15 things to know before approaching a venture capitalist

Not all venture capitalists are dragons

In fact, according to Mike Cabigon, they’re nice people that want everyone in the deal to make money. But that doesn’t mean they’re going to fall over themselves to finance your business. Here are 10 things to remember before approaching a VC, and five enduring myths about these mysterious creatures.

1

Don’t approach a VC too early

“For the most part VCs will not back early stage technologies or ideas because the risk is too high,” says Aki Georgacacos, a founding partner of Calgary’s Avrio Capital. “Early stage companies ought to focus on friends, family and angels.” Once you have demonstrated that the product is real and that people are willing to pay for it, then you go to the VC. “After you have a business that has some viability, that has demonstrated it can be relevant, there’s enough VC money around that a good, fundamentally sound strategy with reasonable valuation expectations, a capable management team and a good business plan will get funded,” he says.

2

Sweat equity counts for something

There will be a component of goodwill in a company’s valuation that accounts for a good idea. “If the idea might cure cancer, that goodwill will be up to half a million,” says Randy Thompson, the owner and CEO of Venture Alberta in Calgary. “If it’s just another flavour of bubble gum you’re probably closer to zero, but if I’m going to give you goodwill for your idea, adding sweat equity on top of that is a little much.”

3

How have you protected your idea?

A VC will want to see that you have protected your idea in some waY, but that doesn’t necessarily mean patents or trademarks (although it might). Other forms of protection are a contract with a big client or lots of users. “If you had a sponge that cleaned up tailings ponds and Syncrude had said to you, ‘If you can do this, we’ll lock you up on a five-year contract.’ Well who really cares if someone steals your idea at that point,” Thompson says. “You have a locked-in contract with a big multinational.”

4

Quantify the problem that your product solves

“People will say, ‘Sharing photos in social environments is painful, and I’m ready to solve it,’” says Mike Cabigon, “The first thing I ask is, ‘For who? Tell me what makes you believe that?’ Someone once showed me an online forum complaining about a feature in a photo sharing thing, and there were over 20 million views. That was a good quantification of a problem.”

5

Land a solid management team

“We’re looking to see that there is a capable set of management that is associated with the opportunity,” says Georgacacos. “A good management team will typically overcome mediocre technology, but the inverse of that is not necessarily true.” Do you have somebody who works in the space your idea is in? If, for instance, your invention is a medical device, do you have an advisor from Harvard medical school on your side?

6

Know the VC you’re pitching

Know how they make money and who their bosses are. Do they specialize in IT? Healthcare? Restaurant services? Who are the limited partners: Do they include the Ontario Teachers Pension Plan? The WCB? AIMCo? And what are those limited partners trying to make money at? When you understand that, you understand VC math.
Georgacacos’s fund, for instance, is only interested in later-stage companies. “We typically want to see a marketplace that is fairly well defined as opposed to a company that is seeking to create new markets,” he says. “Typically we are looking at taking execution risk as opposed to development risk, so the client may or may not have revenue, but it definitely has revenue visibility in the near term, that is revenue within the next six months.”

7

Tell a story

“I’m not as interested in people giving me pitches as I am in hearing their story,” says Cabigon, who estimates that he hears about 100 pitches each year. “That’s not me trying to be a nice guy. It’s just that the story tends to tell what they do much better than the standard PowerPoint and going through the briefing as if it were a formula. Everyone can Google how to do this. What’s more difficult and what can set you apart is if you can tell the story of why you are doing what you’re doing. Usually, if you tell the story correctly, it captures everything you want to hear in a venture pitch without actually going through the steps and the demos.”

8

It’s all about the idea or product

People often assume that their product is the most interesting thing about them, when in fact it’s the least. “You can have a great idea but if there’s not a market prepared to accept that idea, if the concept is before its time, if you don’t have a management team that can properly execute, then it’s an exercise in futility,” says Georgacacos. “It’s never the idea,” Thompson says. “It’s all in the execution.”

9

VCs are risk takers

VCs are not looking for a win-lose proposition. “I want to make a bet where I have an idea that it’s going to work, that it’s viable,” says Georgacacos. “If I can bring some resources and management and expertise to the board and allow this company to have access to my network around the world, then I can add value to this business and make it grow. Maybe my downside scenario is getting my money back and my upside scenario is making 50 or 60 per cent, but I know in all likelihood that the business will not be a negative 100.”

10

VCs are looking for reasons to say ‘no’

“The reality is none of us make money unless we place money,” Cabigon says, “so every time I see one of these pitches I’m sure hoping it’s the next one we want to do.”

11

You must have skin in the game

Thompson says entrepreneurs often think that coming up with the idea is enough of a contribution from them, and they expect investors to take the risk. The founder might have a bank loan or a shareholder loan, but the strategy is to pay those back so that they’re clear of the risk. “It’s a deal breaker,” Thompson says of not having your own money on the line. “It’s pretty much a guarantee that you won’t get funded.”

12

There is a formula for valuations

There are a couple of rough formulas that VCs use to arrive at a valuation for a company, although they’re hardly mathematical. “Both have come to pretty much the same place: An early stage company with no revenues should never have a valuation higher than $2.5 million,” Thompson says, “and the $2.5 million number is set aside for the few, the proud. You have to have everything in the formula to get a 2.5. Realistically you’re looking from $250,000 up to $2 million. Anything higher than that is probably an inappropriate valuation.”

13

Be realistic in your valuation

Let’s say you come to a VC with an idea that is great in every respect: You have a sponge that cleans up tailings ponds, Syncrude has given you a three-year contract, Eric Newell is on your board of directors and you have 15 patents protecting the sponge. Who wouldn’t want to invest in that deal? “But so often on [CBC TV’s] Dragons’ Den the entrepreneur walks in and asks for a million dollars for one per cent of the company,” Thompson says, “and they all look at him and go, ‘You haven’t sold a thing, you’re three years away from giving Syncrude their first sponge, and your valuation is $100 million?’ The big thing in deal structuring is to make sure there’s enough meat on the steak for everyone to make some money.”

14

A customer order can mean everything

“I’ve made some investments in medical devices,” Thompson says. “It doesn’t mean I understand them at all, but I sure understand when Procter & Gamble says, ‘We need a million of these things.’”

15

You need venture capital to begin with

“We in Alberta tend to build startups that generate revenue fairly early,” Cabigon says. “We have customers in the types of industries that we do well: energy, environmental, agriculture. If you can build a startup around those, you can often get a customer to fund development. So you have to ask yourself if you need VC money at all, or can you get to that second step without taking a nickel of venture capital.”

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