In the September 2001 Inc story, More Strings Attached, Jill Andresky Fraser tells the story of Cherrill Farnsworth and her relentless efforts to raise venture capital for her growing company. Farnsworth did raise the capital, but it wasn't easy.

Raising venture capital has never been easy for early-stage companies, but today it's getting even tougher. According to the PricewaterhouseCoopers MoneyTree Survey in partnership with VentureOne, equity investments in venture-backed companies fell to $8.2 billion in the second quarter of 2001 compared to $10.4 billion in the first quarter.

"VC investments peaked in the first quarter of 2000 and have been declining ever since," says Kirk Walden, national director of research for PricewaterhouseCoopers. Entrepreneurs vying for seed or Series A financing might find it hard going, as investments in this area have declined sharply, only accounting for 15% of the second quarter's investment dollars, when traditionally, they accounted for roughly half of all investment dollars. Later-stage funding garnered more dollars, as venture capital firms invested in existing portfolio companies to help build those businesses.

To shed some light on what investors are looking for today, interviewed two of its mentors involved in venture financing. Guy Kawaski is CEO of Garage Technology Ventures, formerly, a venture capital investment bank providing placement and advisory services for high-tech companies and investors. It serves companies that seek to raise between $2 million and $10 million in a first or second institutional financing round.

Brad Feld is one of 10 managing directors of Mobius Venture Capital, a private equity firm. The firm typically invests $2 million to $5 million in early-stage deals. Just how tough is it to get financing these days, and for those companies getting financed, what's making them stand out?

Guy Kawasaki: It's as tough now as it was easy two years ago. The bar is very high - perhaps too high for early-stage companies. You can divide VCs into three groups: those who want beta sites, those who want purchase orders, and those who want payments as proof of the viability of the company before funding. This is a far cry from the days of "concept companies."

The companies that are getting looked at, much less funded, have three characteristics:

  • A hard core technology. No more "clever ideas" like giving people a dog in exchange for a one-year commitment to buy dog food. If the company is not based on something that has real science to it, it doesn't have a chance right now.
  • A core management team. The ability to boot PowerPoint isn't enough any more. Now teams need real experience in building and running a company.
  • Identifiable customers. You can't wave your hands and claim that your customers are Fortune 1000 companies. Now you have to name names and cite the size of their relevant budgets.

Brad Feld: Over the past few years, VCs shifted from investing in proprietary technologies and experienced entrepreneurs and--instead--started funding business models chasing the 17th company in a particular sector, for example, and lost sight of business fundamentals. For instance, an online B2C company is actually a retail business on the Web--not a technology business.

Today, VCs are focused almost entirely on funding companies that have proprietary technology or know-how. "Business model" financing is no longer interesting. In addition, the entrepreneur and management team are once again front and center on VCs' minds. How has your company's investment strategy changed over the last year?

Kawaski: We have made the transition from generalists to specialization in five sectors: communications, semiconductor, software, infrastructure, and wireless. Our sweet spot is $2 to $10 million in the first or second institutional round of financing.

Feld: By mid-2000, we had dramatically slowed our new investment pace and were in the final throws of making the shift away from companies that were business-model centric, for example all B2C and B2B companies. We also had done several dot-com spinoffs and by the fall of 2000 had decided that we would not continue doing this. Over the last six months, what industries received the most capital?

Kawaski: It's probably network storage and infrastructure. For example, one of our clients, Lefthand Networks, recently raised $13 million. This is an example of a company with extensive industry experience, mature product development process, and deep technology.

Feld: Wireless, semiconductor devices--especially those linked to wireless, enterprise software, and communications software and services. How long are investors willing to wait for a company to become profitable or generate revenues?

Kawaski: Six months to show revenues, 18 months to show a profit.

Feld: Time to profitability is highly variable and dependent on the type of business being created. Revenue generation is much more important. We're pushing companies to generate customers and revenue within their first year of life, with year two revenues being significant enough to see trend lines and a solid gross margin ramp. Interestingly, my focus has shifted from absolute revenue to gross margin, or gross profit, depending on how the accounting is structured, as gross revenue and revenue growth can be extremely misleading, especially in the grow-at-any-cost mentality. Has the shaky economic climate and the renewed emphasis on performance made your investors get more involved with the companies they invest in?

Kawasaki: Investors are very involved in the companies with problems--and investors and entrepreneurs both wish this weren't so.

What's more interesting is the amount of due diligence that's required for an investment. It is much longer and deeper than in the past three years. Now investors are looking for reasons not to do a deal. This is the opposite of two years ago. The lack of market madness has meant a slowing down of the process of funding and building a company. Ultimately, for entrepreneurs, investors, and customers, this is a good thing.

Feld: We've always been very active investors; however, we're spending even more time with our existing companies and less time sourcing and chasing new investments. Much of the activity surrounding company building during 1997 to 2000 was predicated on momentum and hype.

The partners at SBVC, including myself, are primarily business operators. As a result, we've gotten much more involved in helping our companies develop clear, sustainable businesses as this is our natural state. It's much more comfortable for me to help run an operating company than to create a marketing hype machine.

Copyright © LLC

In today's venture financing climate, it's more important than ever to have your start-up's business plan, pitch, and value proposition down before you talk to potential investors. But how do you know when you're ready? Take our Are You Ready to Get Funded? quiz to find out.