The Ultimate Guide to Getting VC Funding

This guide to VC Funding is the result of 20+ years of Growthink helping entrepreneurs and businesses raise venture capital or VC funding. Over this time, we have helped pitch thousands of venture capitalists, hosted VC gatherings, and even had many VCs as clients.

Below you’ll learn everything you need to know about how to get venture capital funding for your company.

Here’s an outline of this VC funding guide:

1. What is Venture Capital?
2. The Value that Venture Capitalists Offer
3. How Venture Capital Firms Make Money
4. Types of Companies that Venture Capital Firms Finance
5. How Venture Capitalists Assess Companies
6. The Presentation Materials You Need to Raise VC Funding
7. Factors to Consider when Seeking a Venture Capital Firm
8. How to Create Your List of Potential Venture Capital Firms
9. Identifying the Right Partner at a Venture Capital Firm
10. The Three Ways to Contact Venture Capitalists
11. Meeting with Venture Capitalists
12. VC Funding FAQs

 

 What is Venture Capital?

Venture capital, also abbreviated as “VC”, is a subset of private equity and refers to institutional investments in early-stage, high-potential growth companies (like yours).

Private equity refers to investing in shares in privately-held companies, rather than publicly-traded stocks.

And in this context, institutional means that venture capitalists are NOT investing their own money as angel investors do. Instead, they are investing money on behalf of institutions, such as pension funds and university endowments (as well as the collective funds of some very wealthy individuals).

A venture capital firm is an investment company that regularly makes venture capital investments.

The size of the venture capital fund is the specific amount of money the venture capital firm has raised (from pension funds, etc.).  Successful VC firms regularly raise new venture capital funds to invest in promising new companies.

A venture capitalist is an individual who works at a venture capital firm, who makes such investments.

 

The Value that Venture Capitalists Offer

Venture capitalists often provide value beyond the actual dollars they invest in your company. Venture capitalists often provide additional value via:

• Contacts that they have in their networks that can help your business
• Advice in running your business, based on deep experience in your industry and in successfully growing ventures
• Contacts to additional sources of capital

Many VC firms are made up of entrepreneurs who have launched and grown their own successful businesses. As such, they are often able to provide significant strategic guidance and connections that can help your business grow.

 

How Venture Capital Firms Make Money

To recap, a VC firm is a financial institution that focuses on providing capital, in the form of equity, to companies that offer them the prospects of significant growth.

The partners and associates at venture capital firms are known as venture capitalists. The term “VC” or “VCs” applies to both venture capital firms and venture capitalists.

Unlike an angel investor, VCs are professional institutions that invest other people’s money. VC firms raise capital for their own funds from sources that primarily include pension funds, financial and insurance companies, endowments and foundations, individuals and families, and corporations.

The VCs are then charged with finding high-growth companies, making investments in them at favorable terms, guiding and nurturing them, and enacting a liquidity event (e.g., selling the company or having it complete an initial public offering).

Because they are utilizing other people’s money, and are judged and compensated by the performance of their investments, venture capitalists are extremely rigorous in their investment decision-making process.

VCs tend to invest in companies with a significant market potential of $50 million, $100 million, or more. This is because even with all their relevant experience, the average venture capital firm will lose money on half the companies they invest in and only break even on a third.

Where VCs make their money is on the approximately 20% of companies they invest in that see explosive growth and provide remarkable returns of 10 times to 100 times or more on their investment.

Specifically, it is important to note that relatively few venture capital investments produce large gains. In fact, venture capital industry insiders sometimes refer to the 2:6:2 rule. This rule is that an average portfolio of ten investments will include two losses (e.g., companies go bankrupt), six moderately performing companies (may break even on the investment or lose a little), and two very successful returns.

In fact, an analysis by Bygrave and Timmons of venture capital funding between 1969 and 1985  found that just 6.8% of investments returned ten times or more of the invested capital. Conversely, over 60% of investments lost money or failed to exceed the amount of money earned if the capital had been put in an interest-bearing bank account.

The result of this analysis is that typically a venture capitalist will want to see the ability to get 10X their money back or more from investing in your company. As such, if you are seeking $1 million from VCs, you must show them a realistic scenario where you can turn that $1 million into $10 million.

Types of Companies that Venture Capital Firms Finance

Most venture capital firms invest between $1 million and $25 million in the companies they fund. The amount they provide often reflects the size of their funds. For example, a VC with a billion-dollar fund cannot manage 1,000 one-million-dollar investments and thus tends to offer more capital to each company it funds.

Virtually all VC firms have specific criteria that guide them such as the amount of financing they give to a company, the stage at which they like to invest, the sectors they are interested in, and the geographic area in which they will invest.

Also, venture capital firms have very strict criteria regarding scale, speed, and liquidity potential. They want to fund companies that can grow very quickly, achieve significant revenues, and be sold or go public for many times the company’s current valuation. Typically, venture capital firms like to exit an investment within 5 to 7 years.

As a result, VCs tend to fund technology companies that typically have scale, speed, and exit potential.  Remember, they are looking for companies with the potential to turn every $1 million they invest into $10 million.

 

How Venture Capitalists Assess Companies

As mentioned, venture capitalists primarily look for companies that can grow really fast with an infusion of capital.

The other key thing that VCs look for is a quality management team. In fact, many VCs say they rather bet on the jockey (i.e., the management team) than the horse (i.e., the company’s products and/or services).

With regards to the management team, VCs look for the following:

• Management teams who can really execute, which often includes:
  • Management teams who have successfully worked together in the past.
  • Management teams who have succeeded in prior positions.
• Management teams who really know their business/market, which often means:
  • They are known as experts in their industry.
  • They have been working in their industries for a long time and know all the ins and outs.
• A good fit with the founder(s) and management team:
  • Entrepreneurs and venture capitalists are partners. That is, they generally work very closely together to achieve a common goal (growing a successful company and getting to an exit). As such, it is critical that there be a good personality fit and ability to work together between the VC and the company’s founder/management team.

 

The Presentation Materials You Need to Raise VC Funding

In  order to raise venture capital, you need to develop the following presentation materials:

1. Teaser email
2. Business Plan (including financial projections)
3. Slide Presentation/Pitch Deck

The Teaser Email

“Teaser” emails are emails that “tease” the VC into wanting to learn more about your company.

The teaser email typically includes 5 to 6 bullets about the venture and is very short (200 words or less).  The goal of the email is simply to create a general interest in your venture so the VC commits time and energy to learn more about it (by requesting additional documents or setting up a meeting).

Below are two teaser emails (edited for confidentiality purposes) that I have used to generate tons of VC meetings:

 

 

Both of these teaser emails achieve their goals, which were to:

• Create intrigue and excitement
• Show that the market size was big enough
• Prove that the management team was capable of executing and could generate revenues
• Show key partnerships that could spur the company’s growth
• Create a sense of urgency (implying that we were going to get financing within 90 days with or without them)

The Business Plan

A lot of entrepreneurs like to think that business plans are no longer totally necessary – that they’re “old school.”

Because we at Growthink have been helping entrepreneurs raise venture capital since the 1990s, we remember the days when some startup companies got funded solely based on your business plan alone. We realize that those times are gone and that venture investors are much, much more rigorous these days.

It’s also true that your business plan usually is NOT the first communication you have with an investor. You shouldn’t just send your business plan around to venture capitalists left and right.  Instead, at the beginning of your dialogue with a VC, you’re much better off sending a PowerPoint or an Executive Summary rather than the whole business plan, unless the investor specifically requests to see your business plan.

To help you complete your plan, here is our business plan template, and tips for writing a business plan for venture capitalists. 

 

The Investor Slide Presentation or Pitch Deck

The final piece of the presentation materials you need to raise venture capital is your slide presentation or Pitch Deck.

A well-crafted pitch deck will contain the highlights of your business and financial plans and should echo the clarity that is put forth in your Executive Summary.

Learn more about how to create an effective pitch deck, complete with over 100 examples of pitch decks that raised funding.

 

Factors to Consider when Seeking a Venture Capital Firm

Once you prepare your marketing and presentation materials, the next part of the venture capital process is to find the right firm. While this may seem simple, it isn’t. There are thousands of venture capital firms in the United States alone, and going after the wrong ones is one of the most common reasons why companies fail to raise the capital they need.

When seeking a venture capital firm, there are seven key variables to consider:

1. Location: Most venture capital firms only invest within 100 to 200 miles of their office(s). By investing close to home, the firms are able to more actively get involved with and add value to their portfolio companies.
2. Sector preference: Many venture capital firms focus on specific sectors such as healthcare, information technology (IT), wireless technologies, etc. In most cases, even if you have a great company, if you fall outside of the VC’s sector preference, they’ll pass on the opportunity.
3. Stage preference: VCs tend to focus on different stages of ventures. For instance, some VCs prefer early-stage ventures, for example, emerging companies with no revenues, where the risk is great, but so are the potential returns. Conversely, some VCs focus on providing capital to established companies to bridge capital gaps before they go public.
4. Partners: Venture capital firms are composed of individual partners. These partners make investment decisions and typically take a seat on each portfolio company’s Board. (Note that companies that VCs fund are known as “portfolio companies.”)

Partners tend to invest in what they know, so finding a VC partner that has past work experience in your industry is very helpful. This relevant experience allows them to more fully understand your venture’s value proposition and gives them confidence that they can add value, thus encouraging them to invest.

1. Portfolio: Just as you should seek venture capital firms whose partners have experience in your industry, the ideal venture capital firm has portfolio companies in your field as well. In fact, a VC may ask the management teams of their portfolio companies about your venture since these individuals are industry experts. In addition, if your venture has potential synergies with a portfolio company, this may significantly enhance the VC’s interest in your firm.
2. Assets: Most companies seeking venture capital for the first time will require subsequent rounds of capital. As such, it is helpful if the VC has “deep pockets,” that is, enough cash to participate in follow-on rounds. This will save the company significant time and effort in raising future funds.
3. Fit: As mentioned previously, entrepreneurs and VCs are partners. That is, they generally work very closely together to achieve a common goal (growing a successful company and getting to an exit). As such, it is critical that there be a good personality fit and ability to work together between the VC and the founder/management team.

Finding the right venture capital firm is absolutely critical to companies seeking venture capital. Success yields you both the capital your company requires and significant assistance in growing your venture. Conversely, failing to find the right firm often results in raising no capital at all and being unable to grow your company.

 

How to Create Your List of Potential Venture Capital Firms

If you talk to an experienced direct marketer, they will tell you that “The list is everything.” If you don’t have the right list, you are wasting your marketing dollars. The right list is ten times as important as whatever you put in the mailing envelope, or whatever offer you include in your outbound telemarketing script.

The same holds true for your list of prospective venture capital firms. That is if you are going after the wrong VCs, no matter how good your company is, you probably won’t get funding.

There are three steps to creating a killer VC list.

1. Develop a list of VC funds. You can do this either by purchasing a list or database access from a firm such as Growthink Research or by going to the National Venture Capital Association’s website (which lists NVCA member organizations).
2. Narrow your list. VCs invest primarily based on:

• Market sector
• Stage of development
• Geographic location

The other factors presented in the last section, mainly partners, portfolio, assets, and fit, become more important after you create your initial list.

Virtually all VCs have websites that make this information readily available. Find investors that are a fit with your company for all three of these areas. For instance, if you are a pre-revenue software company based in Chicago, your best bet is to find a venture capital firm within 200 miles of Chicago that has experience funding pre-revenue software companies. Sites like Growthink Research allow you automatically filter your lists by these criteria.

1. Make sure the VC is active. Go to the press release section of the VC’s website and/or search Google News to see how active the VC is. If your venture capital deal isn’t done within a year, they probably are not actively investing in new deals and may not be worth contacting.

What you will be left with is a list of VCs that are actively seeking companies like yours. Once you have this list, you need to identify the right partner at that firm to contact.

 

Identifying the Right Partner at a Venture Capital Firm

As mentioned above, venture capital firms are composed of individual partners (and associates that assist them). These partners make venture capital investment decisions and typically take a seat on each portfolio company’s Board.

Partners tend to invest in what they know, so finding a partner that has past work experience in your industry is very helpful. This relevant experience allows them to more fully understand your venture’s value proposition and gives them confidence that they can add value, thus encouraging them to invest.

Fortunately, most venture capital firm websites list their partners with great pride. Each partner typically has a bio that includes their educational credentials, business accomplishments, and VC investments that they have made. In identifying the right venture capital partner to contact for your company, try to find the partner that, from their background, will truly grasp the opportunity and can really add value.

Once you have identified the most appropriate venture capital partner, it is important to figure out how to contact them. As partners are often inundated with business plans, having a personal connection and/or introduction is often the difference between getting heard and not getting heard.

For instance, if you attended the same university or worked at a company that they did, call or email them and use this as the introduction. If not, it is important to network. Call people that may have been associated with the partner and ask for an introduction.

Getting the partner’s attention is the first key hurdle in raising venture capital. The second hurdle is getting them to believe in the opportunity, and finally, giving them the enthusiasm and information needed to convince other partners in their firm that investing in your venture represents a sound investment.

The Three Ways to Contact Venture Capitalists

To recap, at this point, you should have a list of venture capital firms that seem to be a good fit for your company with regards to their geographic, sector, and stage foci. In addition, you have reviewed their websites to make sure they are actively investing, and you have identified the ideal partner at their firm to contact. Now, let’s talk about how to most effectively contact these partners.

There are three main ways to contact partners at VC firms:

1. Get an introduction
2. Meet them online or offline
3. Contact them cold

I have listed these in descending order of preference, meaning that the most effective contact method is via an introduction. Cold contacting is the least effective, however, it still works time and time again.

1. Getting Introductions

Getting an introduction is the easiest way to get a VC’s attention. Because VCs are inundated with pitches from entrepreneurs, they simply lack the time to meet with everyone. An introduction gives you priority over other entrepreneurs who contact the VCs.

There are six key types of individuals who can introduce you to the VC you are seeking.

1. Entrepreneurs whom the investor has previously backed or is currently backing.
2. Other investors with whom the investor has co-invested.
3. Market, product, and technology experts such as senior executives at dominant companies or lauded professors.
4. Lawyers, accountants, consultants, and other industry people.
5. Angel Investors and Board Members.
6. The venture capitalist’s online social networking colleagues.

2. Meeting Venture Capitalists Online or Offline

As mentioned above, many VCs participate in online social networks through which you can get introductions to them.

You can also create relationships yourself with VCs through the online medium.

For example, you can find out if the venture capitalists has a blog (many do). If so, read their blog to learn more about them and what excites them. It is also smart to post comments on their blog. Oftentimes they’ll reply to your comments, and before you know it, you have established a relationship with them.

You might also see if the VC is active on Twitter (many are).  If so, follow them on Twitter and see what they’re posting about.  See if there are opportunities to start a dialogue.

3. Contacting Venture Capitalists Cold

The final way to contact venture capitalists is “cold” – that is, without an introduction and without meeting them at an event or conference or online.

While this method is the most challenging, since you need to get through the VC’s filters, it can be highly effective.

The best strategy for contacting VCs “cold” is to email them. Note that calling them is much less effective as you will nearly always get their voice message and rarely if ever will you receive a callback.

With regards to emailing the venture capitalist, usually, the email address of each partner is listed on the VC’s website. If not, call the VC firm to find out the partner’s email address.

 

Meeting with Venture Capitalists

If your email and initial information exchange goes well, the next step will be to meet with the VC, during which you will present your pitch deck.

Upon success with these meetings, you will move into the negotiations and due diligence phases.

VC presentations are similar to presentations to other parties such as potential corporate partners. Your goal is to succinctly present the key points about your venture, get the party excited, and expertly answer any questions they have.

Like other business presentations, it is critical to show up on time and dress appropriately (khakis and a button-down shirt often suffice, but don’t be afraid to call the receptionist of the VC firm and ask). Likewise, everyone you encounter during your visit is important, from the receptionist you meet when you walk in, to the analyst you wash hands next to in the restroom.

Treating anyone with a lack of respect could come back to haunt you. You need to be professional in every aspect of your presentation if you are going to be considered as a candidate for funding.

 

VC Funding FAQs

Below please find 6 articles that answer key VC funding questions.

1. Common Venture Capital Terms
2. How to Give a Convincing Venture Capital Presentation
3. How to Develop a VC Elevator Pitch
4. 3 Questions Venture Capitalists Will Ask You
5. Common VC Funding Terms and Negotiating Issues
6. Pre-Money vs. Post-Money Valuations

 

Common Venture Capital Terms

The following are some of the commonly used terms in the world of venture capital and their meanings:

Elevator Pitch:

Perhaps the most commonly used cliché ever when it comes to acquiring funding for a venture, it is still the most sensible. Picture yourself in an elevator with a potential investor. If you can explain your business concept to the potential investor before the investor gets to their floor, and capture their interest, you have succeeded. Although this scenario probably never occurred in real life (alright maybe once), it is still an excellent idea to imagine yourself in the scenario.

Business Plan:

Nearly every venture capital firm requires a business plan. A business plan starts with an executive summary, which gives a brief synopsis of the business concept and history, industry, market, competition, management, marketing plan, as well as financial projections (see here for the business plan components you must include). The rest of the plan explains the contents in the executive summary in much more detail. The executive summary is the key to getting an investor’s attention.

Slide Presentation/Pitch Deck:

Aside from business plans, venture capital firms require the management team to present a slide presentation in which they show their business concept and summary financial projections. Unlike business plans, which are usually mailed or e-mailed, slide presentations have Question and Answer sessions in which potential investors will prod the management team with questions and ascertain whether the business is of interest to them.

Due Diligence:

VCs or any analytical investors for that matter carry out due diligence before investing in a business. In due diligence, analysts conduct in-depth research, analysis, and forecasts of a business concept and revenues in order to determine the viability and value of a business.

Return on Investment (ROI), Internal Rate of Return (IRR), Hurdle Rate, Net Present Value (NPV):

In conceptual terms, ROI and IRR is where the Cash Flows from a venture break even with the original cost of investment after factoring in the Opportunity Cost of Investment or “interest” that the investor could have gotten from another investment of similar risk. Formulaically, ROI and IRR are the rates of return “r” at which the NPV equals zero according to the basic valuation formula:

NPV= Cash Flows/ (1+r)^t minus Capital Investment, where t=time

The Hurdle Rate is the minimum ROI or IRR a VC or another investor will accept; otherwise, they will refuse to fund a venture.

Although valuation gets more complex than this in reality, the essence of valuation follows these basic principles.

Multiples:

Investors and venture capitalists will often talk about multiples when discussing a prospective venture. Although valuation and complex analysis will take place prior to the funding of a venture, multiples are a language everyone speaks and are used as a way to gut-check forecasts and valuations of financial projections.

For instance, the most commonly used multiple is usually the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) multiple, which is [Enterprise Value / EBITDA]. Companies in certain industries will usually have EBITDA multiples within a certain range and venture capitalists can use these to assess whether to invest in a certain venture.

Seed Stage:

The seed stage is usually the earliest stage of the company. In the seed stage, a business is forming a management team, developing prototypes of products, or beta testing them in the case of services. Seed-stage VC financing is typically provided by angel investors or friends and family.

Early Stage (Series A&B):

After the seed stage comes the early stage of a company. With early-stage startups, a prototype or concept has been tested and proven and a management team has been formed. However, financing will still be needed for the next stage in order to start production and get the business to a self-sustaining level where retained earnings can fund future projects. Series A refers to the first investment of institutional capital in a company.

Later Stage (Series C, D, etc.):

At this stage, a company is self-sustaining but needs more financing to expand more rapidly in order to increase production or expand to new markets. At this stage, companies have shown that their products or services have traction in the market and that they require financing to “run” with their concept.

Mezzanine Financing:

This is the financing stage right before the IPO. In this stage, the company is in very good shape and is looking for financing before investors cash out during the IPO. The risks involved become less risky as the stages progress and mezzanine financing is much less risky than seed stage, early stage, and later-stage financing.

Initial Public Offering (IPO):

An IPO is the first offering of a company’s shares to the public. It is used by pre-IPO stage investors to cash in on their investment as well as raise money for the company.

Upside:

Upside is the increase in the value of an investment. It may be realized upon a harvest or exit.

Harvest or Exit:

Venture Capitalists harvest their investments by cashing out during an Initial Public Offering (IPO) or realizing returns on some of their equity investment through a partial or complete sale of the company to an acquirer. An exit is a complete harvest of an investment. Sometimes venture capitalists exit through a stock repurchase by the company in which the remaining equity holders buy the stock of the owners cashing out.

Private Equity:

Private Equity is ownership in companies that are not publicly traded on an exchange. Since private equity is not traded at volumes anywhere near volumes of publicly held companies, it is highly illiquid and requires a higher rate of return. However, the upside of private equity is that it does not need to follow Securities and Exchange Commission (SEC) regulations at the level publicly held companies do, thereby reducing compliance costs. Venture Capital is a type of Private Equity and Private Equity is a type of Equity.

Institutional Investors:

Institutional Investors are investors represented by groups tasked to invest and manage funds on the investors’ behalf. They include pension funds, investment funds, and mutual funds looking to earn a rate of return on their funds that would otherwise lay idle. Many venture capital firms receive investment from institutional investors since venture capitalists are constantly looking for growth opportunities and investment ideas. 

 

How to Give a Convincing Venture Capital Presentation

Venture capital presentations are similar to presentations you would give to partners such as corporate or business partners. Your aim should be to highlight the key points about your venture and to expertly answer all of the questions asked, while getting the venture capitalist excited about your idea.

It is important to keep your presentation brief and to the point. The partner with whom you are likely to meet sits through several presentations a day, and will probably not be able to keep up with many of the details in the 20 to 30 minutes that he has allocated to you. Ideally, you will want to include the following points in your presentation:

1. What does your company do?
2. What is the status of your company?
3. What are the key points that make your company unique?
4. What pain does your solution solve?
5. In what market(s) are you competing?
6. How do you generate revenues?
7. Who is your competition?
8. Who is on your management team?
9. What is your timeline/roll-out plan/milestones?
10. How much capital are you seeking?

Remember that you are trying to gain the VC’s interest in your company. Your initial meeting is not the time to try and close the deal. If the VC is interested, he will invite you back for further presentations with his business partners.

Overselling your company is a common mistake that entrepreneurs often make in their initial presentations. According to venture capitalist Guy Kawasaki, many entrepreneurs claim to have a “proven management team” and “proven business model” with “patent-pending technology” while enjoying a “first-mover advantage.” He goes on to comment that those entrepreneurs using the above terms are essentially lying. “Oh god, it gives me a migraine just thinking about those things.”

Instead, the presenter should focus on the needs of the VC, which is primarily to make money. Show the VC how your firm will make him money, and back up your assertions with primary or secondary data.

Moreover, you should be ready to handle any of the venture capitalists’ questions regarding your business. Be extremely familiar with your financial model, and have a detailed road map for how you plan to grow a profitable business in the long run. Know why you need venture money, and what you plan to spend it on. Be passionate, and have the ability to display and communicate every last detail of your venture.

 

How to Develop a VC Elevator Pitch

Everyone has heard stories about the “Elevator Pitch”-the incredible, brief window of opportunity where an entrepreneur has an investor’s undivided attention to describe their venture.

Implausible as it may be, the successful entrepreneur needs to be prepared to make a compelling case for their business in 60 to 120 seconds, whether it’s in an elevator, at a trade show, or in line at the coffee shop. In the unlikely event that you do find yourself in an elevator with a venture capitalist, you’re going to need to be prepared for it. Here are three keys to hitting a home run on the elevator pitch.

1. Most companies make a product or provide a service. Entrepreneurs must be able to clearly define and explain what exactly your company does to make money, and more importantly what the benefits of the product/service are. Focus minimally on how the product works, especially if it’s a complicated piece of technology. Tell your soon-to-be investor what kind of value your product adds to your customers.
2. Compare yourself to an existing company. Many entrepreneurs are afraid to mention similar companies fearing that acknowledging competition will make their startup look like a poor investment. This is flawed thinking for two reasons. First, your company isn’t an exact clone of the other company. Second, if it is an exact clone of a much larger competitor, you might need to rethink a few things about your business. When you’re “in the elevator,” don’t be afraid to mention another firm. But don’t stop there-you’re dead in the water if you leave it at that. You must now explain why you are different and how you’re going to beat them using that difference. That’s how you will get a VC’s attention.

1. In your last seconds, you need to make the case that the market needs you. Drop a fact or two as evidence that the market has needs that are not being met. You, the entrepreneur, are going to fulfill the need that none of your competitors are fulfilling.

Armed with these tips, there is one final piece of advice – practice. You should practice your elevator pitch over and over so you are able to give it as clearly and concisely as possible.

 

3 Questions Venture Capitalists Will Ask You

Having finally made it to the presentation stage with a venture capitalist is a step in the right direction for you and your business. However, apart from evaluating your presentation, venture capitalists will ask you critical questions and evaluate how you formulate your answers. Three key questions a venture capitalist will ask you are:

1. How much capital do you need and why?
2. What is your valuation?
3. What is your exit strategy?

1) Amount of Capital You Need

If you ask someone to give you money, oftentimes they will ask you what you need it for and why. The same thing will happen when you ask a venture capitalist to write you a multi-million dollar check.

The key to answering this question is to know your business inside-out. It is important that you have full mastery of your projected financial model and that you understand how every funded dollar will be used in your business. In other words, you need a deep conceptual understanding of your entire business idea.

It is common for VCs to ask you what you would do with less money. So if you wanted to raise $2 million, they may ask what you would do if you only received $1 million. This will reveal your top priorities and which milestones you would accomplish with less.

2) Your Valuation

To some, this question may be considered a trick question, as there is no right answer.

If a VC asks you during your presentation how much you believe your firm is worth, don’t reply with hundreds of millions of dollars. He will think that you’re unrealistic and not ready to handle the tough reality of start-ups.

If you understate the answer, he will think that something is wrong.

Even if you manage to give a fair estimate of your firm’s value, it may come back to haunt you later in the actual rounds of raising capital. Giving out a fair value allows the VC to discount it and essentially limits your bargaining power when it comes to the actual funding.

Thus, the best answer is to tell the venture capitalist that you will let the market decide on your firm’s value. If you assure them that your company is going to be a success, VCs will create the market on their own. Ideally, they will bid against each other and raise the value of your firm.

3) Your Exit Strategy

This question basically refers to how the VC will get its return on investment. Typically, an “exit” will happen if your firm gets acquired or has an IPO. Both of these are commonly listed exit strategies, although there are many more.

That being said, the best companies tend to have CEOs that are focused on building a successful business for the long run. Venture capitalists know this and look for those leaders willing to put in hard work for years to come.

To this point, Dick Costolo, founder of FeedBurner (acquired by Google) has a great quote – “Make a map of how you want to grow the business, not a map of what you want to happen to the company.”

His quote touches on the principle that successful companies will create their own exit opportunities as they grow. You should focus less on figuring out ways to exit your company, and instead build a great company with the ideas that you have.

 

Common VC Funding Terms and Negotiating Issues

When companies enter into negotiations with venture capital firms, there are several issues that need to be defined and agreed upon. This article describes the key issues.

Valuation. Valuation is the most prominent negotiating issue. Valuation is the price of the company in which the venture capitalist invests. Valuation determines what percent of the company the investor is buying for their capital.

Timing of the Investment. Many investors will commit a large amount of capital but will contribute that capital to the companies in installments. Often, these installments are only made when pre-designated milestones are met.

Vesting of Founders’ Stock. Like capital, investors often prefer that stock be given to company founders and key employees in installments. This is known as vesting.

Modifying the Management Team. Some investors insist that additional or substitute management employees be hired subsequent to their investment. This gives investors additional security that the company will execute on its business model. An important issue to negotiate with regards to modifying the management team is the amount of stock or options that will be issued to new management team members, as this will dilute the holdings of the founders.

Employment Agreements with Key Founders. Venture capitalists typically do not want companies to have employment agreements that limit the circumstances under which employees can be fired and/or set compensation and benefits levels that are too high. Other key employment agreement issues to be negotiated with venture capitalists include restrictions on post-employment activities and employee severance payments on termination.

Company Proprietary Rights. If the company has an important product with intellectual property (IP), investors will want to ensure that the company, and not a company employee, owns the IP. In addition, investors will want to ensure that new inventions are assigned to the company. To this end, investors may negotiate that all employees must sign Confidentiality and Inventions Assignment Agreements.

Exit Strategy. Investors are very focused on how they will “cash out” of their investment. In this regard, they will negotiate regarding registration rights (both demand and piggyback); rights to participate in any sale of stock by the founders (co-sale rights); and possibly a right to force the company to redeem their stock under certain conditions.

Lock-Up Rights. Venture capitalists may require a lock-up period at the term sheet stage. The “lock-up period” is typically a 30-60 day period where the investors have the exclusive right, but not the obligation, to make the investment. Investors typically conduct due diligence during this time without fear that other investors will pre-empt their opportunity to invest in the company.

Each of these issues is critical when raising money since the outcome can significantly impact the success of the venture and the wealth potential of the company founders and management team. Because venture capitalists are very knowledgeable regarding these issues and have great skill in negotiating on them, companies who are raising venture capital should seek advisors who also have this experience and expertise.

 

Pre-Money vs. Post-Money Valuations

When a company decides that it must raise capital, a key question that must be answered is how much the company is worth. For example, if the business needs $500,000 to get started and/or grow, how much of the equity in that company should $500,000 command? Once this question is answered, the company will go out and try to find investors. When doing so, a key question often arises as to whether the valuation is “pre-money” or “post-money.”

“Before the money” or “pre-money” and “after the money” or “post-money” denote simple concepts. However, these simple concepts can even confuse even the most sophisticated analysts at times. If a company is valued at $1 million on Day 1, then 25 percent of the company is worth $250,000. However, there may be an ambiguity. Suppose the company and the investor agree on two terms: (1) a $1 million valuation, and (2) a $250,000 equity investment. In this case, the company may offer the investor 250 shares for $250,000. Immediately there can be a disagreement. The investor may have thought that equity in the company was worth $1,000 per percentage point, in which case $250,000 gets 250 out of 1,000 shares or a 25% equity position. Conversely, the company may have believed that the investor was contributing to the enterprise that was already worth $1 million. Under this rationale, the $250,000 would give the investor 250 shares out of 1,250 shares or a 20% equity position.

The critical issue was whether the agreed value of $1 million to be assigned to the company was prior to or after the investor’s contribution of cash (pre-money) or post-money.

In the above case, a pre-money valuation of $1 million and a post-money valuation of $1.25 million were equivalent. Because mixing up the terms could significantly increase the cost of capital raised, companies must be sure to understand the two metrics and agree with investors to the metric that raises the capital at the appropriate price.

 

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