7 Questions for Entrepreneurs Before Saying “Yes” to Venture Capital Funding
Welcome to Spencer Trask Perspectives, a monthly interview series with our CEO Bill Clifford and writer John Essick. Mr. Clifford has generously agreed to share his unique insights and expert opinions on topics such as business development, deal flow, C-suite management, startup culture, entrepreneurialism, and more.
We welcome your feedback, and encourage you to submit questions to askST@spencertraskco.com for Mr. Clifford to potentially answer in future articles.
Congratulations! After months of honing business plans, immersing yourself in market research, studying competitors, rehearsing your pitch team, and preparing for and participating in pitch sessions, you have finally attracted the interest of an angel investor or venture capital firm. For the first time, you are validated; someone believes in your vision, besides your family and friends. It is officially go time…or is it? Before rushing in and accepting the first deal that comes your way, there are several questions you should ask yourself to avoid potential headaches and pitfalls down the road.
In this installment of our Spencer Trask Perspective series, I will be you, the company founder on the cusp of landing that first, coveted infusion of cash from an outside source. I will be asking Spencer Trask CEO, Bill Clifford, the top seven questions that you may want to consider before you say “Yes!” to the deal.
John Essick: Bill, I often hear the relationship between an angel or VC firm and a startup compared to a marriage. I know that before many marriages, it is common for one of the parties to have cold feet. Should I be 100% committed to the deal before it goes down, or is it natural to go into the relationship with a little bit of apprehension?
Bill Clifford: Good question, John. It is completely normal to be apprehensive about any deal with a partner as important as your venture capital/angel investor. It is likely that this is the first “outsider” (outside of your Friends and Family investors) that will own equity in your company, and will therefore have direct influence on the decision-making. That does not mean that you should not be 100% committed to taking third-party investment money, or 100% committed to the decision of using a VC firm as the source of that third-party capital. It is only normal that there be some degree of apprehension and concern for every startup founder/CEO. After all, you are bringing on a partner who in most respects is a total stranger and giving them a significant seat at the table. They will have knowledge and influence on company strategy and direction. However, it can also be seen as a step in the maturity and personal growth of the CEO/founder as an individual, as well as a catalyst for the growth of the entire organization. New ideas and relationships are formed that will help shape the course of the company as you all move forward.
JE: At this early stage, is there any way I can really be sure of the value that the investor is bringing to help grow my company? I realize I have several needs at this early stage of development. How do I know I have identified the most important ones to make sure this investor is capable of addressing them?
BC: Just as the VC firm has done extensive due diligence on your startup firm before deciding to invest in you, so must you do the same. Do your research on the VC firm before inviting them to submit final term sheets to you. Too often, VC firms can seem intimidating to startups. The firms likely have impressive industry reputations, and of course, they have the money. In the process of your due diligence, be sure to be very specific in discussing and interviewing people within the firm who will be working with your team. Assess their ability to understand and interact with your team on the issues that are critical to the success of your products and services. Obtain commitments that these individuals will be available to work with your team should this VC firm be awarded your business. Identify the types of value-added services that a prestigious VC firm brings to the table along with the funding. It is these “extras” that set a beneficial firm apart from other firms who just bring “dumb money.” The best VC firms should be able to connect you with a network or portfolio of companies who have had to tackle similar challenges in the past. They have certainly helped companies like yours with assistance from the members of their own staff or through relationship building with staff of other companies within the firm’s portfolio.
JE: I have been so focused on, first, getting my company off the ground, and then, putting together the perfect team for my search for funding. Now that funding appears to be in the cards, will I require different talent for different roles to move my company forward? How can I expect things to change and should I be prepared to make hard decisions about ending relationships with people who have been with me from the outset?
BC: There is no reason to believe that you need to throw loyal employees overboard just because you have received VC funding. Actually, it is quite the inverse. You have built a company that has qualified for third-party funding, and therefore already passed some difficult hurdles. You have found a market that has growth potential, developed a product or service to address that market need, and assembled a team of people that can deliver an acceptable level of customer satisfaction. If this were not so, you would not have attracted VC interest. In order to keep your VC “masters” happy, you need to keep doing what you have been doing, only faster and better. Shoot for even greater success. Remember that increased customer satisfaction results in higher revenues, margins, and, most importantly, profits. To me, that sounds like you will need more of the same kinds of people you have had with you up to this point, not less!
JE: I have done my research and feel confident about my company’s direction at the moment, but it is no secret that things seem to evolve quickly in today’s business world. How can I be sure my startup is serving a business market need that will exist one, three, or five years from now? Going forward, is my role going to be more about managing change or should I be able to continue to focus on the idea that got me here?
BC: Excellent question! You can never be sure that the horse that brought you here will be the horse that you ride home. At first, you may be in a market where every car must be silver. However, within 48 months it turns out the market wants nothing in silver anymore. Everything must be either black or white. In that case, you do not want to be the world’s leading and sole expert on painting cars silver. Wouldn’t it have been better to be the world’s expert in how to paint a car? In markets that are very fickle — a great example being today’s technology markets — windows of three or five years are unheard of luxuries.
The key is to understand the critical skills that made your company appealing to VC firms. Yes, there may be one or more unique products or services that launched your company to success. You may still be riding the crest of that success one, two, or three years after your founding. However, continued long-term accomplishments typically depend on your ability to identify and respond to the changing nature of market demand, and adapt your company to that change. Having a firm grasp of the critical skillset of your company usually dictates whether or not your company responds to the dynamic needs of a changing market. It may be outstanding translation of customer needs into product design or perhaps high-speed product performance. Whatever it is, be sure to reinforce your skillset in every new iteration of the product or service you offer your customers. That is where your differentiation in the marketplace will be found.
JE: I am pretty confident in my abilities and my vision, and I will be the first to admit that I really enjoy having the final decision on important matters. However it has been made clear to me that my funding source will want more say in decision-making on important matters going forward. How do I know that I can play well with others?
BC: The reality is that as your company grows and prospers, there will be more and more people that you will have to interact with that want to have a say into how your company conducts business. You will likely have a Board of Directors, shareholders, and other officers of the company. And, yes, if you accept VC money, then you will have significant investors. Therefore, it is not a matter of whether or not you can get along with key influencers on your business — it’s when. Actually, the best time to start is when you have VC partners. Their interests are aligned with yours. After all, they have put up capital as an indicator of their belief in your company’s ability to succeed. They have evidenced confidence in the decisions you have made in the past, and therefore likely to show continued confidence in the decisions you will make in the future. While a VC partner may ask more questions of you than your staff or others may have asked in the past, they are looking for strong CEOs and founders to run their portfolio companies. They will trust you to make the hard decisions that need to be made 5, 10, or 20 times per day to keep the company running in the right direction. It is why they banked on you to run the ship, and that’s why they bet their investment capital on you.
In my experience here at Spencer Trask, our portfolio CEOs actually seek, not shun, our advice and counsel on matters great and small. Our role is not to run your company, but instead provide guidance and assistance. We help identify and screen critical new talent. We vet new product plans and marketing programs, and develop budgets and banking relationships. We provide leverage that startups could never create on their own.
JE: The investor that is showing interest has a very good track record of helping startups get to the next level. However, that experience does not exactly match or apply to businesses that are in my industry or quite like mine. How can I be sure that they will understand my goals and not try to turn my business into something I do not want it to be?
BC: Accepting this offer is a formula for disaster! Choosing a VC firm without direct, recent, and successful prior experience with startup companies in your specific industry will undoubtedly bring frustration, missed opportunities, and lead to poor decision-making. Somehow, I doubt that the limited partners (financial investors) in a qualified VC firm would approve or permit the investment to be made unless it were described to them in some way as to be “related” to their core approved investment thesis. They would have to believe that the financial returns were of such magnitude that the “stretch” in the investment T&C was warranted. A VC firm with other priorities would no doubt be quite accommodating, their team jovial and friendly in all your interactions, and present a term sheet that is not unnecessarily burdensome. However, these are the deals that you should consider most circumspect, and generally run away from as fast as you can! With more than 1,000 VC firms in the US alone, I’m sure that you can find one or more that have direct experience in your specific business and industry.
JE: I believe the budgets my financial team and I created are realistic. Still, I know unexpected issues could arise that I have not counted on. How can I be sure the deal provides enough cash reserves to adequately cover my company’s burn rate until the next funding round, which could be as long as 24 months? Is there a formula I can follow to help me feel more confident about my numbers? If money begins to become an issue down the road, can I expect the funder to be willing to inject more capital?
BC: VC firms would not invest in companies in a first round if they did not have a longer-term investment strategy that included follow-on rounds. Typically, a firm invests capital from a committed capital fund — that is a fund from which limited partners have committed a certain amount of capital that the VC firm can invest. They then make a small investment from this fund in companies that fit the profile for which the firm has described in its prospectus to its limited partners. The VC firm would not invest all of the funds in new deals. They typically set out an allocation strategy by which they set aside a certain amount for new investments, and a certain amount for follow-on round two, mezzanine, later stage, and other future investment. This is a conversation that you should definitely have with your VC firm partner before engaging in any formal relationship.
Most firms have follow-on funds with which they can invest additional capital in companies that they have invested in using monies from prior funds. Generally, they invite other VC firms to co-invest alongside them. For example, an A round investment would consist of two or more firms participating in the investment. One would be considered the lead investor and introduce the others to participate. In this way, should additional capital be needed for either equity or debt financing, you would have access to the “dry powder” (unallocated capital) of two or more venture funds to draw upon. Be assured that if you are meeting your financial objectives and milestones, access to additional investment capital should not be a problem for your company. Participation by more than one firm also gives you access to the market research and in-house and portfolio company talent of two firms — a nice benefit for you and your team to draw upon.
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About Bill Clifford
Bill Clifford is Chief Executive Officer of Spencer Trask & Co., a privately owned advanced technology incubation firm. Prior to joining Spencer Trask & Co., Mr. Clifford served as Chairman of the Board and Chief Executive Officer at Aperture Technologies Inc., General Partner of The Fields Group, and General Partner of New Vista Capital. He is also the former President and Chief Executive Officer of Gartner Group, the world’s leading authority on the information technology industry, user and vendor technology strategies and market research. During his tenure at Gartner, annual revenues increased from $175 million in fiscal 1993 to $780 million in fiscal 1999.
Mr. Clifford currently serves on the board of directors of Cybersettle Inc. and SWK Holdings (SWKH.OB). He has been featured in CEO Magazine, Leaders Magazine and Forbes, and is a keynote speaker and panelist at numerous Technology Industry conferences.