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What VCs Want to Hear

By Gabor Garai When entrepreneurs go searching for venture capital, one of the first questions they must be prepared to answer is how prospective investors will recoup their investments. The answer entrepreneurs love to provide is this: "We'll go public and you'll make oodles of money." The way most people behind startups envision things, an initial public offering (IPO) remains a win-win situation: The venture capitalists get their money out, and the founding entrepreneurs stay on to grow their businesses, just as they always dreamed would happen.

That answer was fine through 2000, but because public markets have fallen on tough times, it is the wrong response in today's business climate. During all of 2002, according to the National Venture Capital Assn., there were just 19 initial public offerings of outfits backed by venture capital, vs. 226 in 2000. That's a reduction of more than 90%.

THINKING THINGS THROUGH. To assure today's VC's that they will be able to exit with their investments and profits, the correct answer -- or part of it -- is that the business they are being asked to back will be acquired by another, usually larger, entity. Unfortunately, it's not enough to simply talk about being acquired. An entrepreneur needs to envision the scenario in detail: How will it happen? What kind of acquirer will it be? How will valuations be determined? What is the likely timetable?

One of the keys to providing the answers venture capitalists want to hear is to make a judgment about the kind of acquirer most likely to find the business appealing. Generally speaking, there are two kinds:

Strategic acquirers. These are usually corporations that buy a company because they have decided it complements their existing operations or fills a market or product niche they wish to enter.

Financial acquirers. These are the conglomerates or equity funds that are focused most heavily on bottom-line considerations -- cash flow, return on investment, and other such matters.

CASE STUDIES. Ideally, if you are an entrepreneur courting VCs, you'll be able to back up your assertions with examples of other companies in your industry that have been acquired by strategic or financial buyers. From those cases, you may be able to extrapolate how valuations are determined and propose a feasible acquisition timetable -- that is, by providing informed projections of the growth level the business will have achieved at the time the acquisition is most likely to occur.

Even if you are able to back up your assertions, more information will be needed to fill out the details in the acquisition scenario you sketch. For example, it's vital that your business fit the model a prospective acquirer is likely to find most attractive. More often than not, this means a company that has not only seen rapid growth, but also became profitable within three years to five years.

That emphasis on profitability over the medium-term also suggests that the so-called "big idea" outfits will be a much harder sell as far as VCs are concerned. Companies of this sort -- the Amazons and Yahoos -- tend to require large amounts of investment capital and longer periods to achieve consistent profits. Instead, today's emphasis is on narrow markets and perhaps less exciting products than the stars of the dot-com boom. These days, they are the ones most likely to impress prospective acquirers.

ON THE WAY OUT. The strength of the case you make will go a long way toward determining whether you get funding. To the extent that you can make a convincing argument that some high multiple of earnings or revenues will make your company an attractive acquisition, you'll improve your chances of being funded.

The down side is that you must be prepared to live with the case you make -- and for entrepreneurs, life after an acquisition isn't usually very exciting. No matter who buys it, the odds are pretty high that you won't be around within two years of the sale. Either you'll become frustrated with the new owners, or they'll become frustrated with you. If you can't live with the good-news/bad-news reality of today's exit-strategy environment, then you should consider whether you really want to be raising venture capital in the first place. Gabor Garai is a partner in the Boston office of national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.

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