know the process.” The steps taken by the venture capitalist
between receipt of a proposal and the signing of the deal are
described in the following sections. There are four stages: initial
meetings, due diligence, negotiations, and closing.
Initial Meetings
As mentioned earlier, venture capitalists often give priority to
deals sent by people they know, either because they have met
the entrepreneur or because the referral is from someone the
VC trusts.
The first review of the written material is typically done
by analysts. They will review the executive summary, and if
still interested they will then request and review the whole
business plan. After reviewing the proposal submitted by the
entrepreneur, the analyst summarizes the deal in a specialized
form or internal database, and briefs the partner if the proposal
shows some value for the firm. At this stage the partner
might call the entrepreneur directly and ask for a few clarifications
over the phone. If all goes well, the venture capitalist
invites the entrepreneur and his or her management team for
a more detailed interview.
When the investor and the entrepreneur meet for the first
time, there is inevitably a certain amount of nervousness in the
air. For the entrepreneur, the meeting is very much like a job
interview, and making a good first impression is critical. The
entrepreneur will present an outline clearly describing growth
prospects and profitability forecasts along with the usual display
of enthusiasm.
Many entrepreneurs think they need to show slides or display
jumbo-sized flip charts at the meeting. In fact, this is unnecessary:
Most venture capitalists are not interested in watching a
long professional presentation. The entrepreneur is better off
bringing a model or a few product samples, or perhaps a picture
book that clearly describes the operating units and illustrates
how new technology operates within the company. The presentation
should be short and focused on selling the company. VCs
are fast learners, and they have already reviewed the business
plan or at least its summary. Again, the goal is to sell to a sophisticated
buyer. Therefore, the entrepreneur can go straight to
the important points: market size, growth rate, products or services
to be sold, and “why we will win.” The presentation
should be smooth, enthusiastic, and never boring. Forty-five
minutes to an hour is probably a good target.
The venture capitalist will often also want to pay a visit to
the entrepreneur and his or her company, even if it is a start-up
with few visible assets. During all these meetings, the venture
capitalist will not only be looking at the various items spelled
out in the entrepreneur’s business plan or presentation, but
will also be assessing the character of the entrepreneur himself.
Every venture capitalist is looking for different characteristics
in each entrepreneur depending on the venture capitalist’s field
of specialization and the entrepreneur’s area of business.
Almost every investor wants to see a positive attitude and
evidence of good character traits on the part of the entrepreneur,
without which the VC almost never invests. This covers
integrity, loyalty, honesty, enthusiasm, creativity, leadership, a
sufficiently wide knowledge base, and the physical and mental
energy to complete the tasks within the allotted time frame. It
is thus imperative that the entrepreneur understands his own
potential, or what makes him stand out from others. For example,
if the entrepreneur is weak in creativity, he may bring
one of his most creative team members with him to respond to
questions from the investor. It is very much a team effort.
Due Diligence
Before an agreement is made between the two parties about
the terms and conditions of the investment, the investor will
conduct due diligence on the investee company. This means
carrying out background checks on the company’s management
team, cross-checking facts and data about the industry,
and checking representations in the entrepreneur’s investment
proposal. The venture capitalist will try to root out misrepresentations
that may be present in the entrepreneur’s proposal,
or any other anomalies that might give the VC reason to doubt
the soundness of the investment.
As a first step, the venture capitalist interviews management,
if it was not done at an earlier stage, and visits the company’s
premises. The starting point in any such visit is
normally a Cook’s tour—a tour of the entire operation, with
introductions along the way to key people in the company.
During such a tour, the venture capitalist tries to see as much
of the business and as many people as possible. The VC may
stop along the way and ask questions of the employees, trying
to understand the type of people needed to make the business
successful, and will absorb as much visual information about
the business as possible. This is a formidable task: to learn
enough about the entrepreneur’s business in 30 to 60 days to
invest in it with confidence.
During the tour, the entrepreneur clarifies various aspects
related to the company’s operations, introduces the
venture capitalist to key operations people, and explains the
role of each. Next, the entrepreneur explains the bottom line
of the business, to help the venture capitalist better understand
the functions—such as purchasing, accounting, and
manufacturing—that are required to deliver the end product
or service to the customer.
Sometimes, however, it is not possible to conduct a Cook’s
tour—in the case of a start-up company, for instance. A startup
company often has no existing operation, although it may
well already have leased office space for the company’s operational
team. Some venture capitalists will nonetheless make a
trip to see these initial preparations in order to observe the
management team on its own turf, and to help them better understand
the cooperation among members of the team.
After the Cook’s tour, the venture capitalist will want to
know more about the industry, the products, and other important
issues. The venture capitalist will ask for the details
of every key aspect of the business. The entrepreneur needs
to answer questions without hesitation to create the impression
that he is on top of everything. Hesitating or not knowing
something will result in the question being posed anew
to the entrepreneur along with a request for his earliest possible
response.
The venture capitalist may also need to sit down with industry
experts. An idea may seem unique to the venture capitalist,
but it will be old hat to people with more insight in the
industry. It does not take long for a venture capitalist to determine
whether the entrepreneur has a unique approach to a
problem or if it is just a variation on a theme.
The venture capitalist will tend to ask personal questions
in order to get a feel for the kinds of personalities that exist
within the entrepreneur’s management group. The venture
capitalist wants to know how strong the entrepreneur is in
handling the expected pressures of the business. Has the entrepreneur
understood the time and energy he or she will need to
run the business? Is the family aware of this and prepared to
support the entrepreneur? What are the entrepreneur’s motivations?
In other words, what does success mean to him? What
makes him tick?
The venture capitalist may spend many hours conducting
due diligence prior to making an investment decision. There
are four activities usually associated with this activity: management
assessment, market assessment, product/service assessment,
and financial analysis. The greatest time allocation is
usually given to management assessment.5 The venture capitalist
will hold meetings with staff to learn more about the industry,
the competitive marketplace, production, inventory
control, labor, and cash flows. The VC may work with a marketing
research firm to conduct a study of the industry and its
products. He may hire production consultants to verify the
manufacturing arrangements. Also, he may call upon the entrepreneur’s
suppliers to find out how much they are paid,
what they like about the company, and the nature of their relationship
with the entrepreneur. Customers, or prospective cus-
tomers in the case of early-stage ventures, will be contacted.
Management references will also be sought.
While the venture capital firm is conducting its due diligence,
the entrepreneur must conduct his or her own due diligence
on the venture capital company. The entrepreneur
should know whether the venture capitalist has enough money
to invest in further financing rounds. Contact ventures in the
VC firm’s portfolio. Learn how the VCs do business, how well
they support their companies, and how they react when things
don’t go so well. The entrepreneur also needs to know whether
the venture capitalist can bring outside expertise and open
doors—for example, customers, executive talent, other investors,
and foreign contacts. Those are the intangibles that
make venture capital smart money.
Negotiations
If the results of the due diligence process are satisfactory, the
venture capitalist may then decide to move to the next stage:
negotiation. In all likelihood, the main negotiation point is the
valuation of the venture, which will decide the number of
shares that the investor firm will receive in exchange for its
participation. If the entrepreneur is raising $500,000 in a first
round, and the premoney valuation is $1.5 million, the VC
will receive a 25 percent stake of the postmoney equity. Premoney
means that the valuation is considered before the round
of financing. The term postmoney refers to the sum of the premoney
plus the money invested in that round.
During this stage, the venture capitalist will generally have
the upper hand, unless the entrepreneur has managed to attract
several investors. However, it is accepted that this kind of
negotiation must produce a win-win solution. To this end, attorneys
have created sets of boilerplate clauses that are generally
accepted as being fair to both parties.
If the VC rejects the business plan, the entrepreneur can offer
to make changes and submit a better plan. If the venture
capitalist is intrigued by the technology or potential market, or
sees a gap in the logic shown in the entrepreneur’s business
model and that gap is later closed, the VC might consider investing
at a later date. The entrepreneur should not interpret
this as an open invitation to keep presenting to the venture
capitalist in the hope that eventually he or she will cave in and
invest. Although VCs are known for never saying a straight
“No,” if they do not specify the circumstances under which
they might change their minds, then the dialogue should be
considered closed for the time being.
As we noted earlier in this chapter, the VC will summarize
his terms in a term sheet, sometimes called a letter of intent
(LOI), that is non–legally binding and helps clarify the terms in
written form. The term sheet is an important document, as it
captures explicitly and implicitly a great deal of the future relationship
between the entrepreneur and the VC. The entrepreneur
should review it with legal counsel, and perhaps also with
mentors or advisers familiar with the process.
The Closing
After due diligence has been completed, the lawyer for the venture
capitalist will contact the entrepreneur’s counsel to complete
the requisite legal documents for the funds transfer.
These documents will be followed up with a letter of commit-
ment stating that the investor’s lawyers will send the copy to
the entrepreneur and his lawyers.
Each document necessary for the closing has specific objectives
and covers separate ground. If all the requisite documents
are not present at closing, the parties will not be able to close
the deal. In large deals the lawyers may get together the day
before the closing date to see if all the papers are in order. This
is called “dry closing,” because no money changes hands. Simply
picking a date and showing up for a closing is practically
certain to result in the closing being aborted.
Read More : The Funding Process
