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
There comes a time in every technology company's lifecycle when its
owner wonders whether, when and how to land venture-capital investment.
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
- Private-equity investors, who take an equity stake in later-stage
firms with a proven track record and often seek less than a majority
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
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
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.
Microsoft Fits into the VC Puzzle
Microsoft built much of its business model on having
successful partners. Because well-funded partners are
more likely to be successful, Microsoft has an interest
in making sure that its partners are sufficiently capitalized.
For that reason, Microsoft maintains a global Emerging
Business Team, or EBT. This team scouts for innovative,
early-stage product and services firms to help them
advance their Microsoft-partnership cause and to broker
their introductions to sympathetic venture capitalists
Microsoft's EBT has good relations with numerous VCs,
many of whom -- like their portfolio companies -- often
struggle to understand how to best engage with and navigate
Microsoft. EBT members try to help new partners grow
up and outward with access to capital, insider advice
and timely introductions.
But because the team is relatively small and widely
distributed, qualifying technology companies seeking
Microsoft's help and access to VC funding ought not
to expect a great deal of hand-holding or intensive
guidance. -- E.O.
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.