The Process of Raising Venture Capital

This section focuses on the process of raising venture capital from institutional sources or from organized angels. Investments made in the earlier stages (by family, friends, and small private investors) are not characterized by an orderly structure. Capital may be raised from institutional sources or from angel associations after the company is established and the business organization for raising capital is completed (including the business plan). This financing is usually founded on principles similar to those governing first-round investments, but at this stage entrepreneurs already have some experience and can also rely on the funds which were invested in the early rounds.

This section is aimed at novice entrepreneurs who have not yet experienced capital-raising personally.

What Interests Investors

Before approaching an investment round, it should be ascertained whether the company meets investors' standards. The main issues which interest investors are the following:

• Management Almost all investors regard a team of entrepreneurs and managers capable of leading the company to success as the key to an affirmative decision. Investors expect to see teams whose aggregate skills turn them into a "commando" unit, capable of functioning under stress and finding creative solutions that will secure the company's anticipated success even in front of a tough environment. A good team includes managers, technology and business-development leaders, and advisors who complement the team in the field of finance and with contacts in the business world.

  Investors look for the entrepreneurs' commitment to their project. Jeff Bezos, for instance, the entrepreneur who founded the e-commerce company Amazon, demonstrated an exceptional degree of confidence and commitment by abandoning a promising career at an investment bank in favor of the new company and investing in it money from his own and his parents' savings. Investing in a working model of the product, preparing a technical specification, and other such factors which indicate the entrepreneur's commitment and investment, are always helpful in encouraging investors to make affirmative decisions.

  Relevant experience in the field or other managerial experience is also helpful in attracting investors, but in their absence a company can still rely on the experience of others. It can recruit experienced experts from the relevant field to its management team or team of advisors, and their involvement in the project can contribute to the capital-raising efforts.

• Market The existence of a large potential market, of which the company may gain a considerable share, is an essential and basic consideration which becomes more important as the company matures. For instance, institutional investors seek products with an annual sales potential of at least several hundred million dollars. Beyond a knowledge of the size of the market, investors need to assess the company's understanding of the market and be convinced that its proposed solution does indeed meet the future needs of that market. In most cases, the size of the market and the company's projected profitability are crucial factors in the company's potential, because even prudent managers and exceptional products cannot usually generate more than the maximum projected return, given the forecasted market data. Components which considerably affect a market's appeal are the impact of existing and expected legislation, either federal or local, anticipated demographic changes, tax consequences, projections with respect to the entry of potential competitors into the market, and the identity and nature of such potential competitors.

• The company's relative long-term edge Investors seek out the product with a high added value to its target users that will become the sustainable market leader. For instance, a high tech startup has usually inferior resources at its disposal compared to high tech giants, and/or must therefore rely on visible technological depth and/or superiority of other domains. A major issue is the company's relative long-term comparative advantage over its competitors. A technological advantage is typically insufficient in itself, so the company must construct a "package" that is composed of a revenue model, a marketing model, a model for protecting its intellectual capital, and a set of schemes for cooperation. Investors will examine the components of this business model, and assess the chances of realizing the potential of the product or the service.

• Synergism with investors Investors in general, and corporate investors and venture capital funds in particular, prefer combinations in which the value of the investment will rise due to the investors' contributed experience and contacts. In addition, they may look for the added value of the company's products to their own offerings, or to the offerings of their portfolio firms.

• Anticipated exit Over and above all of the issues mentioned above, investors obviously also examine the possible exits they will have to realize their investment, and the potential to achieve exceptionally high returns.

Preparing to Raise Capital

Contacting investors when the company is not yet fully prepared not only reduces the chances of an affirmative reply, but also diminishes the prospects of the company (and possibly also the prospects of subsequent ventures undertaken by the entrepreneurs) to secure financing in the future by giving an impression of imprudence. The more prepared and mature the company is when it approaches outside investors, the better its chances of obtaining the investment and at the value it hopes for. Venture capital funds are best contacted only after a company has a solid managerial backbone, a business plan prepared on the basis of thorough market research, and preferably also some product prototypes.

Choosing the Investors

First, a profile of the potential investor has to be drawn. There are many venture capital funds; some focus on a particular field or technology, others focus on certain stages of financing, and others have rules with respect to minimum and maximum size of investments. First and foremost, the likelihood of capital-raising is highly influenced by having pre-existing direct or indirect connections with the VC. However, beyond this pre-condition, the main issues which need to be examined are: (1) The fund's reputation in the market; (2) The experience it has and the investments it has made in the relevant field and in the stage reached by the company (relevant experience can help in contacts and even in development); (3) The fund's track record working with entrepreneurs; (4) The fund's contacts with bodies which can promote the company; (5) The fund's ability to take part in additional rounds and to recruit additional investors; and (6) The identity of the partner in the fund who handles investments in companies in the startup's line of business, because personal connections with the partner and his or her ability to contribute to the development of the company are crucial components in its success.

An entrepreneur could draw a matrix in which all of the funds are rated on the basis of the degree to which they meet basic criteria (field of investment, amount of investment, and stage of financing) and their "rating" in the issues listed above. At the end of this process, the company has to choose the most appropriate funds for an initial application.

Contacting and Meeting with Investors

Once the investors to be contacted are chosen, the company usually sends them a summary of its business plan with a cover letter. As mentioned above, whenever possible, this should be done with the backing of personal contacts, for recommendations, and/or the assistance of advisors who are "door openers." The chances for an "orphan" business plan to survive the initial screening process are slim.

A very small number of the companies which submit business plans to funds advance to the point of a meeting with the entrepreneurs. Only well-prepared companies which meet the criteria listed in the section above on what interests investors (and, naturally, which meet the fund's specific criteria) will reach the stage of a meeting. The impression created by the entrepreneurs in this meeting has a crucial impact on the fund's decision to invest. The fund does not intend to evaluate the technology during this meeting (it will engage experts for this purpose), but to gain a general impression of the entrepreneurs' ability to execute their vision. The entrepreneur must assume that the material he or she sent was not necessarily read attentively, and that in any case some people who are encountering the company for the first time will also be present at the meeting. The meeting will start with an introduction of the entrepreneur and his or her group and of the investor and his or her group. Afterwards, the entrepreneur will usually have an opportunity to give a short presentation about the company.

The presentation is a tool for communicating a message in a simple and efficient manner and is not a goal in itself. While it is important that the presentation should be vivid, it is also important to focus on the essence of the company and its offerings rather than on the presentation technology, as it may cloud the underlying message. The use of technical aids is not necessary at all, and when the group is small, some people prefer to just conduct a conversation.

Deciding upon an Investment

Based on the information furnished by the company (mainly the business plan), the meetings with the entrepreneur, and investigations which the fund will conduct with respect to the product and the team, the fund will decide whether or not to continue the investment process (see the next section on how venture capital funds work with respect to the internal decision-making process of funds). From the fund's point of view, the decision to continue the investment process involves the high cost of having experts in the field examine the plan and the company. In any case, the decision is subject to an agreement on the terms and to a due diligence process. If the decision is affirmative, a series of additional meetings will be held in which a term sheet will be drawn. The fund's signing of the term sheet is, in fact, the official seal of the fund's decision that it is interested in giving the investment serious consideration.

Furthermore, in order to be fair to the companies, funds try not to sign the term sheet unless they have reached a decision in principle to make the investment, subject to a due diligence process, and other specific examinations. This is because withdrawing from an investment after the term sheet has been signed could hurt the company, which has by then invested a significant amount of resources in working directly opposite the fund without pursuing other routes (including a customary exclusivity "no shop" clause undertaking in the "term sheet").

Due Diligence

During this lengthy process, the investor checks the company over from both the business and legal aspects in order to verify the facts presented to him in the business plan and the negotiations, and examines any material information which could affect the value of the company and the investment decision. This examination is usually performed by the lead investor in any given round. The process serves both the investors, as a means of getting to know the company better, and the company, by improving its acquaintance with the investors who could accompany it over several years.

The components of the examination and its emphases change in accordance with the phase in the company's development, but generally include the following main components:

• A business investigation of the technology, the market, the intellectual property, the assumptions underlying the business forecast, the revenue structure (if any), the expense structure, and the budget. A material part of this investigation is carried out before the term sheet is signed.

• A legal examination of the company's organizational documents, ownership structure, the resolutions passed by the shareholders and the board of directors, material agreements, the company's assets and liabilities, and ownership of intellectual property, including patents, the company's rights to its name and Web site (these issues are examined by attorneys who specialize in intellectual property), agreements with the company's employees, agreements with interested parties, proceedings opposite various authorities, and legal exposure.

• An auditor examination and analysis of the company's financial statements, taxation, and any liability. This examination is carried out by the investor's CPA.