Will you make money with the first customer or will you first have to amass many users in order to make your product or service viable?
- Which legal incorporation will be the most appropriate for the type of business you are launching?
- How would you prefer to split responsibilities (leadership and management), investments and shares (paid-in or in kind) between you and your business partners?
- Estimate your external funding needs and the percentage of shares you are happy to pass on to third party investors.
- Based on this, establish what will be the most appropriate and suitable investor for your business plan and risk profile. To do so, put together the following:
- Characterise your business with regard to your business area, your potential customer base and staff as well as the anticipated investment horizon.
- Understand available funding schemes (subsidised loan programmes, equity, debt, quasi-equity etc.) that a venture capital fund might offer.
- Be aware of funding strategies and ascertain which would be the most appropriate for your business model, that answers the needs of your projected (or preferred) growth and revenue potential and speed.
- Be very clear about the 3-7 year investment horizon with often exorbitant growth expectations that venture capital brings with it. Can your business match it and are you and your team good enough to execute this? If not, consider other options.
Once satisfied with your growth model, and it might take some reading, thinking and talking, make a decision with regard to your preferred investor type for your next step. Likelihood is that you will have to tap into different pots at different times, no matter what type of business you are trying to build. According to your choice your approach will have to vary significantly. Make sure that you fully understand what the appropriate requirements are or you will waste your time and money. For those business models that will generate revenues quickly and are expected to reach break even within a short period of time, say one to two years or less, more conservative funding models, such as loans, could well be favourable. Again, it depends on your own preference and the market for funding, that is on liquidity at investor level.
If you should think about raising venture capital, now or in two years, you are in for an interesting but challenging ride, but you also better have stellar growth prospects. Within the venture capital industry talk is mostly about those investments that have made headlines, not those that failed. And currently, it is about consolidation and who will be around to continue investing in the years to come. Broadly speaking, venture capital is a form of equity capital provided to companies that are not quoted on a stock market. Usually, it is used for product or technology development, as an expansion of working capital or to make acquisitions of products or companies. In some cases it is used to resolve ownership or management issues at smaller companies with strong growth potential. Overall, it aims to provide long-term share capital for high growth.
Venture capital is frequently understood as a sub-set of private equity, especially in Europe. Overall we can distinguish between early stage, later- or expansion stage and buyouts. The term private equity is usually applied as an overall category for investments in unquoted equity, that is equity not listed on a stock market, but a frequent use for it is to describe buyout investments or restructuring of larger companies.
Venture capital, as a sub-set of private equity, is particular as an investment, because it is supposed to be aimed at speeding up value creation within start-ups or smaller companies with high growth potential. That is, of course, not necessary always the case, but admittedly in general the intention. Therefore, the venture capitalist should be expected to take a very active and hands-on part in helping you to grow your business during launch, early development, or expansion of your business. Venture capital is about the active combination of equity, expertise and contacts in the market.
For our purposes, venture capital or early stage investments are those we will focus on. As per common understanding, they are made in start-ups; that is young companies that have just been created or are starting to take their first steps as a business entity. However, the field is diverse by size and by type of investors. Early stage investments are also not singular events. Any given business is likely to receive multiple investment rounds from different kind of investors as the business develops, often more than four or five. You can easily identify three investment areas that venture capital investors might consider; they are seed, start-up or growth.
A seed investment will be appropriate for a company launch and the development of its product or testing. Usually the seed round will be modest amount of funding as it will carry the company through the first stages of product development, the creation of a prototype and/or the preparation of a sophisticated business plan. Typically, the seed capital comes from family, friends or so-called business angels. Some specialised or regional venture capital funds also pursue this type of funding as part of their overall business strategy. This will be followed by a start-up investment, which is appropriate at a later stage of a company’s development. Frequently the business will already make some revenue, though no or limited profits, and have a product that can be launched into the market.
This is the point where venture capital investors become more interested and many technology-focused funds specialise in this area. Other, non-specialised venture capital funds invest only a small percentage of their capital in start-up companies, as they do not have the capacities of managing the risks associated with start-ups in specific industries. These funds focus on businesses already operating and seeking to grow into new markets. Only when a business generates profits, or is distinctly set to generate profits, will larger funds, especially those operating at a pan-European level, start to become interested. In order to reduce risk, a venture capitalist usually will provide capital in steps according to a company’s development. Following a successful start-up investment, for example, your business is likely to need further capital injections to grow its revenues, market share or product lines.
To be able to fully comprehend how a venture capitalist chooses a specific investment strategy – which will define all investment decisions – you need to understand their own position. They most often manage private money on behalf of institutional investors, such as banks, insurance companies and pension funds, or of wealthy families – but are requested to invest some part of their own money, too. Their value proposition is to return interest well above other investment opportunities, such as the stock market over a period of usually ten years. The structure of the these funds are such that the venture capitalist will receive a small, but not modest management fee to pay for his running cost, and will participate in the upside at the end of the funds life. The venture capitalist is therefore concerned to make as much money as possible within the time he has been given – or faster. In fact, the venture capitalist is just an entrepreneur like you, active in financial services, who will benefit from the growth of his company and feel the pain of the decline.
Add to this the fact that not all investments turn out to be profitable for the venture capitalist. On average there might be only one or two companies in a venture capitalist’s portfolio out of maybe fifteen that make a significant win when they are sold. Many will be written off over time, others will just repay the investment, and a number will make a modest or good profit to the investor. Let us be clear about this, the venture capitalist must make decisions based on expected return at all times. This can lead to your company not receiving investment, or in the venture capitalist pulling out of your company if things are not going well. It can also mean that you that will be pressured to sell your business at a time that is convenient to the venture capitalist, but not to you or the development of your company.
The venture capitalist will therefore only invest in companies that have a strong business model, and like you will only spent effort on products that have a strong market potential. It is this potential of extremely high growth that will make the venture capitalist interested in your business, and the fact that it can be sold within three to seven years at a substantial profit, preferably to the stock market. The high growth expectations of the venture capitalist exclude many very good business ideas from receiving venture capital, only because their growth potential does not match the expectations of the investors. Therefore, not having been able to raise venture capital is absolutely no value judgement on the business as such. However, there are also venture capital funds that manage public (or less profit driven) money, often with a specific regional or industry focus, which provide money on partly less strict terms.
Now, before approaching a venture capital fund make sure that your business is in the right industry, that is has realistic high growth expectations and that you and your management are prepared to work hard for the money they might give you. To satisfy a venture capitalist’s expectations and to get funding is not simple – but if it is, it might not be the right investor for you. You need not only understand the venture capitalist’s business and goals, but also need to define your own and your needs. Once you know what you are going to do and how, select those investors that are investing in exactly this (seek out information on their existing portfolio, their past investments and success – read their blogs, articles and interviews with them, talk with people who have already worked with them) then prepare for a potential venture capital pitch. In real life, of course, always expect the unexpected.
Step 3: Ambitions
You will probably know very well what you believe your business will be. In fact, how you envision your business depends a lot on you and your character. Be aware of yourself and how this will impact your business philosophy, the work environment you will be building for yourself and other and the image you will project on behalf of your business. There are many character straits that make a perfect entrepreneur.
Some character traits that successful entrepreneurs display follow. You should make sure that where you don’t have the relevant assets you make sure someone else contributes. Analyse yourself for the following characteristics: are you positively driven and resilient to failure, are you inspired and can inspire, do you endure and overcome hard times, do you understand risks and can you take them, do you focus on detail but can make decisions and results driven and are you competitive while honest enough to believe in what you are selling?
To be successful you need to be willing to take many risks, not only financial risks. The way to success can be hard and long, and for some it never comes. Starting your own world changing business can feel like the curse of Sisyphus, rolling a huge boulder up a steep hill, only to watch it roll back down, seemingly for eternity. It is your character that will determine to some degree if your business will roll back down or it will, one day, go over the top.
Therefore, you need to know your own strengths and weaknesses and you need to address them openly within your idea. You might even find that you are not the right person to drive the growth of the business and indeed many entrepreneurs do not grow their business beyond what they feel comfortable with. Work to your strengths; get support where you have weaknesses. Experienced investors will see through you quickly if you try to mislead them about yourself – or your relationship with them will be seriously tainted if they only find out later.
But even without prior self-analysis it is a challenge to put your business idea into a structured and easily understandable way onto paper, partly because your idea constantly evolves and partly because to put things onto paper requires you to make decisions as to what should be left out. Be clear about what you want, your success in raising funds stems from more than a “great idea”. That idea of yours does need a sound business plan, we come to that in a minute, and it needs an identity and place in this world. So, how does your business relate to the world? What is its purpose? How will it change it for the better?
Think about values, such as ethics, integrity, care and compassion, quality, standards of behaviour. Do the values resonate with your staff, customers, suppliers, partners and owners? Make sure that they are good and that people feel proud to be associated with them. Once you settled this, you might ask yourself how your business will change things for the better and if this vision is relevant and desired by your customers, staff and stakeholders. Be realistic and make your vision achievable – in the end it defines your relationship with the market place and all stakeholders. This will lead you to your mission, i.e. what is special about the business and how does it compare to other organisations – and how can this be achieved?
Set yourself goals and time-lines by when you plan to achieve them. Define how you will measure your achievements and what will constitute success. This can change of course, and new goals necessarily are developed as old ones are achieved – but at any time you need to know what your business’s main goal is, by when you aim to achieve it, and how its achievement will be measured. In summary, you need a strategy. Define criteria on how you can monitor execution and performance – and prepare for potential external influences and from where they likely to come.
Finally, analyse of what your strategies are comprised, how responsibilities and activities are allocated across business functions, departments or teams. You need to know who does what, where, when, how, for what cost and with what required effect and result. Prepare time scales and methods for all the actions within the strategies, and who owns those responsibilities. Now translate them into performance and activity expectations – create internal standards, key performance indicators, service level agreements, etc. Of course, all this might be difficult during the very early stages, but you should still try to make a good effort as it also helps you to better understand the needs within your business as they arise over time.
Once you feel happy with your preparations, work with your management, employees, and partners as well as potentially, customers, to finalise and commit to:
- Targets and Objectives
- Performance Indicators
If you are satisfied, you are ready to think about your business plan. With a strong understanding of your own business, its position, team, capabilities and shortcomings you will find it much easier to write a convincing and well-founded proposal to potential investors. Still, chances are high you are a long way from getting the cash needed. A clear business definition will help you write a business plan, which will help you create a good presentation and a good pitch. But do not forget, these are just tools to create interest. The decision to invest is based on the product you propose and the team behind it, both of which you can structure and work on.
You feel ready to move on? Make sure your idea holds up and your basic business definitions are strong. Test your outline before you start writing a business plan and before pitching (seriously) to investors. Meet a few people you know, trust or believe might be interested in supporting you. If they feel your idea is addressing a real need and you are the person to pull it off, they will help you to develop the idea further. Funding might only come later, but to have built the relevant contacts early on can be a significant advantage.
Step 4: What to Avoid
To put your inspirations and convictions, your ambitions and goals into relevant business materials for fundraising purposes will take a little thought, but should not be too much of a hurdle. However, you need to make the effort to distance yourself from your own enthusiasm in order to understand your counterpart, the investor and his needs, when you put these materials together. I trust here that you are able to do this and that you take the relevant steps to ensure that you have understood reasonably what this will take in every single case. We touched upon the venture capitalists basic intentions in part two of this series, so you might want to go back to refresh your memory if you are unsure about this, or look at relevant publications and other resources, many of which you can easily find via the web.
This done, you need to be clear about the basis of every presentation of your business to professional investors: it must be an objective and structured business plan. The business plan is not the only and in most cases not the first document you will give to investors, but every other document or verbal presentation must convey its key issues, too. Next to the business plan you need an executive summary, a slide show presentation and a verbal ‘elevator pitch’ – short and poignant enough to interest a potential investor in your business during a ride in an elevator – or any other short encounter you may happen to have. Before I go into detail and discuss what you should be doing, let us quickly point out a few things that you definitely should be trying to avoid.
By knowing what not to do, it will be easier for you to focus on the important aspects when creating your pitch and when presenting your company, because you have already cleared your head a little. This is not an exhaustive list, but if you at least manage the following aspects initially, you are one step ahead. Rigorously, stay away from:
- Excessive use of spread sheets
- Get lost in endless technology details
- Unspecific sales proposition or user benefits
- Generalist strategy and target market
- Simplified sales forecasts and customer focus
- Lack of specific assumptions and execution plan
- Non-existent team members and advisers
- Lack of enthusiasm, interest and conviction
Be genuine if you talk about your business or nobody will consider you a serious partner, but also have an appropriate sense of humour. Do not oversell yourself, but be also not afraid of speaking out. In addition, and be honest with yourself about this:
- Never let mediocre people present your company or negotiate on behalf of it
- Never focus only on products and your technology
- Never ignore potential competitors’ reactions to your business and products
Now that I have quickly covered a number of things that you should avoid at all cost, let us look at the ground rules for presenting your business to potential customers, suppliers, strategic partners and investors. You should revisit these rules frequently or even better, set them in stone as part of your business philosophy. Let’s move on, you first need to write a good business plan and put together your other pitch materials.
It will help you to have realistic expectations already at an early stage. Do not always assume the worst about potential strategic contacts and investors, but at least assume that they:
- Are not necessarily interested in investing in your business
- Have little time for your idea and get tired quickly
- Cannot understand all technology or product details
- Have no desire to solve your problems
With this in mind, here are a few things you should make sure to focus on:
- Actively raise curiosity and interest
- Allow people to reserve time for questions
- Clearly explain your business terms
- Address weaknesses to build trust
Avoid making mistakes many others have made before you. There is plenty of material being published on paper and online that can help you to better understand the issues. Dig around a little, especially for failure accounts. Look at investors’ websites, read about the good investors, even if they are abroad. Learn what makes a good investor for your own needs. Be realistic about your expectations, be positive with a clear understanding of the real issues, and communicate these.
A few things to consider are typical characteristics that successful venture capital funded start-ups have shown. A non-exclusive list of these include:
- Clarity of vision or purpose in one sentence
- Addressing a large market, especially those market set for fast growth
- Customers that are liquid and willing to spend
- One specific solution that is of utmost importance to customers,
- Challenging conventional wisdom with new ways of solving problems
- A great and smart team with high expertise
- Agility and speed in competition against large companies.
- Profit maximisation and mission critical spending only
If you can, start your business with only a little money as it will install discipline and focus, while reducing risk. A large market with customers waiting for your product can provide revenues quickly.
Step 5: Business Plan
Your business plan will have to reflect the situation you are in. In fact, if you have money or can bootstrap, you might not need a business plan at all, though it will help you to focus and evaluate progress. Since we are here focusing on raising venture capital, however, your business plan becomes highly important and you better make sure you’ve done your homework and understand first whom you are going to approach and what they are currently seeking in an investment. There are actually quite a few venture capitalists, including some of the old Silicon Valley firms, that have their own business plan structures or outlines on their website, check them out.
Overall, there is a lot of literature available that explains how to write a business plan. Read two of three of the guides that seem reliable and applicable to your situation in order to establish the best aspects of each guide. Avoid the useless things you can find en mass on the internet, be selective and critical. In short, be smart about it. Overall, the length of your business plan depends on your individual circumstances, naturally. I recommend keeping it between 20 and 40 pages maximum for a technology based business; however, make sure it is long enough to cover your business effectively and short enough to keep the reader interested.
There is, of course, no exact limit to page numbers, but be realistic, raising €5 million to fund sophisticated research and development might need more than 40 pages with appendices, but raising €250,000 to extend marketing for an existing product can be done on 15 pages or less. Be short. If investors are interested they will ask for additional information.
There is not one right version but many and you can take different suggestions into account to get to the perfect solution for yourself and your potential investors. Here are some key elements that are of importance when addressing investors:
- Executive summary: Start with the company’s purpose in one clear sentence. Outline key features of the business plan; make your business and the investment opportunity understood quickly and easily, list basic facts and financials (2 pages)
- The problem: Describe the pain or need of your customers (or the end-beneficiary of your product and service) and the urgency of it. How does the customer addresses the issue today and in what way is your solution solving the problem and why will the customer buy it today (2-4 pages)
- Solution and products: What are your products and services that solve the problem you address? Outline current and new products and services offered. Name the user benefits, the customer value and summarize your unique selling propositions. Do you have use cases? Detail the development status of your products and services, and their PR status, their patents, general intellectual property and proprietary know-how (2-4 pages)
- Market and competition: Illustrate market characteristics, size and growth, total market size, served market sized and your expected share of that. Explain specifics of your market segment and outline short-term as well as long-term market developments. Introduce competition and your positioning against it (2-4 pages)
- Marketing strategy: Clarify your current marketing and sales strategy, marketing instruments used and strategic pricing issues. Name existing distribution channels, relevant partnership issues and sales methods. Outline your forward looking marketing plan, including sales forecasts (2-4 pages)
- Business organisation: Introduce your current system and the needs for management and expertise. Describe the main assets (including production), your purchasing and outsourcing issues as well as sourcing partnership issues. Provide an implementation schedule and roll-out plan of the proposed operations and give staffing requirements (2-4 pages)
- Assumptions and risks: Disclose your key assumptions in the business plan. Make a SWOT analysis of strengths versus weaknesses and opportunities versus threats (2-4 pages)
- Management team: Introduce skills and experience relevant to the proposal in summary and attach full CVs in the appendices (2-4 pages)
- Financial plan: Disclose the financial history if available and give financial projections for the next 3-5 years, including break-even and cash flow calculations, pro-forma balance sheets and profit and loss statements as well as any additional financing requirements (2-4 pages)
- Appendices: CVs of management team/key individuals & financial statements
Writing a business plan is difficult and requires creativity and inspiration, but also perseverance and constant refining. Do not underestimate its importance; be explicit about your plans, assess all aspects of your project equally and, for your own and the investor’s sake, generate an initial but realistic estimate of the amount of capital your business needs.
Too often I have seen entrepreneurs assuming the business plan as an occasion to impress with technical expertise, mistaking investors for like-minded enthusiasts for their idea, and expanding on an unnecessary number of details. Alternatively, some entrepreneurs believe a business plan to be an impassive formality addressing solely potential benefits of investors. It is neither one nor the other, but your basic concept of how you think you can make your vision happen, with whom, with how much money and in what time frame and circumstances.
However, many start-ups have received venture capital on the basis of a mediocre or even no business plan. Investors can see through the plan itself and spot an excellent opportunity and the right people that will make it happen. But beware, many also have received money despite mediocre founders, management, products and business plans. After all, venture capital is an imperfect market with huge information gaps; many decisions are taken by venture capitalists based on subjective opinions based on past experience and knowledge of current developments.
Before writing you plan, first sit down and try to understand how a venture capitalist will read it. Then structure your thoughts. Don’t be condescending or apprehensive, be convincing instead. Assume that they are smart, usually that is the case. Venture capitalists are interested in making money by financing the growth of successful companies that can be sold for a multiple of their investment. Show them that your company is what they want, how your technology works, the future of your products, realistically expected profits and that you are the person to get what it takes.
Content is one thing, style and design another. Make the business plan readable and avoid jargon and common position statements. If you deal with international venture capitalists, use plain English. You might be all right using your local language for a local investor though. Write for non-specialists, underlying the financial viability of your business, and move the detail into appendices. A good way to see if your writing is any good, ask someone outside the company to check it for clarity and flow – but remember that the final readers will be potential investors.
Use graphs and charts to illustrate and simplify complex information and use titles and sub-titles to divide different subject matters – this makes your plan easier to read. Ensure it is neatly printed of clean and good paper, but avoid extravagance. Please, do avoid spelling, typing or grammar mistakes – these will influence your success negatively. But also know that the business plan is in the end only a tool.
Step 6: Executive Summary
With a business plan at hand, you got much of your preparations done. Unfortunately though, it remains a long document for making a first or second impression. You therefore need to develop a few more support tools, the presentation or slide deck and the executive summary ranking right on top. Depending on the circumstance you might present your business either to an audience that has already read the business plan, or – more likely – to an audience that has not read it in detail or not at all. In fact, you executive summary will likely be the first information you pass on and read. In all likelihoods you had already difficulties to restrict yourself to 20 to 40 pages in your business plan, so it will be a challenge to restrict yourself further.
Once you have a good business plan, you should also have an executive summary. This is unfortunately not always true. Because you are likely to start with a sketch of your idea from which you build your business plan, you have an executive summary before you have your business plan and you start working from that. However, once you have finished your business plan and/or put together the presentation, you should revisit your executive summary as you had it in mind before writing the business plan. There will be quite a few changes you will have made while working in more detail on the plan. It is critical that all of these (the significant ones) are reflected in you executive summary. But not only this.
Improve the summary where you can, make it an interesting and informative two pages. Write and present figures or graphs in a way that creates interest from potential investor, while covering all major aspects discussed in your business plan. Restrict yourself and impart information wisely, clearly and to the point. The reader should be excited to ask for more information, but have a good idea of your business, its opportunities and its needs. Indeed, let us rephrase this slightly. Your executive summary is not going to inform (even though it will be informative), but it is going to sell. Your business, in fact! If you cannot understand this, you will not be able to write a good executive summary. Back and try understand potential investors; some cannot be any clearer and more open about what they expect than what is on their websites. Answer their needs.
Now, once you have done this, feel free to create different versions of your executive summary, specifically focused on different investors (business angels vs. venture capitalists or corporate venture departments, banks, customers etc.). Just make sure you never mix them up. Once you are happy with the changes, the new executive summary should be placed at the beginning of your business plan, but make also a representative stand-alone copy that you can hand out to potential investors. They will ask you for it after you delivered a compelling elevator pitch or at any other suitable or unsuitable time.
Whenever you can, have a printout of your stand-alone version of the executive summary with you, at least when you know you might be in the vicinity of a potential investor. Keep it in mint conditions and up to date. The executive summary, though a short paper only, is really one of the keys to any investor’s interest. If first you as a person and character have interested him, and then the idea and vision you outlined, the executive summary will be the essential step in convincing him to invite you back to invest and talk in more detail. Make it stick.
Step 7: Slideshow
You may at some point be asked to visit an investor and give a presentation of your business within a short time window that also needs to allow for questions and answers. Your presentation therefore should not be any longer than 15 slides – and quite frankly, ten is a very good number. Use a large font size in order to restrict yourself to the key message – and avoid too many bullet points.
Guy Kawasaki of Garage Ventures in the USA openly suggests to present ten slides in 20 minutes using font size 30, while Fred Wilson of Union Square Ventures, also in the USA, suggests to keep the deck to only six slides. This is not bad advise, but it is how they would like to see a presentation. In the end it is about your audience of the day (make sure you know it well) and about yourself and with what you feel comfortable. Find the best way for you to feel happy while serving your audience and their needs. And do not forget, nobody invests in a presentation. It is the people that will bring an idea to live and that are the best team to make it happen that will receive the money.
Overall, your presentation should follow the structure of the business plan, but you should use this opportunity to really focus on the baseline. The structure below is a possible outline, your own business might need some adjustments, but always keep in mind not to present what you like, but what your audience of the day wants to hear:
- Summary (1 slide)
- The problem statement (1 slide)
- Products and market (1-2 slides)
- Competition and risks (1-2 slides)
- Strategy and business model (1-2 slides)
- Financial needs (1-2 slides)
- Management Team (1 slides)
- Contact details (1 slide)
Make it visually appealing. Use your logo and your company’s colours, lightly. Make sure each slide contains your company name and contacts as well as the date of the presentation, in the footer for example, in case you are asked to print it out and distribute it. Use bullet points rather than whole paragraphs of text, leave excel spread sheets out. Your presentation should be clean and the viewer should be able to understand each slide at the first glance. Pictures can often convey a message faster and better than a slide full of text, but do not overload the presentation and keep the pictures absolutely relevant. Once you have prepared a presentation, you need to work on the verbal presentation. The execution of your presentation needs to be:
- Critical information only
When presenting, be yourself. Sometimes there might be a member of the management team that is naturally a better presenter, let this person give the presentation. Even the most sophisticated venture capitalists are only human, the first impression is very important. Don’t forget, an investor’s decision to give you money is only partly based on the technology, but also on the business strategy. However, maybe even more important are the people that will manage the business. While the business strategy can be adjusted, the team can only be replaced with difficulty. So, a great idea with unenthusiastic and unconvincing management will not attract funding. Make sure you always keep the presentation focused on this.
Step 8: Pitching
First impressions are very important and venture capital is very much a people business. One way of mixing a good first impression with the delivery of key sales arguments is the elevator pitch. The American idea of pitching to somebody the length of an elevator ride (they are much shorter in Europe), stands for a very brief, ‘verbal’ introduction of your business or vision. Imagine it to be delivered to an investor you have been introduced to, by chance, in an elevator on the way down to the ground floor. You have only very little time to outline exactly those things that will stick in the other person’s mind and make him or her call you. It is very important that you do not move away from the topic or that you elaborate on one individual aspect too much. Do not forget, you might only have as little as 20 or 30 seconds, so make sure you have a short and snappy pitch. However, in reality you might have a little more time, so have enough structured thoughts to fill the pitch to one or two minutes, if needed. Pitching can be prepared, but it is a lot about improvisation, too.
Prepare your pitch once you have finished your presentation, you will already be familiar with the content of your business plan and you will have practised verbalising it. Start by writing down in five or so bullet points what you want to say. Learn your core arguments by heart, but speaking should come naturally to you. Don’t forget, the pitch contains a few core aspects, somewhat in this order:
- The opportunity and market problem
- The value proposition and the solution
- The differentiating factors from competition
- The milestones and the (financial) requirements for success
- You and your contact details (always have a business card handy)
It sounds easy, but you will have to work hard on the execution, again and again. Simply for one reason, first impressions do not break a deal, but a good first impression will raise strong interest and curiosity. It can elevate your executive summary or business plan towards the top the large pile of business plans that investors receive from all kinds of entrepreneurs. Investors may receive hundreds of business plans a year, many more telephone calls and a huge number of emails, executive summaries and face-to-face pitches.
To differentiate your pitch you have three key selling points:
The content I trust you have been working on for some time now (or maybe you want to go through it again every once in a while in order to keep yourself abreast of your sales arguments), but the presentation needs to be there too. And not just in a scheduled meeting. Not even only in the elevator, possibly taking you down from the investors’ office to street level where you want to catch a taxi. No, you need to deliver and convince in every possible and unforeseen situation, while sounding natural and at ease. Imagine some unlikely but resonable situations and prepare your pitch for these – do not be shy, practise. To make it easy on yourself, that is to be able to react quickly to an opportunity, your pitch should be, at all times both memorable and believable at the same time and:
- Clear in enunciation
- Concise in content
- Passionately delivered
In general, the first five seconds of your elevator pitch are crucial. If you fail to deliver those, the remaining 20 or so won’t matter too much neither. Be prepared to pitch in less comfortable surroundings than an elevator. And if you don’t believe it, the fact that Chris O’Leary wrote a whole book called Elevator Pitch Essentials about pitching in different situations should give you an idea of how many people struggle with it.
There are hundreds or more websites, blogs, videos (check for good and bad examples) and books delivering tips on pitching. To deliver your pitch you must analyse your own situation, understand your opponent and his needs, and adjust as you go along by improvising and using a little magic. Your personal mood will also impact your success, so you might want to keep happy thoughts on the front of your mind when you are about to pitch. For example, just nodding your head a little while practising might associate a positive attitude in your delivery of the pitch – it can also reaffirm your message to a listener.
By the way, there are hard factors and soft factors that you can sell in your pitch. Personal sacrifices in order to grow your business can be a sales argument. Investors like to see that the entrepreneur is ready to cross his own comfort zone in order to achieve success. It may sounds like a parody saying you ”started in your garage”, but shows the will to succeed and your believe in your own idea. I am not suggesting to use that exact sentence, but extremely high commitment to your idea is a key selling point to the investor. Consider starting with limited resources, it will force you into discipline and focus. An entrepreneur committed to his idea and with a healthy appetite to assume personal risk, showcases a can do it attitude by starting a venture even if there is no funding in sight yet.
Attitude and actions can be highly convincing. If you do not genuinely stand behind your business idea, or just want to make big bucks, you might find it harder to get a value adding investor to back your venture. Make sure you can convey all relevant soft factors while pitching, too. Experienced investors will see through you, sooner or later, if you are not genuine.
Step 9: Closing In
Once you have all your prep work done, you will feel confident to capture the world and to bring on disruptive change to your industry. You will feel like a winner. Of course, with your highly convincing elevator pitch you will surely raise ample interest from venture capitalists; you are certain to hand out your business cards and executive summaries en mass; you will receive numerous invitations to portray your business plan and look forward to giving several cutting edge presentations to investors, to whom you will also bestow your pristine business plan for further evaluation.
It is at this stage that you will have to prepare for the fall. Chances are high that your proposal will be rejected; you will have to make so much more of an effort to raise interest than you expected that your enthusiasm and self-believe may start to falter. Even if your business plan is a well-conceived and sound concept and your business is led by a committed and competent management team, in reality, a venture capitalist will not invest in your business unless the expected financial return is in line with the risk and return profile the investor is seeking at that point in time.
The acceptance of a business plan is a very selective process for an investor. On average, you can assume that less than 5% of all business plans received by investors get funded, if not less. This also depends on the economic situation, of course. The best business presentation therefore does not guarantee you an investment. To engage an investor takes for most of us a lot of commitment, hard work and persistence. There are venture capitalists out there that will fit your criteria, try them. Most are listed on the directories of their national trade associations.
A good way of approaching venture capitalists is to select just a few funds initially. Your main considerations should be to assess:
- Geographical location of your business and the investor
- Development stage of your business
- Investment type required or preferred
- Your industry sector and specific know-how
- Amount you intend to raise at this stage
- Feedback from their portfolio companies, if and where possible
You should focus on those venture capitalists whose investment preferences match these features. Do your homework, work your network. Get as much input from intermediaries as possible (i.e. lawyers are a good source of information on venture capital funds). But do not be shy to revisit someone a year later, their investment preference might have changed or your business might benefit from recent market trends.
Before you approach venture capitalists make sure that your business uses its existing resources adequately, that you have good cash flow forecasting systems, that you give customers incentives to encourage quick payment and that you have ample credit control procedures. The bottom line is the first are of interest that an investor will scrutinise. Make sure that you carefully plan payments to suppliers, that you maximise sales revenues (if you have any), that you control overheads and consider sub-contracting to reduce capital requirements if this is appropriate for your business. These are points any potential investor will be very interested in, as they are in production and inventory levels, quality control, key performance indicators, targets and execution plans.
The process of approaching venture capitalists is long, very hard and resource intensive. You will have to spent significant time on this, and during your fund raising it will be your main occupation. There are first-hand accounts on the web which you should read up on, use the internet for some initial insights. But be aware that every single business, investor and CEO are different and produce different reactions and results in similar situations.
At some point you should be lucky and your proposal will fit a venture capitalist’s criteria and his risk and return profile. Be sure though, to have a plan B that gives you enough cash to pull your business up by its own bootstraps if you should not get venture funding in good time. Many good business ideas are developed into business without venture capital.
Here is a short, non-exhaustive check list to compare your business against. Is your business
- Based on a clear and simple purpose and value proposition?
- Addressing large markets likely to experience extraordinary growth?
- Focusing on cash rich customers who will pay a premium for your very unique offering, and very early on?
- Offering convincing and important solutions to your customers’ problem, does it kill the pains of your customers?
- Focusing its resources on what is critical and thus invests on its priorities and on maximum profitability?
When you have the interest of a venture capitalist, pitched your vision to the investment board, your funding business seriously begins. The prospective investors will move on to perform due diligence. In many cases the investor will sent you a letter of intent or a term sheet, which will outline broadly how a potential investment should be structured. This is usually not legally binding to either party, but it demonstrates the investor’s interest in your business plan and that an investment is considered. You are strongly advised to involve your experienced legal and financial advisers as of this stage at the very latest.
Step 10: Due Diligence
Once you have received an offer letter or term sheet from a venture capitalist, you have taken the first real hurdle. The investor is interested in you, your team and your vision for your business within its market. The offer letter is non-binding, but a very reliable indication that the venture capitalist is going to commit to your business if a more detailed analysis, also called due diligence, of your business supports the initial view. You have left the era of slide shows and first impressions. The interest of the venture capitalist is based on the fund’s investment focus as well as on market trends and economic situation. The due diligence process will last usually somewhere between two and six months, though negotiations might take up to 12 months and more depending on complexity, size and other circumstances.
The due diligence will typically involve a set of basic reviews that help characterise your business. These will most certainly always involve:
- Evaluation of the management team
- Audit of the financial accounts
- Evaluation of the technology
- Analysis of the intellectual property rights
- Evaluating existing customers’ recommendations
Depending on the venture capitalist, some parts of the due diligence might be performed by third parties, such as accountants, intellectual property lawyers, industry specialists and human resource councils. Do not be afraid of this process, on the opposite, it will help you to discover weak spots you were not aware of before and how to handle them. The due diligence assesses if your business is ready to take the proposed investment that includes the identification of problem areas so as to deal with them following the potential investment. Do not try to hide these, but be open and seek solutions that will enable you to grow your business with the support of the investor. Even if in the worst case you do not receive funding, you will have learned a lot.
As already mentioned earlier, the founder and team are of the essence. The evaluation of the management team is therefore extremely important for you. It is also a very subjective part of the due diligence. Some objective assessment will be done, but much is based on the overall feeling of the venture capitalist about you. Especially where no third party is involved this is the case. Be open and yourself, do not try to hide or to over-share aspects or your personality or past success and failure.
The audit of the financial accounts will be done by the investor, his internal analyst or a third party. Focus is on your financial situation and the processes in place that will safeguard the investment. If you have set up your business with a professional accountant, this should not be a problem, unless your revenue predictions do not tally with the assessment of the investor. For start-ups with no accounting history, focus is on the strength of your financial forecast and processes that have been put into place.
Depending on your business the evaluation of your technology also is a key aspect, as the technology is one of the few assets that your business can offer as a security or as it will give your business a reasonable first mover advantage. However, even if you do operate using licensed or open source technology, the longevity, your access rights to it, your capability to support adjustments and the overall stability of the technology are important.
The analysis of the intellectual property rights is not only looking for patented technology. Though in some cases this is a very important step to have done, in others it is smarter to keep the technology proprietary and all details undisclosed. Either way, your intellectual property needs to be protected, for as long as possible or necessary, and understood.
The evaluation of existing customers’ recommendations is an important step when assessing the overall offering of your business. Since most venture capitalist will not invest in a business that has not reached at least prototype stage, there will be opinions of existing or potential customers about your product offering. These will be used to verify your business plan forecast and to ensure that the market potential is reachable.
Apart from what the due diligence can do for your own understanding of your business – and, of course, for the potential investor – this is also the time where you should make your own inquiries about the venture capitalist. Quite a few things can be found in the relevant industry media, see for example the relevant trade publications, which you should research. There are many good blogs out there, too, maybe even by the venture capitalist you are researching.
Find out as much as you can. How do their portfolio companies speak about them? What are former portfolio companies saying, they might be more open to speak? Are they a member of trade associations or do their peers have anything to say worthwhile? How many funds has the investor previously raised and invested? What were the returns of the previous funds? How many companies have been written of or have gone bankrupt after receiving capital and why? Who are the investors behind the venture capitalist?
Why should you go through all that trouble? After all, you just want to receive that check and get on with your business. Well, any investment from a venture capitalist is a long-term project. They will be involved with you for better or worse over the next two to seven years. Make sure you can see them spending a Sunday afternoon discussion your balance sheet and profit loss accounts in your kitchen, or several Sundays if necessary. Since they are likely to be actively involved in some of the aspects of your business and might spend considerable time at your offices, you need to get on with them on a personal level.
With the right timing you might want to have a go and invite them to play golf with you – or whatever shared interest you might have. Use the time the venture capitalist is willing to spend on you and get as much information and good feelings about him or her as you can. And only then, when you feel you have found the right investor, agree to an investment if you are happy with the terms and amount, the support and the network they offer you.
Be careful, once they own a large share of your company you have to live with them. So be very clear about your own personality first. Are you married? Can you hold long term relationships with other people, can you take criticism? Are you committed and able to forgive? Can you change your own opinion or act against them? Think again, seven years can be a very long time. There are good investors and bad ones and those that combine all possible characteristics in one. Investors might be great people, but bad supporters for your business, or great supporters for your business, but sport unbearable characters. There are also those that probably should be not allowed to invest all. Chances are, you will meet a large variety of investor types.
Step 11: Aligning Interest
The due diligence represents a significant investment of time and money for both you and the venture capitalist. It can therefore happen that a potential investor will ask for a binding agreement, in place of the offer letter, about how the investment will be structured if the results of the due diligence are satisfactory for both parties. If you should receive such offer, you should ensure that you do not carry the whole risk of this agreement, for example the cost of a cancellation of the negotiations – you can also introduce a clause that allows you to solicit further investment proposals that might offer you a better value. Do not go with the first offer just because it is the first. Make sure you have played your cards correctly in order to get the best option for your business.
While you might have found a great firm with a known name and outstanding track record, with great partners that you feel comfortable with in the office, on the tennis court and in negotiations, please make sure that you never forget that your basic goals are different from theirs. Even though you might talk the same language and share the same views even on your business at this time. Your interest might be in growing your business, making a certain amount of money or making a dent into the universe. Whatever they are, the venture capitalist’s interest can fairly accurately be calculated and timed in a spread sheet – and you should be very much aware of them, because they are what will determine your business’ future to a significant degree.
If both parties are happy with the results of the due diligence, you are ready to take the next step. You will need to describe in detail how the investment will be structured and how the collaboration between your business and the venture capitalist will be arranged. If you have signed an offer letter or term sheet in advance of the due diligence, the deal structure should follow the details outlined there. Again, make sure it represents your own long-term interests. The agreement needs to cover four main areas:
- Structure of the investment
- Agreed value of the business
- Managing the company
- The exit
At this point at the very latest you are advised to involve your lawyer, ideally someone who knows your business and is experienced in venture capital deal structuring. You should consider keeping the legal advisers involved even after the transaction has been concluded, as dealing with professional investors frequently has legal implications and relevant advice is likely to be an on-going concern. The investor might offer you contacts here, which can be a good choice; but make sure they act independent from the investor.
Initially you and the venture capitalist will be drafting the outline of the investment agreement, if this has not been done in an offer letter, letter of intent, term sheet or memorandum of understanding. Those they are not legally binding, but they are the basis of a full set of legal documents that will be drawn up later, such as the shareholder’s agreement and the subscription agreement.
If the amount of funding that you are seeking is particularly large, or if the investment is considered to be a high risk to your future investor, the venture capitalist may ask to syndicate the deal with another venture capitalist, i.e. share the investment capital. This is of benefit to the investor, it limits his risk in the investment, but it can also have advantages for you, such as:
- The influence of one single venture capitalist on your business is being diluted
- It gives you the combined business experience of several investors
- It allows for a larger investment
- You gain potential access to sources of future financing
Make sure that the investors’ downside protection does not unnecessary harm your business and that the upside sought does not involve a premature sale due to the investors time limitations or risk-return preferences. Your drivers should be to obtain sufficient capital to finance the company’s projected growth. Only if each party’s objectives and interests are understood and aligned and only if all other aspects in your relationship with the venture capitalist are positive, you should go ahead.
Unfortunately, in practise many entrepreneurs – and venture capitalists, for that matter – ignore misaligned interests if the potential success of the investment (because of stellar return expectation) is too big and too near. If you dig deep enough, you will find a large number of investments that have turned bad, for both the entrepreneur and the investor, because of discrepancies in expectations. Venture capital is an illiquid investment form in which positions are only sold at difficulties. If differences cannot be resolved or positions in the business be sold, the investor might withdraw active support and future capital or, if legally possible, remove the entrepreneur. Either case is difficult for the business.
Step 12: Deal Structure
Both, you and the venture capitalist should aim to achieve an investment, which is structured to satisfy each other’s objectives. Luckily there are a variety of financial and legal instruments at disposal that should ensure that all needs of your particular investment can be answered. Most venture capitalists offer a mix of the following three investment forms:
The three options differ basically in the amount of risk the investor is willing to take and how much security you need to give. Very common are mixed structures that limit the risk of the investor, but give him the possibility to make the most of a potential success. The details of each investment depend on the investor as well as on your negotiations. Your experienced professional advisers will be able to help you come to an agreement and to understand the investor’s needs.
Equity is the riskiest form of funding since its value depends on your company’s success. If you fail to build your business, the investor loses his capital. However, if you are successful, he profits from the success of your company. All equity shareholders, including you, receive the value of all assets minus the companies liabilities in the case of a sale. Investors prefer not only the possible high returns, some equity shares also bring voting rights, which means they has control over you and your management.
At a minimum, you should know the difference between ordinary shares and preferred ordinary shares. Ordinary shares have voting rights and are receiving all income and capital after your creditors have been satisfied. Such ordinary shares are usually given to yourself, the management, family and other non-professional investors. However, many investors like preferred ordinary shares, which rank ahead of ordinary shares when it comes to both income and capital distribution. Make sure you understand the differences in shares offered when it comes to agreeing on the deal structure and the consequences it can have on your business.
Quasi-equity is a special form of debt. It usually comes as convertible loans (generally to be repaid if things go bad or to be converted into equity at a previously agreed price at the exit) or as convertible preferred shares (shares with preference rights, i.e. in liquidation or a dividend distribution). You are likely to be offered a mix of equity and quasi-equity to the extent that the investor would like to give as little money as possible in equity for as many voting rights and preferred-ordinary shares as possible. Quasi-equity enables him to secure much of the investment with a repayment preference, while in the best case it can still be linked to the performance related returns of equity.
Straightforward debt, on the other hand, is not always offered directly by venture capital funds. Those that do not offer pure debt might, however, be able to provide debt financing through third parties such as banks or debt only funds. Of the three investment forms summarised here, it has the lowest risk, especially if it is secured against your company’s assets (unless that is your family home). Debt is repaid at face value plus interest, but debt holders do not share any of the profits your company sets out to achieve. They also do not have voting rights or control over your management of the company. Its advantage is simple; debt is to be repaid before equity shares are repaid. Therefore, if your company is not going too well, and your sales price only covers you business’s liabilities, debt will be repaid while equity owners will not receive capital.
Most businesses will receive more than one round of investments. The result of any new round of financing is that shares issued to new investors can dilute the percentage of shares owned existing investors, if they are not willing to participate in a second investment. To prevent this anti-dilution rules can be put in place to protect management and early investors. If you are likely to have more than one investment round, take this into account when agreeing on the investment structure the first time around, you might perhaps need to keep some capital aside for the second and third round of investment.
The precise percentage of shares in your company issued to new investors depends on the agreed value of the company. This is obviously subject to change. In order to capture your business’s value, venture capitalists will use what they call pre-money and post-money valuations. The former refers to the value of the company before the new investment, while latter refers to its value after the investment. Quite simply, the post-money value is the same than the pre-money value plus the amount of the new equity investment.
Step 13: Valuation
One of the most difficult things during deal negotiations is often to find the appropriate valuation for a company. It is not an easy exercise and not (only) based on negotiation. There are techniques and models that the venture capitalist will use to generate a valuation of your business, based on fairly objective procedures. If you have no or limited experience with this, ask your financial advisor. Widely accepted terms of the underlying processes are published free of charge in the International Private Equity and Venture Capital Valuation Guidelines, which are endorsed by many industry associations world wide. They are guidelines only, written with the investor in mind though, and leave a lot of room for interpretation.
Experienced venture capitalists – and be careful, not all are experienced – will generally use a couple of models that they deem appropriate for your business. They will generate a range of values based on different approaches. Those techniques may range from a plain comparison with similar businesses to a sophisticated financial analysis of the status and nature of your firm. Valuations might occur frequently, they certainly will happen at the time of every investment and at the time the venture capitalist sells his equity share.
With start-ups it is normal that cash flows are not available at the time of investment. This accommodates a distinct risk of failure exists for the business and its investors. Valuations of start-ups can include a lot of guesswork, assumptions and hope. To circumnavigate the lack of data, venture capitalists frequently use a valuation method based on the discounted cash flow. In this approach, the free cash flow of your business is assumed to be the same than the net increase in cash generated by its operations, minus any investment that might happen during the period. This gives some indication of the financial value created by your company for its shareholders, of course, after the repayment of long-term debts. You might value your business more according to the extraordinary market potential multiplied by the profit margin you product will achieve. Though this certainly will be part of the final valuation, it the very rarest cases it is the dominant factor.
However, the selection of appropriate ratios for a comparison of company values is open to subjective interpretation, and you should be cautious about taking any valuation as the right one. For example, the price/earning ratio can also be used for a company valuation. It is a multiple of profits after tax specified for your business in order to establish its capital value. You can find public price/earning ratios for quoted companies on the internet or the financial press. These are calculated by dividing the current share price of traded companies by historic post-tax earnings per share. But start-up companies will not be valued the same as traded companies and you will only find such rations for traded companies. Therefore, they are nothing but an indicator.
To produce a reasonable and acceptable valuation of your business is a key aspect of a successful investment. Unless you are extremely tight for cash, you should not be prepared to sell a stake in your business for an amount below a realistic valuation; this would in all likelihood not provide enough capital for the growth of your business and subsequently following investments would dilute your share in the business. On the other hand, if the valuation is set too high, it will be difficult to generate a satisfactory return for the venture capitalist. An adequate valuation is therefore also in the interest of the investors. In fact, the valuation is a key part of the investment decision, because it is the difference from the valuation at investment to the valuation at the exit, what will create the majority of the profits for the venture capitalist. And if they can see that, they are, of course, more likely to take an active role in the strategic leadership of your business.
Once yourself and the venture capitalist agree on the terms of the investment, the lawyers will draw up the legally binding completion documents. As mentioned earlier, you should ensure that you take legal and financial advice and have a firm grasp of all the legalities and financial details within the documents. The cost of professional advice will usually be assumed by your business, while the investor will usually increase the financing to allow for these costs be covered. This is money well spent; even the best lawyer might not be able to secure your interest at all times and you can be assured that without legal advise you will most likely secure none of your interests.
The investor’s involvement will usually also include a seat on the board of directors. Details are defined in the shareholder’s agreement, which typically will provide venture capitalists with both seats on the board and veto rights on important decisions. If you have done your due diligence on the venture capitalist, you will see this as a benefit, rather than as an additional constraint. Therefore, ensure that the experience a particular investor brings to your business is the know-how it needs. Many venture capitalists focusing on start-up businesses provide a lot of strategic assistance to help their portfolio companies to grow. It they want to stress this involvement, they will call themselves a hands-on investor, but in reality all start-up investors should be able to offer this.
Step 14: Investor
A venture capitalist normally will not interfere in the operational functions of your business, assuming that business strategy is executed properly. Only under special circumstances you should expect him to take on some work of your management. But, while operational functions are left to your management, a good and experienced venture capitalist should have an extensive network of national and international contacts that is useful to your business. The value added that the investor can bring to your business apart from capital should indeed be a main driver of your choice of investor. A hands-on investor though would probably like to be more involved and you should grant and appreciate this. In general, the following areas are those you should expect a venture capitalist to bring help to your business:
- Planning potential future investments. In most cases your business will need more than one round of funding (or the venture capitalist will not risk giving you all the money you need it one go) and raising capital is for most businesses not that easy. However, if you business is doing al-right or better, the venture capitalist has a vested interest in continuing growing you business in order to maximise his potential financial returns. In this case he will be working his contacts to ensure you get good support and he will make sure that your key performance indicators are right on target.
- Recruitment of senior management. In due course you will need to hire additional management, either to replace a leaver or to expand your team. A venture capitalist should not only be able to identify relevant candidates through his network, he also should have relevant experience in vetting other candidates. For senior positions you will be able to draw on the investors time, as these positions will be vital for the performance of your business.
- Reporting & management information systems. These will include finance, operations, sales and more. Managing a start-up is very hard work and your focus will and should be directed at the core of the business. However, clear structures and processes, supported by relevant systems, can help you free up time and resources. Your investor should be able to help you find the and integrate the best ones. It is in his favour too, as you will be able to provide him with better management information faster.
- Supporting on strategic and, in crisis situations, on operational level. The venture capitalist will in all likelihood have a board seat, or he will ask a trustworthy and experienced third party to take his place. He should support you in all strategic matters and decisions, provide leads and linkages to relevant partners. He should trust your operational management and rely on the information you deliver. However, in case you need support on that level (or he has reason to mistrust you), expect him to take a firmer stance and to join you in the office more often. In some cases venture capitalists will work very closely operationally right at the beginning with you anyhow, or at key junctions that your business is taking. Though he has his own agenda when doing so, the help can be highly valuable.
- Selling (their equity stake in) your firm. The one thing the venture capitalist will not forget, though he might not openly show it, is that he only invested into your business to sell it. At this level you can rest assured he will provide you very active help, in some cases even when you do not seek it. In a healthy relationship this help will be productive and – though also loaded with work – usually rewarding. The investor will not only be able to help identify potential buyers, he will also identify the right timing (based on his own preferences, though) and a strategy to maximise the sales price. The latter two aspects can get out of proportions, and a large number of venture capital backed businesses has been sold at the wrong time for a too high price – thus created expectations for the buyers which could not be fulfilled. On the stock market such investments have been known as living dead, never recovering from over-valuation at the initial public offering with the stock traded at levels lower than the issue price. In trade sales such investments will be merged with existing operations or just scrapped completely. If money is your reward, you might not worry too much, if your business means more to you, you should.
Nearly everything the venture capitalist will be doing for your business is focused on planning the exit of his investment. This is an integral part of the initial decision to invest and you should be absolutely clear about the potential consequences for your business. If you do not want to sell your company, it is unlikely that a venture capitalist will consider investing in your business.
Even though the exit of the investment, that is when the venture capitalist sells his equity in your business, concludes the relationship between you and him, it is also the starting point of all negotiations. The venture capitalist will not invest unless he sees a clear exit opportunity. For example, your business might be attractive to a large corporation, saving them R&D expenditure or provide new market access. A change in market conditions may force the investor to consider an exit via different means, but in the end, all his strategies and all his interactions with you during the investment period are finally driven by the exit.
This does not necessarily mean that the investor lacks commitment to your business or that he is just a greedy money grabber – in fact, if he is, you should have found out during your due diligence. But the venture capitalist has a limited time horizon and potentially quite a different take on the future of your business than you might have – for him the investment is a way to increase his capital through a sale at a high multiple of the valuation at the time investment. If you are not comfortable with this fact, you should consider other forms of financing for the growth of your business. A good venture capitalist would tell you so right from the beginning.
Step 15: Exit
Managing the exit is where the venture capitalist’s experience and contacts really can make a difference. It is his bread and butter, after all. However, early stage investments might take up to seven years before they are ready for an exit that suits the return expectations of a venture capitalist and there are many things that can go wrong in this period. There are quite a few ways for an investor to sell his equity stake in your company; they all bring different requirements to you. Overall, the most common forms, depending on the economic situation are:
- Flotation on a public stock market (IPO)
The love child of the venture capitalist. A successful IPO (initial public offering) can generate high profits for the venture capitalist. They are, according to academic research, often overvalued and thus generate the most capital in comparison to other exit forms. An IPO generally enables entrepreneurs, employees holding stock options and venture capitalists to make significant returns. But alas, the appetite of stock market investors varies, and it is not always a good time to list a company on the public markets. At the same time the venture capitalist is under pressure to return his funds with a premium to his investors, subsequently he might act opportunistically and try list your company when the market seems right without considering the needs of your company. Though this does not happen every day, it has ruined a number of promising start-ups who after high valuations on the stock market saw their share price plummet and experienced long-term under-performance. In addition, this can also limit your personal return, as you and the venture capitalist usually will be subject to a lock-up period of several months after flotation for some of the shares in the company.
These issues are complex, if you feel that your business might be subject to this, you should study the interdependencies between private and public equity markets, especially the influence of capital overhang in the private markets, which depend on fund-raising, investment and exit cycles. There are a number of academic works published on this, but a good financial advisor should also be able to help you. However, a successful quotation on a stock market has several advantages for you business, including:
- Publicity and a heightened profile to investors and your customers
- Access to the more liquid public markets for future capital increases
- Your company’s publicly quoted stock can be used for acquisitions
- Stock options can be valuable incentives for employee ‘s commitment
But to successfully list your business on a public market it needs to have enough turnover and offer a unique future growth story to convince potential public investors. Unfortunately, future growth stories are not always related to the actual potential of a company, and you might be advised to consult an experienced PR firm that has helped to list other companies in order to leverage your position. You can list your business on regional, national or sector specialised stock markets, though your business might not fit all of them. Make sure that the one you choose offers your firm the best growth potential at the time of the exit – be alert, the venture capitalist might push for the stock market offering the highest valuation in order to maximise his short term returns. And, if you thought managing a start-up has pushed you to the edges of your possibilities, an IPO will test you even further.
- Selling the investment to another company (Trade sale)
This is for many companies the only exist route. If with your company an IPO is not possible, the venture capitalist will aim for a trade sale. Your business is then sold to another company, either one within the same industry sector seeking to expand its activities or know-how or one from a different industry sector hoping to diversify its activities. Smaller transactions are usually not subject to much regulation and are executed in private, but if your business has undergone significant growth and gained a dominating market position in a particular sector, you might have to deal with the competition authorities at national and, potentially, at European level. A trade sale is not a bad option, though the financial return is likely to be lower compared to an IPO.
There are many venture capitalists that indeed specialise on trade sales, especially in times of low stock market activity, and focus on companies in specific industries that have the potential to interest multinational conglomerates. Many of the large companies buy innovative and disruptive technologies this way, or the buy products and technologies that fit well into their existing portfolio. You can, together with your investor, already at the time of the investment agree on this exit route, and build your business in such way that is interesting for a potential industry buyer. This is a strategic decisions and European venture capitalists are very open to this approach.
If you decide early on to opt for a trade sale, you are also able to enter into strategic relationships with potential buyers early on. While this gives you a direct line to your potential buyer, it also carries significant risks. First, if you enter into strategic partnerships with company A, you might exclude any further dealings with companies B and C, as the are direct competitors to A. At the same time, company A use the partnership to make your business dependent on its collaboration. The first scenario will limit your options at the time of sale, the second option will reduce your valuation.
Do not underestimate the dangers, many larger companies exploit these aspects purposefully in order to acquire technologies cheap, or bind those that they do not want to buy through quasi exclusive partnerships to their business. There are many entrepreneurs that have gone down this route and made very bad experience. However, as with your dealings with venture capitalist, you need to be very careful here. You will have it easier to sell your business at a higher valuation to a trade buyer, if you have been able to stay independent.
- Secondary sale/repayment of preference shares/loans
Secondary sales are more frequent with established firms where the investment structure allows to make money through fees and leverage. However, it is an option for a strong business. If neither of the two options above is possible, for whatever reason, the venture capitalist might try to sell his equity stake in your business to another financial investor. While he will be able to sell his share in your business, you might get stuck with another venture capitalist for another few years. Luckily, such secondary transactions are quite rare for start-up businesses. The motives for a secondary sale might be that the risk/return profile of your business no longer matches the investor’s requirements or that he has to dispose investments towards the end of his fund’s lifespan. You will want to make sure that at the time of investment the fund still has enough time left to invest, for a start-up you might need five to seven years to reach a mature status in which a successful exit is possible.
A secondary transaction can come in two types, either the venture capitalist sells specifically the equity stake in your business to another investor or he sells his fund’s whole portfolio in one go to another investor. If the venture capitalist is selling his whole portfolio to another investor, it is likely that he was just not very good at what he was doing. You should have found this out during your due diligence. Secondary transactions usually are a result of market conditions or timing with regard to the lifespan of the venture capital fund.
- Write Off
Failure will determined by the investor, at times, even if your business has not gone bankrupt, but if there is no hope for the stellar growth that was anticipated at the time of investment and no possibility to sell it on elsewhere. This is, of course, only failure from the investors’ viewpoint – not necessarily from yours or anyone else’s. You might be able to regain the shares from the investor and to repay the investor yourself. You might be able to find bank financing to do so. This would bring the control of the business back into your hands in order to continue your business on a slower growth path.
The write off is the most undesirable exit for you as well as for the investors. This means bankruptcy. Both you and the investor would lose the equity capital. Obviously, this is not an exit route anyone will try to aim for, nevertheless it the case for a large number of venture backed companies – they are just not talked about.
I am the co-founder and Chairman / Executive Director of the European Crowdfunding Network and Executive Board member of CF50 Inc., the global Think Tank on crowdfunding. I also initiated the political discours on crowdfunding at EU level with A Framework for European Crowdfunding and I am a member of the European Crowdfunding Stakeholder Forum at the European Commission. I’m the co-founder of InnoStars and I work as a hands-on operational and strategic consultant on sustainable, innovative businesses and non-profits.
The past decade, I have worked with venture capital, microfinance, technology and social entrepreneurship in both commercial and non-profit settings in Europe and the USA.
A former journalist, I started my career in the early 1990s in the publishing and business information industries. I hold Masters degrees from Solvay Business School, Brussels, and from the University of Hamburg and studied at SEESS (UCL) in London. I believe in trust and respect mixed with a good sense of humour.