Every year, thousands of great ideas are funded by venture capital (VC) funds. At the same time, 10 times, if not a 100 times more ideas are not. The recurring mistakes are not always based on the failures of the business.
It is not always because the ideas are unsound, the product not finished or the customers not happy. It is because the process of securing VC financing is difficult, sometimes arcane, requiring a lot of research and often exceptional patience. Very few 1st-time entrepreneurs are knowledgeable of what it takes and ready to go through the struggle. Yet, unless you can fund your project on your own nickel, VCs are the necessary partners to get your enterprise off the ground.
Having been around the block several times, I offer my own version of the “7 cardinal sins”, those mistakes that, if made, will likely result in failing to raise the money your company needs.
1. Not understanding how the VC industry works
VC financing is a structured industry. If you do not understand how this industry operates, you will make very costly mistakes when it comes to obtaining the capital you need to build your business.
First, a VC fund has a specific life cycle: invest for a few years, nurture for a few years, exit and wind down the fund. It is pointless to seek financing from funds that are in the second or third phase. So do your homework and understand where the people you talk to are with respect to the life cycle of their fund.
VC funds invest in specific industries. If you are in the enterprise software, do not talk to funds who have no interest to invest in that space. At the same time, if a fund has a lot of prior investments in your market, they may simply not be willing to overload their position. Again, do some research on what they do, what they have done, and what they say they will never do.
VC funds invest in specific stages. Seed, Round A, Round B, etc. It is useless to look for seed funding from people who are late stage investors. It sounds silly to state but I have, unfortunately, seen it done more than once.
VC funds have a minimal amount they will invest. This is not a new fact, but due to the huge amount of money early stage funds have raised in the past few years, it has become a factor to keep in mind. The size of each fund will dictate the minimal amount they can invest per deal. Say that a fund has $500M to invest. It is very unlikely they will consider investing less than $5M per deal and it may be closer to $10M. It is just a factor of how many companies they can invest in and follow during the life of the fund and, also, the return on investment profile they “sold” to the Limited Partners (the people or organizations that invested in the fund).
I recently talked to an entrepreneur who told me that I should get two HUGE funds to invest in his upcoming Round A. Two problems with that: the funds he was talking about are way too large to consider the kind of investment he needs (<$5M). Second, they are looking for “unicorns” (>$1B in valuation) and his company will never be one.
So spend some time understanding how the VC world works. How do fund get constituted? What are the requirements for return on investments that fund investors are looking for? Once you had done that, you will better understand the people you are going to solicit and you will narrow down you “target list” of potential investors.
2. Sending 100s of business plans over email
OK, so you have completed your business plan. You are working on your beta product and talking to some potential customers. Time to get serious about a VC round. So, naturally, you painstakingly assemble a list of the VCs General Partners you want to email your plan to. DON’T!
I recently spent a week in the Silicon Valley and met with a number of VC funds. They will all tell you one thing: very few funds, if not to say none, look at unsolicited business plans they receive – even from personal emails. One of the funds I met with looks at 1500 plans a year, invests in 5-7. These are the odds. And rather than look at business plans piling up in their email in-baskets, they’ll get referrals from other VCs, lawyers, other entrepreneurs they have done business with, other people they know, trust and respect.
In other words, there are so many ideas seeking funding these days, that VCs would rather spend their time with those they feel have been pre-qualified. And a business plan over the Internet does not fall into that category.
So what can you do? Well, network! Sounds cliché. It does but that’s the key to success. Attend conferences where you know VCs will be present. Meet with them, even on a casual basis. Showcase your products to events where you know VCs will come scouting for opportunities (or folks that can refer you to them). Research your space and find out who are the key influencers in your market. Chances are they are in touch with investors looking for opportunities. It is hard and it is thankless.
That being said, it’s 100 times better than sending a lot of business plans via emails, most of them ending up in the junk mail folder, the others never being read.
When you start with the process of looking for VC financing, you need to understand the odds. They are terrible in absolute terms. That being said, it is just part of the process of building a company. Think of it this way, you are not taking more chances than the Wright brothers when they came up with the idea of flying in an airplane, built that airplane, took off… and at that point in time had no idea if they could actually safely land!
3. Believing the hype that a “great idea on a restaurant napkin” will get funded
There are urban stories about business plans that got funded around a few drinks and checks cut on the hood of a car. These are wonderful stories. And so are the stories of people with terminal brain cancer, given 2 weeks to live, and who get miraculously cured of their illness. Stuff happens.
That being said, if your strategy to get financing is based on the “hope” for a “miraculous” encounter, you may want to revise that strategy in a hurry.
On the average, it takes 6 to 9 months to close a financing deal (from start to finish). That includes a lot of contacts that will lead nowhere, some that will get you a first meeting, a few that will take you to a second meeting, a term sheet, a due diligence, a lot of lawyers talk and papers, and finally a check in the bank.
Understand that, even if you get the attention of a VC, you are not their sole priority. As a matter of fact, things may happen that will either raise or lower the priority of your file in their stack, like market conditions, internal dynamics of the fund, unexpected events like… a stock market crash – any which can affect your deal.
So be prepared for the process. Be patient. Be resilient. And never give up!
4. Obsessing with early round valuations rather than exit valuation and proceeds
“I do not want to be diluted and lose control of my company”.
OK, by the time you are through your round B or C, you will be a minority shareholder. Don’t take my word for it, simply check the valuation calculators that are on the Web. It is going to happen. And to be honest, it should because successive investors are going to pour $M or even 10s of $M to grow the company. It’s that, or you (as in YOU) put the money in the company from your own pocket.
Entrepreneurs talk all the time about “dilution”. That is an absolute waste of time, especially now. The only valuation that is worth mentioning is the EXIT valuation and how the successive rounds of financing have been structured to determine who gets what. Just google “privilege liquidation rights” for a quick education on how things really work.
To begin with, you need OPM (Other People Money). If you think this is coming with no strings attached, well, think again. Second, the OP (Other People) have no interest in running your company. If they invest in your venture, it’s because they believe you have something to offer. Otherwise, they will take a rain check. Finally, 100% of a company worth nothing is not as attractive as 10% of a company that is worth $100M, $500M or more (my own opinion).
Instead of obsessing about dilution, look at the exit terms and their fine prints. And understand that once you accept the funds from VC investors, then the dynamics of the enterprise are completely changed.
5. Believing that “we have the best product in the world and our market is unlimited”
“If we can get 1% of all the Chinese to buy our product, we will make gazillions of $$”. That sounds wonderful. Except for the fact that this “1% of the Chinese market” you are targeting, is already supposed to buy the product of 1000s of other startups.
All too often, very little thoughts go into validating product strategies beyond “we think it’s great!” Now, it must be said that innovation is extremely difficult to quantify, on a forward looking basis. Who would have predicted the impact of Internet commerce 20 years ago? Or the impact of the PC market in the early 80s?
Precisely! You, and anybody else, operate in a complete vacuum when it comes to making predictions that are credible. That does not mean you can make claims that are completely outrageous (as is all too often the case).
In other words, VCs are in the business to fund highly speculative projects with an 80% failure rate. That makes them very open to new ideas. And very closed to hype that cannot be, even partially, substantiated with facts (even if those facts are incomplete).
Here is one suggestion: include a “Risk and Contingencies” section in your Business Plan. You may not identify all the risks, and for those you do, your contingencies may be sketchy. But at least, you will convey the message that you understand the odds.
6. Ignoring the due diligence process
Great, you got yourself a meeting with some VCs. They seem to like your plan. Now they want to look under the hood and make sure everything is “a OK”. In other words, they will send you a term sheet with a caveat: all this depends on the “due diligence process”. What the heck is that?
Simple. Due diligence is the process of making sure that specific claims you made are substantiated.
Claims about the market potential? Nope.
Claims about future profits? Nope.
Claims about intellectual property? Very much so.
Claims about your corporate structure? Indeed.
Claims that you made about being debt free? You got it!
An investment is a very significant corporate event. Especially when it involves, potentially, millions of dollars into an enterprise that has little or no revenue (and no real assets). Thus, VCs will want to audit the corporate structure, the existence (or lack of thereof) of a shareholders agreement (which potentially involves friend and family or angel investors who have helped the business get off the ground). They will want to research the IP (intellectual property) claims you make and make sure you do not infringe on other companies’ IP.
Entrepreneurs get so consumed with their ideas they forget the fact that, at some point in time, a REAL corporation is going to be funded and operated. And that VCs have a fiduciary responsibility to their Limited Partners (their own shareholders) to invest in corporate entities that are sound, from an investment perspective.
So when you start looking for funding, make sure “your house is in order”. If you are lucky enough to get into serious discussions with investors, that topic is going to become current. And there is nothing like losing momentum for your deal because you have not done the cleanup that is required to allow VC funding.
7. Failing to understand that the work get harder after the money
You got your deal! And now you have brand new shareholders in the capital structure of the company. Congratulations. Take about two minutes to celebrate. And now get to work.
You have raised expectations. You have defined some milestones. You may have made promises. And you were convincing enough that you got the funding you require to pursue your dream. Wait a minute: “your”…not quite. It is not “your dream” any longer. It is “our dream” as in “we” the shareholders, all of them.
VCs do not invest in companies such that they leave the founding teams play with said companies like a toy in a sand box. They will not be intrusive. But they will not be completely hands off. Investing money is a very serious business. With potentially $M at stake.
So the “day after” an investment closes, you, your co-founders, your team will go through something transformational. You have got what you need to deliver, at last. Now you need to deliver. So get to work and enjoy the ride!