In-Depth

What Makes Venture Capitalists Tick

Venture capitalists are far less visible these days, but with the right approach, you can still woo them -- and win their support.

• By Edward O'Connor
• August 01, 2006

Not too long ago, this was a sure-fire way to fund growth even with very little prospect of actually making money. Those days are gone.

Seeking venture capital is harder these days: You have to prepare to go about it in the right way while trying to avoid all that can go wrong. But first it's important to understand what you're getting into in the venture capital world.

Investment Lingo and Concepts
There are two types of equity investors in privately held companies:

• Venture-capital investors, who place money into high-risk, seed- or early-stage firms usually in exchange for a substantial or majority ownership stake
• Private-equity investors, who take an equity stake in later-stage firms with a proven track record and often seek less than a majority stake

In common parlance, all such equity investors are categorized as venture capitalists (VCs). But in reality, all of them are private-equity investors -- they invest in private firms in exchange for equity, as opposed to investing in public firms or buying corporate debt -- and VCs are a subset of these. We'll use the term "equity investors" to refer to all such investors, whether they're in seed-, early- or later-stage firms.

Equity investors are seasoned middlemen. They invest other people's money in their portfolio companies in exchange for an ownership stake. And they do what they can to make the firms in which they invest profitable and to drive them toward lucrative exits, whether through initial public offerings (IPOs) of stock or by selling them to other companies within a certain timeframe. At some pre-defined point, the equity-investment firm returns to its investors their share of any profits.

Candidates for Equity Investment
Because equity investors aim to make high returns on their investments, they seek companies with proven business models, high revenue potential in large addressable markets (often $1 billion or more), high profit margins (25 percent to 50 percent) and a scalable, repeatable, go-to-market and product- or service-delivery capability that will lead to profitability.

These factors are most important to equity investors. But the biggest criterion is an experienced management team, which had better be a group of smart people with whom the equity investor is comfortable working and building the business.

Generally, systems integrators and value-added resellers -- together called service providers (SPs) -- are excluded from consideration by most equity investors. Unless they're riding "hot" trends or playing in booming markets without much competition, SPs tend to suffer from several flaws. They have relatively low revenue potential, their profit margins are diluted by competitors, and they lack scalable, repeatable, efficient service delivery.

Critical factors in assessing an SP's viability as a prospective investment include the scope and market-desirability of services, depth of talented executives beyond the CEO, utilization rates, profit margins, and ability to expand -- in terms of services or markets served -- without cost constraints that eat into margins.

On the other hand, independent software vendors (ISVs) tend to be more favorable investment targets because the software business generally enjoys high revenue and margins, and a higher scale of product delivery whether through channel partners, with resellers or Internet delivery.

In 2005, there were 622 venture-capital fundings (totaling nearly $6 billion) in the U.S. information technology market, representing 47 percent of all VC investments for the year, according to the VCDeal.com section of The Deal LLC, which reports on and analyzes business and financial news in "the deal economy." Of those deals, 264 involved software firms, while 350 others were in the networking, Internet and semiconductors and wireless industries. Only eight were in services firms.

Dealing with the Hybrid Organization
What about "hybrid" companies -- that is, those offering a software product with services wrapped around it? The ordinary objection from equity investors is that the product and services business models are quite different, so how do such companies intend to succeed?

The hybrid company is likely to choose one business model over the other, preferably the one in which it has had the most success, and it should be able to justify that transition while sustaining and growing revenue and profits. (Note: if you're making the transition to a services company, it's better to go elsewhere for capital; if becoming a product company, it's better to demonstrate a track record as a pure-play software shop before going for equity investment.)

Alternatively, the hybrid company can spin off its product business into a separate, stand-alone organization while retaining its services business.

Basics of the Equity Business
Every business has a balancing act. For equity investors, the balance is on two pivot points. First, they must negotiate the interests of their own firms, their portfolio companies and capital investors; additionally, they must balance time and capital. The balancing part involves how much time they spend on their portfolios, how long it takes to find new funding opportunities and how much time passes until they can exit the investment at a substantial profit. By achieving and maintaining balance, the equity investor stays in business and can raise more funds to invest in order to make still more money.

All equity investors are willing to take risks, but they strive to be as educated as possible about those risks. They do this by analyzing the company in which they are considering an investment, understanding the market and sector and defining and steering their portfolio company toward an exit opportunity. Of course, all this study, analysis and postulating takes a good deal of time.

In addition, many equity investors will invest only with other equity investors -- meaning that the round of investment will be "syndicated," with one investor holding the lead position by virtue of having the majority of the capital invested in the opportunity, while the others play supporting roles. When equity investors like an opportunity, they'll "shop it around" to other firms that they've invested with before to get other viewpoints. If there's a nibble of interest, they will often go in together on terms that they negotiate among themselves.

So if you're thinking of seeking equity investment, here's the first rule of thumb: Allow plenty of time both to prepare information on your company for your prospective equity investor and for the entire investment process to take place. Investment capital no longer flows like water, as it did in the late 1990s. In fact, you should plan to measure the preparation time in months: often between six and 12.

For companies that make the initial cut (most are rejected after a cursory review of their business plans' executive summaries), most of that time goes to the pre-investment "due diligence" that equity investors conduct. Obviously, investors want to get to know the people who are running the company in which they will invest. But they also need to dig deeply into the organization's inner workings, studying its business model, strategic and tactical strengths and weaknesses, competitive threats and leveraged partnering opportunities. Typically, investors do that by following the "money trail," the financial ins and outs of your business.

Gone are the days when an equity investor might invest millions of dollars in a company in a week's time based on a two-page outline of a business concept. As a result of the dot-com bubble bursting, the focus of venture capital has shifted from the venture side of things (money invested in high-risk opportunities) to the capital itself (finding the risks that make an investment untenable and a high-return investment probably impossible).

Accordingly, the equity investor's investment-success ratio has risen. It was not too long ago that equity investors would invest in 10 firms, positing that nine would teeter or fall while the one that succeeded would do so phenomenally, erasing the written-down or written-off investments of the rest. These days, equity investors work hard to ensure that at least half their investments will produce their preferred returns. For this reason, combined with the ordinary selectivity of equity investors, fewer than three in 10 firms seeking investment actually win it.

So the second rule of thumb is: Provide full disclosure with a realistic spin. Tell your prospective equity investors everything they want to know -- the good, the bad and the ugly. At the same time, you can -- and should -- present the information in a way that highlights your company's favorability as an investment. In other words, tell the truth, but establish the context for everything actually or potentially negative so that your organization's positive elements overshadow those drawbacks. Show that your company has been successful and is taking steps to remain so; play up its strengths and describe how you're mitigating its weaknesses.

After all that effort, the equity investor is in a unique position to help a portfolio company achieve its objectives. Typically, the equity investor will seek a position on the organization's board; most investors will offer companies some type of guidance as well. Some will provide or broker the provision of value-added services to fill in gaps in their portfolio companies' management teams or to extend their reach into markets, partners or specific revenue opportunities.

But none of the equity investors will do all those tasks uniformly well. So it's not enough to prepare fully to win equity investments. You also need to think about how to get the most benefit from your equity investor while avoiding as much trouble as possible. I'll cover those topics in Part II of this series.