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Copyright 1996 Bruce E. Methven
Methven & Associates
2232 Sixth Street, Berkeley, CA 94710
phone: (510) 649-4019; fax: (510) 649-4024
e-mail: bmethven@aol.com
home page: http://members.aol.com/bmethven
1. Have your business plan reviewed by someone with expertise before you present it
to investors. The reviewer might be an entrepreneur, an executive with an
entrepreneurial bent, a venture capitalist you won't be approaching, or someone who
specializes in preparing business plans.
2. Consider making the entity a limited liability corporation or a limited partnership; this
allows the pass-through of profits and losses (avoiding the "double taxation" that occurs
regarding a C corporation) and it allows corporate investors (unlike a Subchapter S
corporation).
3. Ideally, you want a venture capitalist:
a. Who is interested in early-stage companies and already has investments in
your industry.
b. Who has a preference and the know-how for investments in your industry:
one who knows your market and your industry.
c. Who has a successful record of growing smaller companies.
d. Who can offer sound business advice, moral support and contacts in the
business and financial community in addition to venture capital.
e. Who has co-invested with quality venture-capital firms and underwriters.
f. Who gets along with you well.
g. Who has a good reputation.
4. One source book for venture-capital financing is Pratt's Guide to Venture Capital
Sources (Venture Economics, Needham, Mass.) Also, lists of venture capital
companies are available from:
The National Association of Small Business Investment Companies
1156 15th Street, Suite 1101
Washington, D.C. 20005
(202) 833_8230The National Venture Capital Association
1655 North Fort Myer Drive, Suite 700
Arlington, VA 22209
(703) 528_4370
On the Web, lists of venture capital firms can be found at:
http://www.capitalventure.com/cvvclinks
http://www.financehub.com/vc/index.html
5. Note that venture capitalists will generally refuse to sign confidentiality agreements--but they
will maintain confidentiality as part of maintaining their reputations.
6. Frequently the investor is looking for the following:
a. A company that can become highly profitable and dominate the industry.
b. A company that can go public or merge within four to seven years at a high
price/earnings multiple.
c. A complete management team with a strong leader.
d. Principals with proven entrepreneurial, management and profit experience in
the industry.
e. A strong innovator, technologist or marketing person.
f. A team with complementary and compatible skills.
g. Principals with unusual tenacity, imagination, commitment and integrity.
h. A significant competitive lead and other market advantages.
i. High_value_added goods or services.
j. Exclusive contractual or legal rights.
k. No dominant competitor.
l. A market growing at 25% or more per year.
m. Clearly defined customer and distribution channels.
n. The opportunity to achieve positive cash_flow and break-even sales.
o. Gross margins of 40%_50% or more.
p. A 10% or greater profit after taxes.
q. First-round capital requirements of $1 million to $10 million.
r. An opportunity to recoup 5 times the investment (or more) in five years.
s. Anti-dilution and initial-public-offering subscription rights. (Though often the
entrepreneurs want to avoid these, as will be discussed later.)
7. Some items that particularly excite investors:
a. Evidence of market acceptance (orders, letters of intent, beta sites etc.).
b. Focus by the entrepreneurs and a market niche for the venture.
c. A proprietary or exclusive position created by intellectual property (licenses,
patents, copyrights, proprietary technology etc.), or a substantial market lead
and the lack of dominant competition.
8. Here are the ranges for compounded annual rates of return that investors often
expect, based on the stage of the venture:
Start-up 50%_70%+
First Stage 40%_60%
Second Stage 30%_40%
Third Stage 10%_30%
However, these ranges may well vary depending on the what the investor perceives as
the degree of risk involved.
9. Generally, the usual negotiation ranges are 50_70% or more for the investor who
provides all the required funds when the venture is a start-up. However, on start-ups, if
the entrepreneurs provide 10% of the investment they may be in a position to keep
50% of the equity; if they provide 1/3 of the investment they may be able to retain 2/3 of
the equity.
10. Some factors that may persuade an investor to take less than the usual range are:
a. Previous profit responsibility by the lead entrepreneur and above-average
profit.
b. The presence of a complete management team.
c. An entrepreneurial team with detailed, current knowledge of the target market
and substantial previous experience in getting orders from the venture's
prospective customers.
d. A demonstrably strong position for the venture's products or services in terms
of patents, exclusive markets or substantial lead time.
e. The entrepreneurs taking personal loans or second mortgages on their
houses to invest money in the venture.
f. The entrepreneurs offering collateral (mortgages on real property, liens on the
company's equipment and machinery, patents or other intellectual property
rights) to protect the investor's investment.
11. The oral presentation to the investor should:
a. Be rehearsed; key facts, figures and other knowledge should be memorized.
b. Be concise; venture capitalists are frequently pressed for time.
c. Analyze the opportunity and market for the company's products or services
and why those products or services can establish a market niche against the
competition.
d. Stress the unique skills and backgrounds of the management team that
qualify them for their projected roles in the company.
e. Discuss the history of the venture.
f. Provide a brief view of projected sales and profits over the next five years and
the key assumptions behind those projections.
g. Address potential risks and problems, showing that the management team
has the ability to think through the tough trade-offs and devise alternate action
plans.
h. Give each key person on the management team an opportunity to speak.
i. Offer a succinct list of who owns what shares in the company and who has
paid what.
j. Offer a summary of the details of the proposed deal, including the price and
shares (or a range of them).
k. Indicate the name and telephone number of the person the investor can call
with questions.
l. State how the investor may ultimately cash out (IPO, purchase by the
company over time, purchase by a company ESOP or ESOT, purchase by the
company according to a formula, sale of the venture to another company, finding
a replacement investor, liquidation).
m. Include a short, exciting, written business summary (1,000 words plus charts)
addressing these points.
n. Generally include well-designed, professional prototype or actual product
brochures, and pictures of the product.
o. Let the investor know you are also approaching other venture-capital
sources.
Be prepared to answer all conceivable questions about the venture.
12. Whenever rejected, try to determine the true reasons for the rejection--it will be
useful for the next time.
13. Despite any claims to the contrary, everything is negotiable. The essential
negotiables are:
a. The basic valuation of the company, and how much equity is relinquished for
the money the investor puts in.
b. Who will pay the legal and accounting fees necessary to complete the deal?
c. What type of stock or debt will be issued? (Common stock, preferred stock
(entitled to set dividends), convertible preferred stock (convertible to common
stock), convertible debentures (loans convertible to common stock), loans with
warrants (options to buy stock).) Investors may want to purchase convertible
preferred stock, while the entrepreneurs may prefer to issue common stock or
debt plus stock.
d. Will the management remain as it is? Investors may want a management
change if they believe the company's team is lacking in some skill or if they
believe someone else on the team should be president.
e. How many directors' seats will be allocated to the investor?
f. How will voting control (of stock) be allocated?
g. Will investors have a right of first refusal on subsequent offerings? Will the
original shareholders?
h. Will there be stock_vesting agreements where the entrepreneurs do not own
all of their stock initially but acquire ownership over three to five years?
i. Will there be employment contracts, non-compete and proprietary-rights
agreements with the entrepreneurs? Investors often insist on this.
The management team should decide these issues in advance. On price per share
paid by the investor, the entrepreneurs should decide what they would like to get and
what they will accept.
14. Logical persuasion is generally the best negotiating tactic.
15. The investment agreement should:
a. Specify the amount, timing and type of the investment (stock, convertible
preferred stock, notes, warrants etc.)
b. Provide terms that will motivate the entrepreneurial team if they perform as
planned.
c. Provide down-side protection to the investors by giving them control of the
venture if it is in danger of failing.
d. Provide and protect opportunities for the investor to realize capital gains and
liquidity.
16. The following are usually burdensome conditions to be avoided if possible:
a. Participating preferred stock. In the case of liquidation, investors are repaid first
(purchase price plus accrued dividends) plus any remaining assets are divided on a pro-rata
basis with the common-stock shareholders (usually the entrepreneurs).
b. Anti-dilution "ratchet-down" provisions. The investor is issued additional common
stock if the company completes an subsequent sales of stock at a lower price. If the
investor holds convertible preferred stock, the conversion price is adjusted to equal the
lower sales price.
c. Anti-dilution "weighted average" provisions. Here the conversion price is adjusted
based on a weighted average of each stock issuance. Less drastic but still a problem.
d. "Demand" registration rights. Investors can demand that their shares be registered
for a public sale (typically within three to five years). Underwriters often object to
this, which can make going public difficult or impossible.
e. "Piggy-back" registration rights. Grant investors the right to include their shares in
any stock registration. Again, underwriters frequently object.
f. Mandatory redemption of preferred stock. Here the company must buy out the
investor if the company fails to complete an IPO (or meet other goals) within a
specified time period. Raising the cash may cripple the company.
g. Co-sale provisions. Investors can tender their shares if the founders sell additional
stock before an IPO. This causes conflicts with later-round investors and inhibits the
ability of the founders to cash out.
h. Investor-only sales. If management doesn't find a buyer or take the company public
by a certain date, the investors can find a buyer for their stock alone.
i. Dilution financing. Dilutes all existing stock when current shareholders won't
commit additional funds. This may leave the entrepreneurs with too little to keep them
motivated.
j. Key-person insurance benefiting the investor. Key-person insurance with the
proceeds directly payable to the investor, rather than to the company.
