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Let’s Make a Deal: America’s Top VC Firms Reveal Why They Invest in High-Tech Startups

There’s no doubt about it: Technology companies are leading the pack for this decade’s startups. Spend five minutes on the World Wide Web, glance at the front page of newspapers and business journals, and read just a few of the daily press releases churned out by public relations agencies across the nation, and you’ll realize the incredible surge tech companies are creating. According to American Business Information’s “1996 Business Changes Report,” the number of high-tech companies is increasing faster than any other business category. In fact, the report stated that the number of Internet service providers increased by more than 9,000 percent last year, and computers and networking companies experienced a 44.8 percent increase during the same period.So what differentiates the winners from the losers in this onslaught of high-tech upstarts? Aside from a hot, new product idea, it is the ability of the entrepreneurs to persuade investors — specifically venture capitalists (VCs) — to gamble on their ideas and fund their startups. Without the necessary capital, even the most ingenious ideas will fade into obscurity. For instance, where would companies like Netscape and America Online be without the millions of dollars they received from San Francisco VC firm Kleiner Perkins Caufield & Byers? And could Compaq and Lotus possibly have achieved their current level of success without funding from Dallas-based Sevin Rosen Funds?

What is the secret to making a deal with VC firms? Here, some of the nation’s most active venture capital firms reveal what attracts them to new ideas and what turns them off.

The Personal Factor

Before you begin your presentation to venture investors, keep in mind that those first few minutes filled with small talk may be critical to the outcome of your meeting. Make no mistake about it — your potential backers are waiting for the chemistry to begin. They are evaluating whether or not they want to spend long hours and millions of dollars on you. Although creating a business from just the seed of an idea is a labor of love for many of these investors, some admit that they will not make a deal with an entrepreneur if they don’t feel a camaraderie with him or her. Remember: These people evaluate thousands of good ideas every year, and they have the luxury of choosing the entrepreneurs they “click” with the most.

Although VCs tend to evaluate deals based on black and white issues, there are decidedly gray areas when it comes to the personal factor. After the meeting, you may feel confident that your new company meets all of the necessary requirements, and yet you may not receive VC funding. What went wrong? Perhaps the venture investor thinks you live in a geographically undesirable location; or he or she simply may not like doing business in your industry. Sound silly? Don’t laugh. According to Dana Callow, a general partner at Boston Millennia Partners, “the go/no go” decision may be based more on personal elements than you think.

“There is a human aspect to what is happening in a financing relationship — which is truly a marriage — that sometimes is quantified by how much money is raised or what the business plan looks like, when it is actually the nature of the personalities that drive it more than anything else,” Callow says. “Many [people] try to find the facts and try to look harder and deeper into the weeds about why a financing got done, when in fact, it’s much simpler than that: It’s a good industry area, it’s a good management team, and the venture guys and the entrepreneurs like each other.”

Callow theorizes that the funding of an idea may come down to whether it simply piques the interest of a particular investor. “There has to be an intellectual stimulation,” he explains. “That’s not to say that just investing in a simple distribution business or a bagel company or something else wouldn’t necessarily offer a financial transaction, but at the end of the day, it doesn’t turn us on. I personally get very excited about some of the opportunities in the drug development area. One of my partners happens to be very excited about the Internet area. A third guy has experience in telecom. Each of us can handle, on an active basis, a limited amount of deals. The actual differentiation factor comes down to: the risk is good, the return is good, and this is where I want to spend a chunk of the next five years of my life.”

Believe it or not, something as simple as the locale of the company may influence a VC’s decision to fund your idea. “Some people might want to do investments in Southern California because the weather’s good, but they’ll never tell you that,” Callow laughs. “It’s fascinating. I did a deal in San Antonio. A lot of other [investors] didn’t want to take the extra flight you have to take to get there. I’m serious! But this was a great management team and the product opportunity was really exciting. It was worth the investment, and it can be that personal.”

Management Team

“Almost [all VCs] will want to buy into the management,” says Randy Tom, general partner at San Francisco-based Dynasty Capital Services. “The team must be dedicated, educated, and experienced. Most [VCs] make investments in people.”

This sentiment is common among venture investors. Assuming you get your foot in the investor’s door with your winning personality, the next task is proving that you have the right people lined up to get the job done. Just as the key to a successful retail outlet is location, location, location, the key to a successful VC funding is management, management, management.

The first question you will be asked after beginning your presentation is, “Who are the members of your team?” You should be prepared to supply the names of a reputable group of three or four experienced people who will be an integral part of the business. According to Jon Bayless, managing general partner at Sevin Rosen Funds, there should be a CEO or general business manager, a VP of marketing and sales, and a VP of development. “They would be the three critical skill sets you want identified in a management team before you get funded,” Bayless says.

Callow agrees: “We will go anywhere in the country for an ‘A’ management team.”

However, an “A” team may not necessarily be defined by extensive past experience. Sometimes a team’s potential for future achievements will win them a deal. For instance, software investment firm Hummer Winblad Venture Partners in Emeryville, Calif., values an entrepreneur’s ability to demonstrate excellence and cohesion more than the number of years of experience they have, according to partner Mark Gorenberg. “We invest in people who show excellence and can attract more excellence,” he explains.

Although leadership is the most important element, you needn’t despair if you don’t have a complete management team in place. Most VCs agree that they would assist an entrepreneur in building a team or introduce him or her to the right people if it is a good investment opportunity. In fact, Nora Zietz, partner of Baltimore’s New Venture Associates, the VC firm listed by Coopers & Lybrand as the most active in U.S. investments in 1996, says her firm will back a lone “techie” if his or her idea is strong enough. And there are other firms that don’t require a complete team. For instance, Callow says, “If we can find a team that’s 75 percent complete, we’d still move forward. The most important position to consider is the CEO. We focus on what his vision is, and what his relationship is with us.”

Sense Of Commitment

Like entrepreneurs in other markets, those in the technology industry have to demonstrate that they are personally committed to making their ideas work. “This is not a part-time job,” explains Tom. “They need to have financial resources that they’ve committed; they have to be able to demonstrate that they’re in this for their own creation of wealth and the creation of the company. That’s not to say that they have to remortgage their house and take their child’s college fund, but it means that they must be willing to risk whatever capital they have available.”

Callow also wants to be certain of the entrepreneur’s seriousness about the idea. “We want to know that they have really assessed what it means to be an entrepreneur and eliminated the romantic aspects from the practical aspects,” he explains. “In other words, how well have they thought through their vision, not only from a business standpoint, but in terms of impacting their life?”

Large/Global Market

Venture capitalists favor companies competing in potentially very large, emerging markets. Established markets with many entrenched competitors represent low-growth opportunities in the eyes of venture capitalists. “You shouldn’t have to go in and battle existing, large players for the market space,” explains Bayless. “You should be able to identify a new trend that can develop into a billion-dollar type of market. That, generally, is associated with some major change that’s occurring in the marketplace and the environment in terms of technology or the regulatory environment. Something in the environment is changing to create a new opportunity that perhaps the older, more established companies won’t react to immediately.”

Tom agrees with Bayless. “If it’s just a domestic product, I don’t think it’s going to work,” says Tom. “Domestic markets aren’t beefy enough to support the influx of competitors. There are too many other companies around the world that could be developing comparable products or different types of technology, and young entrepreneurial companies can’t afford to just rely on their local market.”

Callow confirms that Boston Millennia Partners looks for new ventures that appeal to expansive markets. “Typically, we look for companies that can have a minimum of $50 million in revenue, which means we have to be selecting from a number of industry sectors that have scale and growth,” he says. “We generally like to find companies that have a service component, as well as a product component. We invest with a strategy we call a ‘core company’ investment approach — some people call it a platform approach. We like to find a base business around which we can take new technology and apply it.”

You Never Get A Second Chance To Make A First Impression

After you have assembled the tools you need to approach a venture investor, be prepared: They will make a judgment about your company fairly quickly. They have to. Of the VCs interviewed, the average firm evaluates between 1,000 and 1,500 new deals each year, but only funds between five and 14.

“Our level of activity in terms of seeing projects and entrepreneurs is probably the highest it’s been in 10 years,” says Bayless. “We quickly sort through opportunities that, for one reason or another, aren’t going to find interest with us. That doesn’t mean that all the ones we haven’t funded are not good projects, it’s just they’re not projects for us.”

Bayless says his firm can quickly get a good indication of projects that will make the cut because they exhibit several traits: the potential to serve a very large market and the ability to leverage a change in technology — all within a time frame that is at least 18 months ahead of competitors.

“We get a feeling for those things initially, and they require follow up,” he says.

What If You Don’t Meet All Of The Criteria?

If you don’t have all the elements you need, but still believe you have an innovative product idea, is it possible to get funding? According to Bayless, you may not get the full amount you are seeking, but there are other options available.

“If there’s a project we like, we will take it incomplete and help the management team work with it in order to get it into a fundable state. Quite often, we will put together some sort of a bridge loan so the people can leave their employment, and they’ll have some place to hang their hat,” Bayless says. “We’ll spend two or three months with them putting together an operating plan for the business or introducing people to the team that can add the skill sets that are missing.”

If the team needs additional help after the members have been identified, Sevin Rosen offers assistance in identifying what the first products and first served markets ought to be.

What If You Have A Failed Company On Your Resume?

Afraid you don’t have a prayer because your last venture didn’t make it off the launching pad? That may not be the case. Callow says that a failure is not immediate cause for dismissal.

“Having a failure is not going to cut them out totally,” says Callow. “Obviously it’s a flag you look at to try and understand. We currently have a situation we’re evaluating where that’s specifically the case. He’s a very experienced guy. We have evaluated what happened, why it happened, how it happened — really recreated as best we could what happened — and we are going to make a proposal to invest.”

Callow’s open attitude comes from the realization that sometimes failures are beyond the control of entrepreneurs. In fact, he says that failures can often be advantageous because of the lessons they impart to entrepreneurs. “Our most successful deal was a company that was very close to [failing],” he says. “It wasn’t the CEO’s problem. There were a number of factors that happened, and in fact it was a realignment in Washington in the health care area that dramatically impacted his business.”

Zietz goes one step further. She says her firm considers past failures completely irrelevant. The way she sees it, business failures are one of the great learning lessons in life — if entrepreneurs carry that knowledge forward to their next ventures. “If the entrepreneur has learned from the failure, it actually has no effect at all,” she says. “I heard that in Switzerland, by law, if an entrepreneur has been the CEO of a company that has gone bankrupt, they’re not allowed to become CEO of another company, whereas here it’s almost a plus!”

Above all, don’t attempt to hide past failures from venture investors. It is likely that they will find out about the skeletons in your closet during the due diligence phase, when the company does its homework on you and your past. Any chance you may have for getting capital will be ruined if you conceal any truths. “We’ve had situations where people give us information that’s really not accurate,” says Callow. “It can be as simple as what school they went to, but we check it out first.”

What Should You Do If You Are Turned Down For Funding?

If you go through all the motions and jump through hoops to get funding, but to no avail, these VCs have one piece of advice: Don’t give up. “Venture capital is really a marketplace in the purest sense of the word,” says Bayless. “You can’t go one place and assume you’ve got the word from on high. You go one place and you get one answer; you go to another VC firm, and you’ll get another. It’s a real bazaar in terms of financial opportunities out there. You’ve just got to find the one little shop in the bazaar that your project fits into. Don’t get discouraged by talking to all the other ones that don’t do that type of deal. Sort through the list of VC firms that invest in the type of project you have. Those are the ones you want to spend your time on.”

More Money Than They Know What To Do With

VCs agree on one thing: There is more capital available now for startups than there has been at any time in the past. Gorenberg reports that the VC industry invested a total of $10.1 billion in 1996 — a 52 percent increase over 1995 figures — and that software led the industry, grabbing 24 percent of the deals made that year. Furthermore, Gorenberg says there is a greater willingness now than in the past to fund early-stage companies.

But don’t be misled — investors are not willing to fund any mediocre idea that comes across their desk. According to Tom, VCs would rather hold on to their money than risk financing a bad deal. “Certainly they make investments so they can deploy the capital, but they’re not chasing deals,” he says.

Although more capital is available for new entrepreneurs, obtaining VC funding is still an uphill battle. “I don’t think entrepreneurs are in a better place,” Tom says. “I think VCs are in a better place because they now have the money to support their transactions with the businesses they are going to be developing, and they can add greater capital.”

Bayless disagrees. “I think the net result is that it has been easier for a startup to get going,” he explains. “If people have a good idea, and they have a good management team, they can generally get funding. So I would say that it’s a good time to start businesses; it’s a good time to be raising money.”

About the Writer: Lisa Rauck is a former editorial manager forEntrepreneurial Edge. This article originally appeared in the Volume 3 (Summer) 1997 issue of Entrepreneurial Edge.

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