15 Things You Need to Score VC Funding

A veteran entrepreneur tells you what venture capitalists are really looking for before they'll make a deal

I've often said that instead of soliciting venture capital for your new startup, you're better off buying a lottery ticket. You'll save time, money, and spare yourself a lot of heartache. But when you've reached the stage in your business where you have a product that customers love, a business model that works, and a strong management team, everything changes. Now the venture capitalists knock on your door, and the odds of getting a deal become much better.

You need to consider your options very carefully at this point. VCs can be the best thing that happened to your company or your worst nightmare (see BusinessWeek.com, 7/18/06, "Venture Capital: The Good, Bad, and Ugly").

If you choose the venture route, prepare yourself for the mating dance that's about to begin. In this first article, I'm going to tell you what the VCs look for and some of the big hurdles you'll face. If you overcome them, you'll likely get offers from multiple firms. In my second article, I'll discuss what you should look for in a firm and the importance of being picky.

VCs take pride in being risk-averse. They receive hundreds of business plans every month and typically consider only a handful. They are more likely to look at companies that are well known or come with strong recommendations from people they trust. Their due-diligence process often takes months and is extremely rigorous. Most companies don't make it through. To prepare, you should look at your company the way they will.

Here are the 10 things they'll be looking for that you'll need to have in place:

1. Market-ready product. You need to have gone through the trials and tribulations of building a product that works well and meets customer needs. It is not enough for your product to work for one type of customer; it must be able to satisfy the needs of many (see BusinessWeek.com, 5/4/06, "Countdown to Product Launch (Part I)").

2. Solid business model. You must have a proven business model with a clear path to long-term profits. You need to have worked out all the details of what you are selling, to whom, and at what price; and how you are going to reach your customers, persuade them to buy from you, and support them when things go wrong (see BusinessWeek.com, 5/12/06, "Countdown to Product Launch (Part II)").

3. Brilliant business plan. A well-written business plan must credibly forecast high growth and explain your business strategy. It must show a thorough understanding of the market, competitive positioning, growth potential, and new market opportunities. And your target market must be sizeable enough to make an investment worthwhile.

4. Management team. You need to have all the key members of your team in place or document your hiring plan (see BusinessWeek.com, 5/19/06, "Countdown to Product Launch (Part III)"). VCs know that business models will evolve and things will go wrong. They are looking for a team that can navigate rough waters.

5. A clear and well-defined exit strategy. VCs invest strictly for the financial returns. When the time comes, they will want you to support their decision to sell the company, merge it with another firm, or take it public. You may want to change the world and take the company to greater heights, but they will want to make sure there is an out.

6. Board of directors. VCs exercise control and protect their investments through a board that the chief executive reports to. They will want a number of seats that are, at the least, commensurate with their stake in the company. Your challenge will be to balance this board with members who protect your interests and those of other shareholders (see BusinessWeek.com, 11/8/05, "Integrating Ethics at the Core").

7. Detailed financial reporting. You will need to provide monthly financial statements detailing how every penny was spent. All financials from the time you started the company will need to be audited by an independent accounting firm. You will have to adhere to the highest financial management standards and carefully manage money invested by others.

8. Succession plans. After you raise venture capital, your company is not going to be your company anymore. VCs will want to make sure that the management team is best suited to their interest in increasing stock value. They will want to make sure that you are ready to step aside if they determine you can no longer effectively run the company, and that you are ready to replace key managers.

9. Stock option plans and structure. You will have to create a stock and capital structure plan that equitably divides ownership of the company between management and employees. You will need to set aside stock for future hiring. And after raising venture capital, you will likely have two classes of stock: preferred stock that comes with special rights for the VCs—and common stock for everyone else.

10. Intellectual-property protection. You need to make sure that you are not infringing on existing patents and have key inventions patented before the window for obtaining patents closes. You should file trademarks for your product and service names, your company symbols, and any words that differentiate you from others. You must have clear ownership of all company assets.

You also need to be prepared for the VCs' due-diligence process. In addition to asking for all the things above, here is how they are going to check up on you:

1. Management references and background checks. They will ask for multiple references for every key executive. They will not only call these references, but also people that these references recommend. They will seek out others who have worked with you (and for you) to establish a composite picture. They will ask how good you were as a leader or team player, how you dealt with problems or conflicts, if you can be managed, and if you'll step out of the way when the time is right. They will also look for any skeletons in your closet. They won't call your parents, but they may get to your high school teacher.

2. Customer references. They'll ask customers about your products and their experiences with your company. They will ask about what problems they have had and how you fixed them. They will ask how well your product met their needs, what alternatives they looked at before purchasing from you, and how badly they felt they needed your product. They will talk not only to the list of customer references you provide, but also to others within the company. They will use their own contacts to reach senior management at your customer sites. Be prepared for the disruption that this can cause to your business.

3. Analysts. They are going to ask industry analysts what they think of your company and products. They are going to get multiple perspectives on the market size and trends. They will seek information on every key player in your market.

4. Employees/ex-employees. If VCs have doubts, they will find their way to your most loyal supporters and worst enemies. They may speak to employees and ex-employees from different levels of your organization.

5. Competition. They will likely speak to competitors to find out how they see their market opportunities and understand how they perceive the threat you pose. They will carefully study the successes and failures of other companies in your market to assess your chances of success.

There is no doubt that the VCs will get some bad news along the way. No one is perfect. If the VCs believe that your company has a strong chance of returning 5 to 10 times the money they invest within three to five years and can exercise suitable control, they may give you a term sheet. This document details the amount they want to invest, their conditions and requirements, legal rights, financial terms, and the controls they are seeking.

What you will likely find is that once the word is out that one venture firm has given you a term sheet, others will rush their due-diligence process and trip over each other to make you an offer. Now the tables are turned and it's time for you to do your homework.

In my next article, I'll discuss the due diligence that you need to complete, what you need to look for in your investors, and how you can maximize your chances for a successful VC marriage.

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