Before a company commences a fund raising effort, its management team and advisors should identify who the likely investors may be. Not all venture funds seek the same investment opportunities. Some focus on very early stage "seed" deals while others focus on later stage "mezzanine financings." Institutional investors also differ by the industries they target, the size of investments they prefer and the regions of the country on which they focus. Several databases and guides are available to assist a company in finding those funds most likely to have an interest in its offering.
Next, the entrepreneur needs to develop an understanding of what the identified venture capital funds are looking for. Often times, the reaction is to prepare a thick, glossy business plan (or "offering memorandum") including rosy projections. Although it is important from a marketing standpoint to prepare a professional looking offering memorandum, issuers should focus primarily on its substance.
Generally, in screening business plans and offering memorandums, venture capitalists look for the following five attributes:
- Management teams or entrepreneurs having track records of success, preferably in related industries.
- Proprietary products or services targeted at markets expected to be in excess of $100 million in size and growing at rates greater that 25% annually.
- A reasonable prospect of being the leader in its targeted market.
- A team of experienced emerging growth advisors including recognizable securities attorneys, accountants and board members.
- Well defined exit strategies, such as an initial public offering, sale, merger or repurchase.
Management biographies should be factual, account for all periods of time and positions held during an individual’s career and provide a summary of colleges or universities attended and degrees earned. Market size and growth rate ought to be supported by independent data from respected sources. The differentiating features and benefits of a company’s planned or existing products need to be clearly articulated and factually compared to competing products.
Product development and commercialization timelines should be stated. Sales and marketing strategies need to be specific regarding product positioning, pricing and channels of distribution. Financial projections should be for a period of five years and all assumptions should be listed and supported by a financial analysis of comparable companies within the company’s industry. Likely exit strategies ought to be accompanied by a review of recent initial public offerings by, and purchases of, similar businesses.
Culling this information not only provides the backbone of an offering memorandum but also serves as a sanity check on the attractiveness of the underlying opportunity. If the investment opportunity does not meet the criteria established by institutional investors, management should consider making the appropriate revisions, target a different set of investors (high net worth individuals, corporate partners, relatives and friends) or abandon its plans.
Business plans should be concise and in a form investors are accustomed to seeing. Institutional investors quickly discount hyperbole and puffery and value a sense of balance when specific risks are highlighted. Although several publications are available on how to draft a business plan, a better model may be a prospectus for an initial public offering recently completed by a comparable company.
The size of a financing, use of proceeds and type of security to be offered also need to be appropriate. The amount of money a company is seeking needs to be large enough to attract the interest of venture capitalists, typically a minimum of $500,000 - $1 million for start-ups and $2 - $3 million for later stage companies. The financing should be sufficient to carry the company to its next significant milestone at which time it can raise more capital, or to the point at which it becomes cash flow positive. Investors want to know specifically how and when the funds raised will be spent.
Although negotiable, a term sheet including a proposed price per share is generally included in an offering memorandum. Venture capital funds typically invest in convertible preferred stock which has certain rights and privileges over common stock. An experienced securities attorney can assist in drafting and negotiating these terms. Price is a function of the company’s prospects, valuations of comparable public and private companies, the return objectives of the investors and the demand for the company’s stock.
The entrepreneur is now ready to begin soliciting investors. This is an admittedly difficult process. Most institutional investors are likely to be based in another city or region. Moreover, venture firms often have a bias toward investment opportunities referred to them and those they have identified internally.
Short of a personal referral, management needs to illustrate its creativity and tenacity. Find out as much as possible about the venture capital fund, which companies it has invested in and who the appropriate contact person is. Call first, have a script tailored to the person to be contacted and be prepared to fax or send an executive summary in addition to a business plan.
The entrepreneur should be persistent but not a pest. Keep a log of who has been called, when and what the response was. It is not uncommon to make upwards of 100 such calls to secure a financing. Follow-up on a timely basis and schedule trips to visit prospective investors. Prepare a slide presentation to highlight the company in face-to-face meetings. If the initial feedback is negative, make the appropriate changes. One word of caution, don’t stop or slow down the process until the check has cleared. While potential investors may make encouraging statements early on, it doesn’t really mean anything until the financing has closed.
If successful, this process will generate enthusiasm from one or more investors. Ideally they will compete for the company’s financing. Alternatively, several funds may combine their resources, appoint one investor as the "lead" and participate as a syndicate to provide the financing.
Although this process may sound like a tremendous amount of work, expensive and a distraction from producing and selling products, it does maximize the prospect of successfully raising capital from institutional investors. Moreover, securing funding from a venture capital fund can be very beneficial to the success of a young company. In addition to the capital an institutional investor provides at closing, venture capitalists are also a source of ongoing funds and can provide a wide array of guidance and assistance.
