VOL. 126 | NO. 215 | Thursday, November 3, 2011
Venture Forth, Entrepreneurs
By W. Jeff McGoff and G. Robert Morris
As a general rule, when an entrepreneur is trying to obtain capital, first approaching family members and friends and then banks is the least “costly” approach. When attempting to work with a venture capitalist, the entrepreneur might have to give up more control, but typically ends up with much more to gain because working with venture capitalists opens the door to networking opportunities, new contacts and more access to additional funding.
When approaching a venture capitalist, it is important to remember they expect a much more thorough analysis, business plan, forecast and, above all else, market-driven valuations than an investing family member would expect.
For example, the family and friend investor will let you convince them that in five years, the return on their investment will be 100 times more than what they put in, so they are actually valuing the investment two or three years out. Venture capitalists and professional investors make a living doing this and have their own shareholders or investors automatically expecting results.
The professional investor, venture capitalist or institutional investor is not viewing your opportunity with the same zeal as a family member, but looking at the opportunity with the vision of surgeon, trimming away all that is useless and getting down to the essential facts. Venture capitalists look at hundreds of opportunities for every dollar that they invest, so they follow a very thorough process. Generally, the entrepreneur needs to have actually moved through the initial phases of its business plan, used the family and friends round to prove the basic concept and completed the research required to create a meaningful opportunity.
Rarely do venture capitalists or institutional investors take on the risk of a start-up, and when they are even willing to entertain the concept, the lucky entrepreneur should expect to provide preferred equity or similar instruments with all the bells and whistles; conversion and redemption features, puts, calls, board seats, registration rights, management rights and superior voting rights. These added features are designed to hedge the riskiness of the investment while allowing the institutional investor to fully participate in the up-side.
Entrepreneurs should also expect to get beaten up on their valuations. Institutional investors are the savviest investors and will evaluate the worth of the business in a level of detail that friends and family simply cannot. A lower valuation means more equity for the institutional investor and less for the original owners.
When you find the right professional investors, they can actually help you succeed by giving you access to their networks of professionals, business contacts and, most importantly, their guidance and experience. We call this “smart money.”
From a timing standpoint, entrepreneurs should expect a meaningful capital raise to take as long as a year. Raises have been completed in less time, perhaps six months, but in those instances, the stars seemed to align perfectly. Preparing the legal documents, developing a polished business plan and just identifying potential investors takes a lot of time. Not only that, but, traversing the human element is very difficult. For example, potential investors will often express a great deal of interest in the investment, but when it comes time to write a check, they sometimes fall short.
All in all, parting people from their hard-earned money takes some doing, whether it’s a bank or professional investor. It involves taking on a great deal of risk and is often a leap of faith. While you, the entrepreneur, might be supremely confident in the future success of the concept, understand there might be some disconnect between your level of enthusiasm and the cold, hard scrutiny of an investor.
W. Jeff McGoff and G. Robert Morris are attorneys with Butler, Snow, O’Mara, Stevens & Cannada PLLC.