My clients and various internet/tech firms have negotiated a recent spate of venture capital infusions. On top of that, the SEC’s upcoming regulations on Crowdfunding via the Jobs Act looks to change the entire start-up investment playing field. So I thought it might be helpful to run a two week series on the ins and outs of venture capital deal-making.
My aim is to inform the readers about what they can expect when their company starts negotiating with VCs, as well as the changes we can expect when Crowdfunding under the Jobs Act comes into play. In the meantime, please feel free to submit your questions and thoughts in the comments, and I’ll address them as we go along.
Since the expectations of either party to a transaction is ultimately what will make or break the deal, let’s start with those.
This one is a no-brainer. The entrepreneur wants to raise as much capital as possible while giving up the least amount of control to the investor.
Revise your expectations!
Raise money by levels: Firstly, you should only hope (or want to) raise enough capital to get your business to its next “level” of capital infusion.
For example, level 1 may be the startup point when an Angel Investor provides your company with just enough capital to operate for 6 months to a year. By the end of the first year, you should see whether your business looks to be successful enough to entice a VC firm (or group of investors) to provide your company with enough capital to expand, increase its profit, and run for the next 2 or so years (this is level 2). After that, if you had a great idea and your company really takes off, then any of the following could happen:
1. You may need a level 3 series of investments to finance your next 5 year plan; or
2. Your 3 years of success have interested a major industry player to offer a lucrative buyout of your and your existing investors’ shares; or
3. Your 3 years of success have plateaued your business to point where, due to its business model, the economies of scale no longer require expansion — at this point you continue to run the business and make a steady profit indefinitely.
Expect to lose a huge chunk of your interest: The only way a “bootstrapped” start-up will turn into a multimillion dollar company is via substantial capital infusion from major investors. Investors will not invest a substantial amount of money without receiving a substantial percent of the equity in return. This is the nature of the beast and, as you’ll see below, it’s not so bad.
Primarily, VCs aim to make scenario #2 above happen. What that scenario describes is the Exit Option — aptly titled because VCs hope to make their money by investing in the next big thing and then selling their shares (or “exiting”) for a nice profit.
VCs might like the entrepreneur’s idea, they might even respect the entrepreneur as a talented business person. That said, most VCs are experienced enough to know that the stuff that makes a good entrepreneur (vision, risk-taking, etc…) is also the stuff that makes a poor big business manager. So the first thing a VC will want to do with their newly bought equity is to temper the entrepreneur’s vision and risk-taking with the qualities of an experienced business manager — they typically do this by insisting on bringing their own guy onto the managing team.
As noted above, this change in leadership (and ownership) is not such a bad thing… it really is the case that when a business gets successful enough, long-term growth is best served by the innovator taking a backseat to the veteran manager.
Jobs Act Thoughts
I noted above that the Jobs Act is likely to change the playing field. This is mainly in relation to scenario 3 above.
Scenario 3 may be good for the entrepreneur who aims to indefinitely run a modestly successful business, but it also happens to be the bane of the VC since it kills their Exit Option. This is why businesses that are prone to scenario 3 outcomes tend to have the hardest time raising venture capital.
I’ll tackle the Jobs Act in subsequent posts and further explain how the Act will help scenario 3-type companies raise start-up dollars.