October 01, 2008

General Parnter / Co-Founder Clear Venture Partners; Topic: The Venture Capital Process

The Venture Capital Process: Pizza and Nanotech?

As a venture capital investor, I am often asked what it takes to get an equity investment from a VC firm.  I hear business ideas spanning from magazines, to social networking web sites to consumer products. One of the funds which I co-manage has invested in New Hampshire businesses ranging from pizza crusts (Rustic Crust) to nanotechnology (Nanocomp Technologies).   One may ask how can pizza and carbon nanotubes both get venture funding.  What common elements make both of these opportunities venture-worthy?

First, some ground setting.  Venture capital equity fills a gap - business with too much risk for banks (losing money; early stage) and are not yet cash-flow positive enough to internally reinvest enough capital into the business for growth.  A venture capital equity investment is an exchange of capital for partial ownership in a business.  Equity can take many forms, but for the most part, it is patient capital that does not require/demand real-time interest payments; rather "repayment" is deferred and dependent on company performance.  This form of high-risk capital bases its return on its ownership stake - if $1 million of equity buys 40% of a business and the company sells in three years for $100 million, the equity is now worth $40 million.  Conversely, if the business goes bankrupt, the equity is worthless. 

So where does venture capital come from?  While an individual investor ("angel") invests their own capital, a fund's capital typically comes primarily from others: banks, insurance companies, pension funds, etc...  VCs manage funds that have a ten-year life: investments typically occur in the first five years of a fund and value creation/growth and eventual exit events (businesses sold to another company or an IPO) occur in the latter five.  Typical holding times for a venture investor can be from three-to-seven years.  So if a business owner does not want to build and sell in t hat timeframe, venture capital is not an appropriate match.  And these institutions expect a return commensurate with risk.  In venture capital, that means that funds must have, on average, at least a 25%-35% IRR (Internal Rate of Return, essentially, the effective interest rate). 

To achieve such an IRR, a fund must then return to their investors around three times the capital invested.  To get such returns, venture capital must seek riskier opportunities and high risk means that there will be failures.  Typical venture funds lose a third of their investments (complete capital loss), break even on another third and make the bulk of their returns on the remaining third.  Thus, to average out around three times capital invested, VCs need to make at least eight to 10 times their money on their winners.  Of course, nothing works out exactly like this.  There will be losers, singles, doubles and triples - but to make a fund, a VC typically needs at least one home run - but there's no need to swing for the fences every time. 

What do venture capitalists and angel investors look for in businesses?  First, we assess two areas of risk: stage and business.  First, stage.  Simply put, the earlier the stage, the greater the risk (of execution, of failure).  Earlier stage companies often require more of an investor's time as well.  Much will still be missing: a complete team, a formed plan, a cohesive strategy, a product, customers....  Angel investors typically serve on the front lines of equity investing and have more tolerance for early stage deals than most VCs.  That said, early-stage focused funds (such as the fund I manage) do exist.  But you need to understand your stage and find investors for whom your stage (and sector, and story) is a fit.

Business risk is a little more complicated.  An investor will look at several areas of the business, including management, market, product/technology, business model, financial and legal, among others.  In these areas, an investor will assess your situation and compare it with an ideal (recognizing of course, that the true "ideal" never really occurs).  The following table illustrates the ideal that an investor looks for in these categories:

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Management	Made money for investors Successful startup, ideally in same sector/space Complete team in core areas (sales, marketing, finance, etc)
Market	Large, fast growing with few competitors
Product/technology	One-tenth cost or 10X performance of nearest competitors Proprietary position (barrier to entry such as established market position and/or intellectual property, patents)
Business Model	Scalable: make once, sell many times Appropriate for venture capital financing--no real estate
Financial	Sustainable gross margins > 50% Limited financing risk (future rounds likely) No financial liabilities that affect value or equity position
Legal	No legal contracts that affect value or equity position No outstanding litigation around intellectual property or other assets

 

For professional investors, the greater the distance between the ideal and your company, the greater the risk. That risk will either addressed by requirement of a higher return, or by not making the investment.  So how did nanotechnology and pizza crusts both pass the screen?  Both companies had solid management, were in fast, growing markets with few competitors had innovative products with scalable business models, strong gross margins and a positive outlook for value realization (company sale, IPO).  The nanotechnology materials company is a traditional technology-oriented company pursuing large existing and emerging markets, whereas the pizza crust business reflects an opportunity the lead a new product category (shelf-stable natural/organic pizza crusts) in the context of a large market with strong prospects for liquidity. 

So if you think your business has what it takes to access venture capital or angel equity, check out the Speed Venture Summit website at http://www.abi-nh.com/www.speedventuresummit.org.  On October 28, 2008 in Manchester, NH investors and companies will come together.  Perhaps your company has what it takes to be the next deal.

Michael Burgmaier is a General Partner of Clear Venture Partners (www.clearvcs.com), a $50 million fund-in-formation focusing on growth opportunities in New England he is also a Principal with CEI Community Ventures Fund (www.communityventures.com), a fully-invested $ 10MM fund; he can be reached at mb@clearvcs.com.   

Michael Burgmaier is a General Partner and co-founder of Clear Venture Partners (http://www.clearvcs.com/), a $50MM venture capital fund-in-formation, and a Principal with CEI Community Ventures Fund (http://www.communityventures.com/), a fully-invested $10MM fund which he joined in early 2004.  Both funds are based in Portland, ME. 

Michael sources and evaluates deals, negotiates with potential companies, helps lead syndication efforts, serves on boards of directors and helps portfolio companies build value. Previous experience also includes three years as a Consultant/Case Team Leader at the management consulting firm Bain & Company, Inc. in Boston. While at Bain, Michael worked with clients across several industries, including consumer products, biotechnology, durable goods and health care.  With these clients, Michael gained high-level functional experience in marketing effectiveness, growth strategy, supply chain, lean manufacturing, organizational strategy and cost reduction, among others. 

Prior to joining Bain, Michael was the Acting Director/Senior Policy Associate at Children Now and served as a fiscal policy analyst in the Executive Office for Administration and Finance under former Massachusetts' governor William Weld.

Michael holds a MBA from the Tuck School of Business at Dartmouth, an MPP from Duke University and a BA in Economics from Boston College. He currently serves on boards of directors for several companies from CEI Community Ventures; Michael is also on the board of directors of GrowSmart Maine, an organization dedicated to creating sustainable economic prosperity for Maine.

For more information, contact mb@clearvcs.com or mburgmaier@communityventures.com.

QUESTION:  I have been given the opportunity to potentially buy out the small business I work for.  I know the owner will be asking for more then I think it is worth.  However, I think that neither of us really know the actual value of the company.  For a company with little to no hard assets, how do you get it appraised?  If I was trying to find an investor I know my first step would be showing the value, but I am not sure where to begin establishing that number.

 

ANSWER:  There are a variety of different approaches to valuation, based on whether you are buying a minority or a majority; as venture capitalists, we buy a minority and have a different model than you would as an acquirer.  Since you are adding the value (both in capital and in your energy) going forward, the starting point for valuation is where the company is today.    Future value is ascribed mostly to you, less so to the current owner.  One approach is to look at what comparable public companies are valued at in relation to sales and /or earnings.   So, if you are buying a software company selling business and consumer applications, you might look at a "basket" of publicly traded software companies (Microsoft, Oracle, etc) and see how they are valued in terms of Price-Earnings ratios or Market Value-to-Sales terms.  Assume that that basket trades at an average of 4 times trailing 12 months sales.  That's a starting point, not the answer, as  Microsoft and Oracle are large, well established, well managed companies and your target acquisition is not.  Once you establish a starting point, you discount from there-i.e. one takes a 25-50% discount off publicly traded multiples due to the differences outlined previously.  So you might start with 2X trailing sales.  If the company has a lot of challenges (debt, unhappy customers, etc), you discount further.   Ultimately, however, this is  a pretty subjective process, with the owner telling you that the future you're inheriting is bright, to which you would respond that it's your money and energy that  will deliver that future.   At the end of the day, the owner may not care what your analysis is, but may have a number in mind that they want out of the business.  If so, you might work more on structure than price-i.e. will the owner take back paper (e.g. seller financing--you offer to pay a given price  price over time structured as a debt-like payout in which the owner is the bank...in a sense, the seller's business becomes your sources of capital to pay out the seller.)  There's not  a right answer in this, other than to say the market will decided what that business is worth...if you are the only buyer interested, then you are the market.  If there are others willing to pay the owners' price (and you are not), then that's the market as well.

 

QUESTION:  I have read many different opinions from VCs and entrepreneurs regarding the importance of IP to a startup.  I was curious what your opinion on the subject is.  When you are looking at a startup for potential funding, do you have the expectation that at some point in the future that business will be issued patents?  If so, is the future possession of IP a make or break deal?  Clearly the importance of IP differs in different industries, but I wonder if you could still speak to the broad importance.

ANSWER:  The importance of IP is business-dependent.  The key question you are asking is about barriers to entry -- why will your team, technology and strategy win?  As investors, can we become convinced of that?.  When we look at a startup, we look at a variety of issues, including team, market, competition, IP and legal, among others.  Team is by far the most important -- we, more than anything else, invest in people.  Technology will change but we do not feel that we can so easily change people.  But that said, IP -- or barriers to entry -- are important.  We've invested in companies where patents were not yet issued, but we knew that we had a clear path towards patents and securing IP or another key market barrier for competitors existed.  Without patents, the entrepreneur needs to provide other compelling barrier aspects to us such as the ability to build a strong customer base, with those customers becoming so entrenched with your product that you become "sticky" and extremely difficult to replace, etc...  In the end, we need to know that you have the team, strategy and technology to win, so they are really all intertwined.  But if the market is one such that the barrier to entry and customer switching costs are light without IP, then patents become more important and the lack of a clear path towards securing IP can actually break a deal.

 

QUESTION:  If a firm is successful in obtaining venture capital funds, can you tell me how long the process typically takes from a first initial meeting to actually obtaining the funds?

ANSWER:  With almost everything in life, there is no "typical" answer.  We once did a deal from first meeting to close in six weeks and I never hope to repeat that again (and the opportunity was extraordinary and the timing paramount).  For the other deals we have done, timing from first meeting to close has ranged from six months to two years.  For a six month close though, that meant that a term sheet was issued three months after the first meeting.  When a company needs money, they should plan on anywhere from a six to 12 month funding cycle. 

 

QUESTION:  What is the difference in the range of funds that an angel investor would invest in a business versus a venture capital firm?

ANSWER:  I assume by this question you mean the amount of funds an angel investor would invest in a business vs. a venture capital investor - although you also might be asking how the range of businesses in which each invest might differ.  As for amount of funds, angel investors (as individuals) typically invest anywhere from $15,000 to $500,000, with the average I've seen in New England typically in the $25,000-35,000 range.  Obviously you would like angel investors with deeper pockets.  When angels act as a group, the amounts can go from $50,000 to $500,000 - but getting "groups" to act and invest like "groups" is not as easy as it might seem.  At the heart, angels are still individuals and decisions are made at the individual level.  The most important thing you need to look at with venture funds as it relates to the amount they may invest is to look at the size of the fund.  Take the size of the fund and divide it by 15 - that should get you somewhere around the "average" amount a fund might invest, over subsequent rounds, in any one business.  Take it up/down by 25% to better see the range.  So the size of the fund matters greatly for what a fund might invest.  As to industry differences, venture investors won't touch real estate and tend to shy away from retail - anything with gross margins under 40-50% are virtually non-starters for a venture investor.  While most angel investors also will stay away from such sectors, some may be willing to touch those areas if they have experience.  Business model, margin, team and scalability matter most:  you need sustainable gross margins in the 50%+ range, you need to be able to scale (make once, sell many times) and the team needs to be stellar.

 

QUESTION: Does accepting angel or VC funds automatically mean that a business owner will relinquish some control over company decisions, and if so, any suggestions for helping entrepreneurs transition from having total control?

ANSWER:  There is no way to avoid a loss of some control over decisions when a business owner takes venture capital equity.  A VC investor will only invest in preferred stock, which will come with certain rights over and above those of common holders (which the owner's stock will be).  Some of the rights include hiring/firing of CXO level staff, CXO compensation, approval of expenditures and borrowing levels over certain thresholds, right to approve/timing of a company sale....  VCs always start out by saying that an owner needs to fully understand what taking venture capital means (the company is being built to increase value and to be sold, usually within a three-to-five year timeframe).  If there is not alignment on that, then venture capital is not the right asset class for that owner.  Venture capital is clearly not right for everyone and making sure that after the money comes in that a venture investor and founder can work together towards achieving the same goal is of the upmost importance.

 

QUESTION:  I have never hit a point where I couldn't figure out my next step but I have reached this with a product I represent. The product is designed to plug a whole in a company's endpoint security that is often over looked.  In a times when companies are downsizing creates the environment where protecting a company's information is the greatest. Visibility I believe is my greatest problem. How does a business incubator evaluate a product to determine the level of advertising investment needed to get a product off the ground?

ANSWER: It's near impossible to get to a right answer on this type of question.  There's no particular metric or study that I'm aware of that points to a given return for a given level of spend in advertising.  So, I wouldn't spend too much time looking for a reference point there for a couple reasons:

- Few private/angel/venture investors believe that any sort of broad-based advertising campaign is the right strategy to launch a new product, for a couple of reasons: 1) wrong tool--to make a meaningful impact nationally, you'd need to spend far more money than investors will give you; given that advertising is hit or miss, major media campaigns not the best place to spend money, even if you could find the money to support it; 2) investors would prefer to see you test much more capital efficient methods of promotion--e.g.  narrow-casting your message to a discrete audience using less expensive forms of media (e.g. select a particular sector you think would respond to this product--e.g. financial services, insurance--then do a discrete test to a sample of that industry  by renting an email or snail mail list and send and email promotion or inexpensive print promotion (a small 3x5 post card) to trial the product.  If you get some traction then you can show your results to an investor that might be open to funding the next stage of growth.  PR is also a relatively inexpensive means of reaching audience.  Write articles on your topic and see if you can get them printed by trade publications.  Offer yourself as a speaker at relevant conferences.

Use inexpensive means.  But do NOT think about traditional media advertising as the way to get known.  Better yet, hire or bring on your board someone with marketing expertise in this field