“Do you really need venture capital?” That’s the question a well-respected venture capitalist asked me after I ran through my pitch. I was pitching equipment for manufacturers, which is a whole lot less sexy than a quick-flip Internet play.
My industry had the potential for lots of unplanned technical risk, a long sales cycle, and limited exit possibilities. It didn’t matter that I had real customers or that I was solving a real problem verified by these customers. It didn't matter that these customers were the gorillas in their sectors or that they were public, multi-billion dollar global powerhouses.
This VC is one of the few who is both deeply technical and also has CEO experience. But what I most appreciated about her is that she was looking out for me, the entrepreneur. She knew that I’d be better off raising angel money and then looking for strategic investments from customers who needed me to succeed.
For my sector, this plan just made more sense. It wasn’t a good VC play, really, although there was plenty of interest. Yes, perhaps the VCs could get a return. But without the big exit--requiring a big valuation--common shareholders would be left with nothing. She knew that. She also knew that, as the entrepreneur, I’d be better off without the kind of investment that puts common shareholders at a five to seven times disadvantage (commonly called the liquidation preference) when it’s time to exit.
It is rare to get this kind of honesty. More common are investors who find ways to obfuscate instead of giving you a flat-out “no.” VCs never like to say “no.” They may criticize your business plan, and you might learn something useful. They may criticize you personally, which is not as pleasant and usually a reminder that stereotypes are still alive and well in Silicon Valley. Or they may just ignore you.
Another reason they may turn you down – even if they don’t say ‘no’—is that VCs operate under a lot of constraints that make a lot of viable businesses a bad fit for their funds. And they don’t love to talk about these.
Before you consider the exhausting process of raising venture capital, think about whether your business really fits.
Are you really ready for venture capital investment?
The term “early stage” is a misnomer, and is very confusing for entrepreneurs. You want to pitch after you have some major milestones under your belt. It shows you have momentum, that you have reduced risk, and that you have viability in the marketplace. The VC may still consider you “early stage,” even if you feel that you are much farther along. This mismatch is very, very common, especially for highly technical businesses. The entrepreneur is thinking about all the work he or she has done to knock out technical risk, and the VC is thinking about everything that still needs to be done to achieve an exit. It’s a vastly different point of view.
Does your timeline match the fund’s timeline?
How long will it take your company to build enough value to get a 10X return on investment in an exit? If you’re in semiconductor manufacturing, your product probably has an 18-month qualification cycle. Think about it: 18 months of a customer trying your product out before making any commitments to buy long-term, and they may never buy at all. That is 18 months that you need to keep the company afloat before you get an answer, which is going to make any VC cringe. How long before you expect revenue?
If a VC needs to exit in five years, because that’s when they need to get money back to their limited partners, is that a good match for your business? Time horizons vary by fund, so find one that’s a good match for your business. If you’re in it for the long haul, it might not make sense to take on an investor that will need to exit – ever.
Will VCs enhance or complicate an exit?
What is your exit strategy, really, in this day and age? If the most common path is acquisition, talk to potential acquirers about how they like to do deals. It was a real eye-opener to see potential acquirers breathe a sigh of relief that we had no venture capital in the deal. Venture capitalists need to reach certain financial goals for their fund. The acquirer will want to make sure the acquisition is healthy. These two goals can be at odds, and can make a deal more expensive.
For example, if the deal isn’t rich enough to pay off the liquidation preferences and the common shareholders, the common shareholders (i.e. the employees who had equity compensation) are left in the cold. Many times, an acquiring company has to “make employees whole” to ensure the deal will be successful and that key personnel will stick around for a smooth transition.
Remember that venture funding is in a tight spot these days. The current state of affairs, described in the article “Dearth of IPOs Threatens Venture Funding” explains things quite well. Venture funds compete against hedge funds and private equity funds, and the current climate puts venture at a distinct disadvantage. That will translate into more pressure on entrepreneurs doing venture capital deals. Be wary and wise, and think about what is really the best business deal for you.