The amount of venture capital pouring into Los Angeles may suggest that cutting a deal with a VC firm has become a snap for start-up companies, but the process remains long and complex and only the best prepared and most tenacious entrepreneurs wind up with a check.
From submitting a business plan, to meeting face-to-face with a VC firm, to working out the terms of an investment, there are numerous pitfalls that can wreck a deal. The biggest hurdle for many startups is being heard above the noise.
Case in point: eCompanies Venture Group in Santa Monica has received no less than 7,500 business plan submissions through its Web site since it was launched last July. Just one of those has been funded.
"It hasn't got any easier to get financing from a top-tier venture capital firm, and it definitely helps to be well connected," said Steve Ledger, eCompanies Venture Group's managing general partner. "On the other hand, there is a much larger variety of options than there ever was for early-stage financing, from angel investors to large financial institutions that have entered the field."
Many startups that are successful in securing a first round of financing received seed funding from an angel investor at an earlier stage, and are then referred to the VC firm by the angel investor.
A solid plan
While being well-connected helps, it's not enough without also having a strong business plan. Jonathan Funk, principal at Media Technology Ventures, reviews about 1,000 proposals every year, but only two or three of them get funded by his firm.
"We get a ton of stuff," said Funk. "It will typically take me 15 minutes or less to make a decision whether or not I'm interested in an idea."
When a VC firm believes that the idea looks promising, the next step is to meet with the management team. This is a critical step because the business plan and management team are often the only things a venture firm has to go by in deciding whether to invest.
"This tends to be a touchy-feely kind of a process," said Gary Freeman, a partner with the venture investments group of BDO Seidman LLP. "There are specific numbers and milestones they can look at and financial models they can run, but the bottom line for a venture capital firm is if they can work together with the management team."
At the initial meeting with the VC firm, the management team of the startup has the opportunity to make their pitch and show that they and their business are for real. In most cases, this is the end of the story. Funk, for example, has two to three such meetings every week and the vast majority of them do not result in an investment.
On the other hand, if the first meeting goes well, arrangements might be made for the management team of the startup to meet with the other partners of the VC firm. Typically a VC firm will require a unanimous endorsement from the partners in order to cut a deal, but in some cases a majority decision will do.
Down to brass tacks
At this point, the VC firm and startup will look seriously at the nuts and bolts of the deal and begin hard negotiations. In the past, it was standard procedure for the venture firm to do its due diligence before discussing terms, but given the fast-moving marketplace, what had been a linear process has become a parallel one.
"It used to be that when you got to the term sheet, you were at the 25-yard line," said Ledger. "Now it means that you're only half way down the field. We have to start looking at the terms before we have decided whether our heart is really in the deal simply because of the competitive nature of the business."
The most contentious issue in working out terms tends to be the actual worth of the startup. In other words, how much will the VC firm invest in exchange for what equity stake.
"You want to have general discussions about the value of the company early on," said Funk. "Many deals fall through over this issue, so we want to make sure we're not too far apart from the outset and that the company doesn't believe they're worth $50 million when we think they're worth $20 million."
Given the super-high valuations of many high-tech companies, however, traditional ways of measuring the value of a startup have pretty much gone by the wayside.
"The valuation of a startup is pretty highly negotiable," said Freeman. "There are really no good benchmarks, and we can tell an entrepreneur only if something is very much out of whack. The rest really depends on their negotiation skills."
Other important issues that are discussed at this point are the composition of the board, the terms of ownership of the founders, the option pool, liquidation preferences, and other structural issues. None of these tend to be deal-breakers, though.
Simultaneous with these negotiations, the VC firm will conduct its due diligence on the startup and conduct background checks on the management team, look into any intellectual property issues, and research the startup's market.
Once the due diligence process is completed and the term sheet is signed, the startup is handed the check. The whole process, from beginning to end, may take eight to 10 weeks.
"Five years ago, it would be very rare to complete a deal this quickly," said Ledger. "But markets are changing so quickly now that the venture capital firm can't afford to take the time that they did back then."
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