Is Your VC a Chicken or a Pig? Part II: The Role of the Lead Investor – From Term Sheet to Closing (and Beyond)

In Part I we talked about the critical importance of focusing your fund raising efforts on identifying a lead investor – a “pig” – and reaching agreement on a term sheet with them before you spend significant time lining up “chickens” to “follow” along in the deal. Today, we’ll look at what role your lead investor plays post-term sheet agreement when it comes to getting your deal closed.

The first role of the lead investor post-term sheet is working with the company to build out the investment syndicate: that is, to find and close on chickens/followers. The lead becomes, in effect, a part of your pitch team – albeit, without abandoning its primary role as an arms-length investor/skeptic.

The “selling” role of the lead includes identifying, prioritizing, and even pitching potential followers. That typically includes folks the lead brings to the table from its own network as well as appropriate candidates the company suggests. While the company will still be front and center in pitching chickens, the lead is usually the primary due diligence source for potential followers, both “deal” and “legal” due diligence, and actively shares their own thinking on why the deal is compelling with various chickens.

This dual role, working with the company to build the syndicate while also being the principal due diligence resource for the syndicate, makes managing the company/lead relationship complicated as well as critical. The lead, at this point, wants the deal to happen and is committed to making it happen. But only to a point. The lead’s enthusiasm is tempered by its continuing obligation to act in the best interests of its own investors. In addition, its credibility is on the line with other investors, which is something that can cut both ways in terms of how it reacts to any bumps in the road on the journey to closing.

The lead also manages the “deal” part of the deal: that is, the concerns of followers about the terms of the deal. On that score, the lead should focus on convincing followers that the term sheet is “good to go” as is. Indeed, the company should resist any material changes to the term sheet based on follower concerns, just as it would if the lead was the only investor. The whole point of agreeing on a term sheet was to finalize the material terms of the deal. As a practical matter, one or more immaterial changes to accommodate a valuable follower may be acceptable. Any material changes, though, should be viewed as putting in play changes the company might want in exchange, or even grounds for the company backing out of the deal altogether.

The lead also manages the legal process associated with negotiation of closing documents and related legal requirements. Typically, there is one counsel for the investment syndicate, and that counsel works through the lead investor and is paid by the company out of closing proceeds from the financing. (If a follower wants to have an independent legal review, they should pay for it, and that counsel should work through the lead and its counsel in terms of communicating any concerns to the company.) If a lead can’t persuade followers to work through the lead and its counsel, that’s a good sign that the lead is not up to the job.

Once the deal is closed, the lead is usually the “point” investor for the rest of the investment syndicate. If the investors have a director on the Board, it will usually be someone from the lead investor. (Someone that should have been identified at the term sheet stage). When the company has news to share with the investors – good, bad, or indifferent – the lead is usually the first to get it, and often has input on what to share with the rest of the syndicate, when, and how. As with the period of time from the term sheet to the closing, this dual role of investor/advisor can be complex and must be managed carefully.

Lead investors make deals happen, and typically play central roles even after the closing. Smart entrepreneurs know that raising money is first and foremost about getting a credible lead’s name on a solid term sheet. Be a smart entrepreneur: don’t waste time and energy collecting followers until you’ve got a lead for them to follow.

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Is Your VC a Chicken or a Pig? Part I: What a “Lead” Investor is, Why You Need One, and How to Find One

One of my favorite clichés involves chickens and pigs. More specifically, it observes that as interested as chickens may be in breakfast, it’s the pigs that are really committed.

That’s a good way for startup entrepreneurs to think about courting venture capital investors. Collecting a flock of very interested venture investors – chickens – is fine and dandy, but you won’t make much progress towards getting a deal done until you’ve got a pig at the table. So don’t waste a lot of time chasing chickens around until you have a pig corralled. You know you have got a pig in hand when you have a solid term sheet with a “lead” investor inked.

Truth be told, most VCs think of themselves, or at least present themselves, as lead investors. I suppose most probably do lead a deal now and again. That said, though, in any given deal, there is generally only one lead investor. (Co-leads are fairly common, but even in those cases one of the co-leads in fact plays the role of the lead.) That is, one investor who not only wants “in” the deal but wants to “own” the deal.

The first big role of the lead in a deal is to let the relevant chickens know that someone has pig-like interest in the deal. That someone likes the deal enough to put up a big bunch of capital (usually the biggest chunk) and to do most of the heavy-lifting of getting the deal done (which, as we’ll see, is no small thing). That resource commitment, coupled with the signal to the market that a credible (well, hopefully) investor is that serious about the deal, is typically the inflection point when the chickens start getting serious about actually committing some eggs to getting the deal done.

If getting a lead investor lined up is the sine quo non of getting a venture financing done, how do you go about it? Simple. Qualify potential investors as leads before you spend too much time with them. Limit your initial investor solicitations to folks you think are possible leads and folks you think might be sources of referrals to possible leads. When you get a meeting with an investor, if there is any potential interest at the end of the meeting be certain to ask if yours is a deal the investor would consider leading (and if not, can they refer you to any investors who might be).

Step two is to avoid wasting time with investors who are not qualified leads until you have a signature (or handshake) on a term sheet with a lead investor; a term sheet that outlines all of the material terms of the investment. Depending on who the lead is (their reputation in the market), and how big a piece of the deal that the lead is taking (how many other investors with how much more money will it take to fill out the syndicate), agreement on a solid term sheet is the point where most interesting investment opportunities become likely deals.

Next time, we’ll talk about what roles lead investors play after the term sheet is signed.

 

Should You Take Your Startup To Silicon Valley?

I’ve advised many flyover country entrepreneurs that if their sole goal in life is to raise the most money for their startup, at the best price and in the shortest period of time, they should move to Silicon Valley. That is where good entrepreneurs raise the most money in the shortest order and at the best price on a pretty consistent basis.

Lately, I’ve been thinking more about that advice, and while I generally stand by it, I’ve come to the conclusion that there is an important exception: a class of startup entrepreneur that, in fact, is usually better off launching in flyover country than Silicon Valley. The idea of an exception to the “move to Silicon Valley to get the best deal” advice came to me as I started thinking more closely about a corollary to that advice, to wit that if, having moved to Silicon Valley you can’t raise capital, at least you will have found out faster that your startup is not VC-worthy.

It’s that last word, “worthy,” that hit me as needing more thought. Over the last couple of days, it gelled that some entrepreneurs might fail to raise capital in Silicon Valley – not because their startup is not worthy of investment, but because they are not ready to play on that particular stage. In which case, going to Silicon Valley may result in failing to get a startup financed not because it was a bad idea, but because venture capital’s Broadway was not where it should have started out.

Here’s the deal. For entrepreneurs that know how the venture capital business works (in reality, not just in theory); have a track record that suggests real knowledge of what makes the best startups tick; and have meaningful entrepreneur, investor, and service provider networks that include a few solid Silicon Valley contacts, taking their startup to Silicon Valley makes sense. (Again, with the qualification that getting the best deal as fast as possible is the only factor in the decision.) For other flyover country entrepreneurs, maybe not so much.

My thinking in this area was kick started a couple of weeks back when I met with a 20 years-old-ish Northeast Wisconsin entrepreneur who had what seemed like a pretty good idea for an app. With less than $50k, he had taken it as far as 10,000+ users and some very good press. He had pretty much everything you look for in an entrepreneur: vision, passion, integrity, flexibility, an ability to make things happen with minimal resources, and a desire to learn. But, when we talked about the possibility that he should pick up and move to Silicon Valley, it occurred to me that if he did he would most likely be eaten alive.

What this entrepreneur lacks that would be a huge problem for him in Silicon Valley won’t be hard for him to learn here in Wisconsin if (as I am sure he will) he puts his mind to it. He doesn’t know either the substance of the venture capital business or the lingo (which is surprisingly important, particularly when a VC knows you are from the sticks). While he has great entrepreneurial instincts, he has not lived, even vicariously, in the high impact entrepreneurship world. Right now, the number of folks in his network who do have that knowledge and experience, and those connections, can be counted on the fingers of one hand.

These may seem like small things, but they are important things and things that pretty much every entrepreneur who gets funded in Silicon Valley has. They are things that folks like gener8tor have made a business out of providing to their portfolio entrepreneurs (and in fact lots of other entrepreneurs). And things that a small but real cadre of Badger folks with that kind of experience and those kinds of networks are eager to share with folks who are otherwise as compelling as the young man I met with several weeks back.

So, if you are an otherwise Silicon Valley-worthy high impact entrepreneur in flyover country, but don’t have a solid understanding of the ways and lingo of the venture capital business, a well-grounded understanding of what separates the startup winners from the losers, and a decent network of folks that have those things that you can leverage all the way to Silicon Valley – don’t go to Silicon Valley. At least not yet. Learn what you need to learn here, connect with the right folks, and when you are ready to play on the Silicon Valley stage, well, decide what your priorities are then.

 

 

Ways Entrepreneurs Spook Investors

The perceived quality of the entrepreneur is, for most venture investors, the single most important factor in evaluating a startup investment opportunity. As they say, an “A” team with a “B” opportunity usually wins out over a “B” team with an “A” opportunity.

One way to approach the “what makes for an “A” entrepreneur” question is to look at what makes a good entrepreneur. Today, though, I am going to take the opposite approach. What traits can make even an otherwise compelling entrepreneur come up short in a venture capitalist’s eye. Here are some too-common entrepreneurial qualities that spook investors.

  1. The “No Competition” Entrepreneur. Few things turn off more venture investors faster than an entrepreneur who insists she has no competitors. If you are convinced you don’t have any competitors, you are wrong. Every dollar that a customer spends on your product is a dollar they didn’t spend on something else. Maybe that something else is very well defined (say, an alternative dog walking app for smart phones) or maybe it is very amorphous (say, personal entertainment). More likely closer to the former than the later, but you get the idea. If you are one of those entrepreneurs who just can’t find any competition, don’t expect to find any investors, either.
  2. The Defensive Entrepreneur. My personal (least) favorite. Ask any question and these folks perceive a personal attack on their integrity, competence or both. Most investors just don’t want to give their capital to entrepreneurs who can’t put their ego and insecurity aside to answer questions directly. Even – probably particularly – when the answer is “I don’t know.” Defensive entrepreneurs send an all-too-clear message that when the going really does get tough, they will look for excuses, not answers.
  3. The Big Business Entrepreneur. This one bit me big time fairly early in my career. Going into the second round of a deal where I was the “suit” for the seed and A rounds, we needed an industry pro to take the CEO role at the B round. We figured someone who could run a billion dollar division of a Fortune 500 competitor could surely run our little startup. Huge mistake. While there are examples of folks who have transitioned from managing big businesses to the startup world, they are outnumbered by folks who took the leap and cratered. If you are a “Big Business” manager transitioning to the entrepreneurial world, you need to make it crystal clear that you understand how managing a startup is different than managing a big established business, and that you are the kind of person who can do both. (If you don’t know the difference, you are not that person.)
  4. The “God Complex” Entrepreneur. Typically, but not always, an academic. Most often, someone in the life sciences, who has figuratively (if not literally) held life in her hands. Alas, the skills associated with saving lives, whether via brilliant surgical technique or cutting edge research, just don’t have much in common with running a high impact startup business. The few folks who have made the transition prove the rule. Pretty much the way Michael Jordan proved that exceptional basketball players don’t make even adequate minor league baseball players.
  5. The “I Can Do It All” Entrepreneur. These entrepreneurs – and they are a dime a dozen, I’m afraid – missed out on Econ 101, or at least the day they explained the law of comparative advantage. I’ve yet to find a good entrepreneur who was not better at some things than others, and who did not also know that focusing their personal efforts on the tasks where they add the most value is the best thing they can do to make their startup prosper. On the off chance that you in fact can do it all – don’t.
  6. The “It’s All About Me” Entrepreneur. I’ve followed this one down one too many rat holes. They can be hard to spot, but as soon as you conclude that an entrepreneur’s worst nightmare is not failure, but success with someone else at the helm, run, do not walk, to the nearest exit.
  7. The Uneducable Entrepreneur. Look, I get it. Entrepreneurs are often wrong, but never in doubt. But the good ones, even when reluctant to acknowledge their mistakes, are very good at learning from them. Good investors don’t generally rub their entrepreneurs’ noses in their mistakes, but they don’t write many checks for entrepreneurs who don’t learn from those mistakes.

I am sure there are other spooky entrepreneur traits, but this list covers a big piece of the territory. If you see yourself here, you might want to think about making some changes in your entrepreneurial profile. It will likely make raising capital easier. Even more to the point, it will likely improve the outlook for making something good happen with any capital you raise.

Raising Capital for Your Startup: It’s About More Than Money

Most of the time for most entrepreneurs, raising money for a startup is not a lot of fun. Absent some combination of a hot deal and a hot market, fundraising is a real chore, too often full of demoralizing turndowns and even more demoralizing walls of silence. Still, as bad as it can be, the process almost always includes some important opportunities that good entrepreneurs will seize and use to their advantage.

The first opportunity the capital chasing process offers is self-reflection. Asking other folks for risk capital forces you (at least if you expect any success) to think about your business objectively, from the perspective of an outsider. And not just any outsider, but a jaded professional investor. Vision and passion are certainly appreciated by most of these folks, but as table stakes, not closing arguments. To seal a deal, you will need to get back to the cold hard realities of your value proposition, your business model, your evolving competition, your financing plan, and your exit strategy. Mission critical stuff that can get lost in the fire drill of day-to-day startup life.

Another opportunity worth grabbing on to in the fundraising process is the learning opportunity. If you have been at all careful about qualifying your investors, you will be talking to folks who very likely know a lot about the environment – technology, competitive, financing, exit, etc. – your startup is living in. If you listen carefully, and ask good questions (you should, in all events, be vetting potential investors as much as they are vetting you), you will almost certainly learn a lot of valuable information from the fundraising process, as much or even more so from investors who turn you down.

Finally, the fundraising process will give you valuable feedback on your teams’ capabilities, collectively and independently, in an area – raising capital – that will only become more important as your capital needs grow on the road to your exit. Raising capital is a skill in its own right – indeed as mission critical a skill as there is. Getting a periodic handle on where your team measures up in that regard may not be worth the trouble in and of itself, but when you need the money you might as well get as much besides money as you can out of the process.

Approaching the fundraising process as a learning opportunity, as well as a way to generate needed capital, may not make the effort any more fun. But it can make it a lot more rewarding.

Building Your Startup Team: Complementarity and Chemistry

Most professional venture investors believe the best predictor of startup success is the quality of the team. Good teams can and do fail, but as team quality drops below “awesome,” the chances for success drop very fast. Thus the cliché that most investors will gravitate to an “A” team with a “B” opportunity over a “B” team with an “A” opportunity.

There are a lot of reasons team quality is so critical to startup success. The incredibly stressful startup environment is the biggest. Startup teams need to accomplish difficult goals with minimal resources in terms of time, capital, and people. Additional stress accrues as outside forces – competitors, markets, technologies, etc. – evolve and force teams to make significant adjustments, often including basic “pivots” (business model, for example) on the fly.

If the extraordinary stresses of the startup environment explain the importance of getting the team right, they also offer a clue to what makes a superior startup team. At the foundational level, what separates the superior startup team from the merely good startup team is complementarity and chemistry.

Complementarity is pretty straightforward in concept, if not always in execution. Within the confines of available resources (financial) and the constraints of team chemistry (more later), you need to make sure the team includes top-tier players at the mission critical startup tasks (i.e. the tasks that need accomplishing in the current round of funding), as well as the flexibility to successfully “wing it” with respect to important ancillary functions.

The trick to building a complimentary team lies in recognition of, and dealing with, the well-established HR principle that when people get to choose who they work with – or who works for them – they tend to choose people like themselves. Now, if you are a founder, and thus most likely very confident of your own near-perfection, that might not seem like a problem. If you’ve got perfection, why not clone it if you can?

Consider if Apple had been founded not by Jobs and Woz, but by Jobs and … Jobs. If you know the Apple story, you know what a catastrophe a Jobs/Jobs founding Apple team would likely have been.

The bottom line is that however perfectly suited you may be for leading your startup to fame and fortune, building a team of clones is seldom the best way to go about it. Instead, look for people with different skill sets. And as much or even more so, different personalities and perspectives on business, technology, and life. The most successful startups – even those like Apple in the years after Jobs returned from exile that were dominated by a leading personality – build leadership teams with diverse skills, experiences, perspectives, and personalities. Just ask Tim Cook.

And that leads to the second, and harder to execute, aspect of assembling a superior startup team: chemistry.

It’s not enough to assemble a team that “covers the waterfront” in terms of skills, experience and personality. You need to make sure those folks can also form very strong bonds with each other (thus the “chemistry” analogy). Because in the constantly changing world of the startup, relationships between key players on the team are going to be under almost constant stress as company circumstances evolve and people have to adjust to changing opportunities and challenges. As anyone who studies morale in the military will tell you, folks in foxholes are motivated more by their loyalty to the folks around them than to “the cause” as such.

On that last point, one of my favorite quotes from an entrepreneur came when he was asked what he would tell his team at the beginning of his next startup journey. He replied: “Folks, we are going on a very long and difficult journey. On this journey, we will carry our wounded – and shoot the deserters.”

The quality of the team has long been the most important factor for most venture capital investors, for good reasons. As you think about assembling your team, particularly in the early days, don’t make the mistake of hiring folks because they look like you, or because they are a perfect skills fit. Look more for folks who compliment your skills and personality – and that look like the kind of people you want on your side when the going gets very tough. Because it almost certainly will, likely many times.

Things Entrepreneurs Should Know (About Venture Capitalists)

If ever there was a prototypical “love-hate” relationship, there is a good chance it was between an entrepreneur and a venture capitalist. It’s the perfect kind of relationship for the love-hate dynamic: lots of pressure; big egos; mutual dependence; and over-lapping but different and evolving relationship objectives and constraints. Unfortunate as it may be when things get ugly: surprising it isn’t.

While ugly entrepreneur/VC relationships are inevitable, there are more of them than there should be. As both a VC and a VC-backed entrepreneur I’ve seen a lot of entrepreneur/VC relationships get ugly that shouldn’t have; or at least shouldn’t have as soon as they did. Many times, entrepreneur/VC relationships break down when one side – and it is more often the entrepreneur side – doesn’t appreciate some of the realities that shape the attitudes and requirements of the other side.

And so this brief review of some of the realities of the world venture capitalists inhabit, and how those realities impact their relationships with entrepreneurs. Some are deeply ingrained in the nature of the venture investing business; some seemingly arbitrary rules of thumb. And yes, in almost every case subject to the occasional exception that most often proves the rule.

  1. Venture Capitalists are Fiduciaries. Venture capitalists manage money entrusted to them by their own investors (commonly referred to as “Limiteds”). That makes them fiduciaries, and that, in turn, means they are legally bound to act solely in the best interests of their Limiteds. Thus, as much as they may like and respect their portfolio entrepreneurs, their Limiteds have first call on their loyalty. A VC with any integrity at all (and you surely would not want to work with a VC lacking integrity, right?) will, when faced with a choice of doing the best thing for her Limiteds or doing the best thing for her portfolio company, pick the Limiteds every time.

    The fiduciary character of the VC/Limited relationship manifests itself in all sorts of ways beyond the obvious “should I invest more capital to save this company that I want so much to succeed, or would that be a bad move for my Limiteds” sort of situation. For example, entrepreneurs are often bemused by the emphasis VCs put on dotting every “i” and crossing every “t” in the deal documents. Well, that’s because while they personally might think a particular “t” does not need to be crossed, they have to think of their Limiteds – more specifically, what their Limiteds might think if not crossing that particular “t” turned out to be costly.

    More generally, being a fiduciary makes VCs very sensitive to making and managing deals within the real if not always well-defined parameters of the then current market. So, for example, I once knew a very prominent VC who thought that the whole idea of anti-dilution price protection was silly (I actually agree with him on that). That said, he got it in every deal he did for his fund. Why? Because if he didn’t his Limiteds would want to know why every other VC got it for their Limiteds, and he didn’t get it for them.

    The bottom line here is that entrepreneurs are well-advised to remember that as much as they may think of their VC as their VC, she is in fact first and foremost her Limiteds’ VC. And if she is any good at all, as much as she may like and respect you, in terms of her priorities her Limiteds are at the top of the list.

  2. Venture Capitalists are … Entrepreneurs. You heard that right. VCs are entrepreneurs just (well mostly) like you. They put together a business plan and take it on the road to raise money from mostly very sophisticated institutions. If they deliver the goods, they will likely find it easier to raise capital for their next fund. If they don’t they will probably find themselves in another line of work.

    Beyond just generally helping you have some empathy for VCs, realizing how their life and yours have so much in common should tell you something about their nature. Look in the mirror. Do you have a big ego? Are you often wrong but never in doubt? Are you a tenacious bulldog when it comes to building your business? Do you have at least one serious personality … quirk?

    Well, so does your VC. Which is to say, as difficult as you may find them to work with at times, you can be pretty sure they feel the same way about you.

  3. Venture Capital Funds Pivot, Too. If there ever was a startup that evolved exactly according to plan – from the first money in to the exit – you can be sure it was one of those exceptions that proves the rule. The same goes for venture funds. VCs leave funds unexpectedly. Markets evolve, and investment strategies evolve with them. Unexpected opportunities and challenges come up, and with them changes in resource (capital and people) allocation. Stuff happens and funds change, just like startups.

    When stuff happens at a VC fund, portfolio companies can suffer. One of the saddest VC/entrepreneur stories I know involved a company where I was an angel investor and director. The entrepreneur was really good, and really wary of brining a VC into the business. He bootstrapped and invested most of what he had made in a prior deal. Finally, with a good product, cash-flow positive operations on $5 million revenue, and great press, he concluded (rightly, in my opinion) that to come out as a leader in the market and really scale the business he needed to bring in some capital.

    So, he took $10 million from a very reputable venture fund at a good price, working with a partner who had followed the company and made noises about wanting to invest for several years. The first three months post-close were fantastic. And then .., the VC left the fund for greener pastures. The fund assigned a junior associate to the deal, and started looking at how to get out sooner rather than later. The company ultimately failed, largely, I believe, because what looked like such a sweet entrepreneur/VC pairing turned sour.

    Ok, the general point is that your relationship with your VC and her fund will evolve. Sometimes for the better. Sometimes for the worse. It pays to stay attuned to what is going on in your VC’s life, and her fund’s life. Is her star – and the funds’ – rising or falling? How much dry powder does the fund have? How much of that is for your deal? How is the rest of your VC’s and her fund’s portfolio doing? Knowing all of this, of course, doesn’t mean you have a lot of influence on it. But it can give you some inkling about how your relationship with your investors is going to evolve, for better or worse.

  4. Venture Capitalists are Business Partners not just Investors. Entrepreneurs are all over the map on the notion that VCs bring more value than just cash to the table. In my view, good ones do. But that really is not the issue here. The issue is that whether or not you think your VC has anything to offer besides money, you can be sure your VC believes she does, and in any event she is going to have some serious things to say about how you manage your business. And it doesn’t really matter how much of your company she owns: as folks who have run afoul of a bank loan covenant can attest, you don’t need to have an ownership interest to have a controlling interest.

    The point here is that you should be very careful, as you put together your deal with a VC, not to get so focused on the economics that you miss the management implications of the deal terms. Make sure you talk with your lawyer about control issues like class voting rights; Board seats and observer rights; fiduciary obligations (which can cut different ways in different circumstances); any voting agreements or side letters with investors; and most of all the extent and nature of the “Protective Provisions” in the deal documents. You’ll almost certainly find that there will be things you will not like in these areas, some of which you will likely not be able to change. But you can often change some of them at the margins at least, and even when you can’t it is better to know about the realities of control before your VC asserts them at a crucial moment.

  5. Venture Capitalists Don’t Do NDAs. Having been a serial entrepreneur I get why entrepreneurs think VCs should sign Non-Disclosure Agreements. Having been a VC as well, I get why VCs don’t do NDAs. And, well, the VCs are right. If they signed an NDA with every entrepreneur they took a business plan or pitch from, you can be sure they would spend most of their lives in court defending claims that they “borrowed” some entrepreneur’s idea and used it in another deal. (And that does – very rarely, I think – happen).

    Now, the VCs don’t do NDAs shtick would be a really big problem if it did not have such an easy solution: don’t tell a VC, until a term sheet is signed and final due diligence is in process (if then), anything that is really proprietary. If that seems impractical, consider this: You can sample my secret sauce without me sharing the recipe. For example, I can show you data demonstrating how my device detects metal fatigue, and likely even tell you some of the concepts about how it works, without telling you anything that would allow you to recreate my device.

    Seriously, there is no reason to share real, valuable proprietary information in your business plan or pitch to VCs. You can have a “black box” at the heart of your value proposition if you have sufficient indications of credibility (team, data, etc.) surrounding it. How strong those indicators need to be depends on how extravagant your claims are for your black box. If you have a device for sampling someone’s breath and diagnosing an infection, put a credible scientist beside it with some relevant literature and some early data and you’ve told me more than enough to get my due diligence going. If your telling me that your black box violates the second law of thermodynamics (I’ve seen plans like that a couple of times), you’ll likely have to show me a lot more: perhaps, say, that Stephen Hawking is your CSO.

  6. The 20-50% and 10x Rules. Valuation is what most entrepreneurs focus on in negotiations with VCs (often to the detriment of equally important issues like control and exit provisions). Entrepreneurs, of course, want higher valuations (thus less dilution), and can be very creative coming up with fancy spreadsheet forecasts and financial analysis.

    I must say I have seen some very slick spreadsheets supporting valuations for startups. Most of them, though, confuse precision with accuracy, and fail to deal with two fundamental realities of how VCs look at valuation. And in the process, provide a plethora of trivial details for folks to pick apart.

    The first valuation reality, and probably the best known, is that a Series A investor’s approach to valuation is very practical and simple: show me a model, from my investment to the exit, that I can believe in and that gets me at least $10 back for every $1 I invest. What they want to see is a list of likely buyers; the metrics for the likely sale; and some sense of how much additional dilution they will suffer to get there.

    That is a “big picture” kind of analysis that just doesn’t require a very detailed spreadsheet. It’s an analysis that places a lot more importance on the accuracy of assumptions than their precision, and limits the number of cells in the sheet to debate about. So why not save the time and expense of the finely detailed and precise spreadsheet model that reaches a conclusion only loosely correlated with what the investor thinks is important?

    The more overlooked valuation rule is the 20/50 rule. Most VC investors want to see an A round where the investors acquire at least 20% of the company, but no more than 50%. VCs want some minimum stake that reflects their centrality to the business. Most of them think that minimum is 20%. That may be arbitrary and capricious, but it is what it is.

    On the other hand, most VCs don’t want to see the founders and their team give up more than 50% of the equity in the A round because they want the founders and the team to have sufficient incentives to maximize the valuation of the company well past the A round. Again, 50% may be just a number, but it is pretty commonly “the” number in terms of maximum dilution at the A round.

    The trick with the 20/50 rule is how it can impact valuation when the size of the VC Fund is mismatched with the size of the needed A round investment.

    Most venture funds have a rule that limits how much of their capital can be deployed in any one company. That number is commonly 10%. So a $30 million fund is usually thinking that it can invest up to $3 million in any one company. Further, most VCs, given $X to invest in one portfolio company, will want to make sure some minimum fraction of X – let’s say 1/3 for an example – is available for the round after they first get in the deal.

    Ok, so let’s assume our VC’s Fund is $30 million. They want to put $2 million into you’re a round, and they have another $1 million lined up from another investor that will follow them into the A round. So they have $3 million for the A round.

    If you apply the 20/50 rule, you’ll find that to get the minimum 20% ownership for the A round investors, the maximum pre-money valuation is $12 million. If you want a significantly higher pre-money than that, you are probably better off looking for another lead investor with a deeper pocket; perhaps the smaller fund will follow in the higher priced deal.

Now, as I noted at the outset, the various rules and such noted above are, like most rules not found in physics or mathematics books, subject to exceptions. Maybe your deal should be one of those exceptions. But even if your deal should be an exception, the chances it will be an exception will be maximized if you know the whats and whys of the rules before you start trying to convince a VC to break them.