Steve Sammut, a senior fellow and lecturer at Wharton School of Business, talks to Arabic Knowleldge@Wharton about how entrepreneurs can deal with venture capitalists.
Arabic Knowledge@Wharton: I guess the basic question we wanted to start with is what are some of the major sources of capital for a new startup and how does venture capital – or a VC – compare with other sources?
Sammut: That’s a good way to start this discussion. Historically, there have been a variety of sources of capital. I think entrepreneurs need to look at their local situation as well as their industry, and their stage of development, to begin to think about the sources of capital. Classically, high net worth individuals and especially those who have made their fortunes in industries similar to what the company expects to pursue are a very good place to start. Many of these groups in different regions have angel networks. They are relatively easy to identify with an online search. Some have very formal processes. Others are much more informal. Some act as if they were venture capital funds, that is to say, a group within the angel network gets together and they buy one equity position. So that is an important source.
Also, for very early stage funding – in provinces in other countries, states in the US, federal governments, and I believe this is even emerging in the United Arab Emirates as well as Kuwait – there are programs sponsored by the governments. In some cases, these are programs where the money goes into venture capital funds. But in others, companies actually can be directly eligible, usually on a competitive basis. So what I would recommend is that entrepreneurs look at their own country or locality to see what programs exist. The next step is formal venture capital. This takes different forms in different places. But for the most part, these are partnerships managed by a general partner or a management group using money provided by limited partners. Those limited partners are often pension funds, corporations and endowments. Now, generally speaking, venture capital funds over the last decade or so have moved to later stage opportunities – and what entrepreneurs need to determine is how to identify local venture funds. That is very easy to do with various online directories and other directories. For example, in the Middle East there is a Middle East Venture Capital Association. Their website would provide linkages into available venture funds. But I think we can elaborate more on dos and don’ts and issues with venture funds.
There is one last source for obviously much later-stage companies. And, again, it depends on the locality and the desires of entrepreneurs. I don’t necessarily recommend this until the timing is right, and that is initial public offerings or listing on local stock exchanges. There are very different listing requirements across countries and across stages. Some exchanges or boards are designed for very early stage companies. But it is a matter of very careful determination as to whether to go that route – principally [by considering] what impact it will have on future capital needs.
Arabic Knowledge@Wharton: Absolutely. Let’s say you are an entrepreneur who has fulfilled some of the early stage requirements and you are ready to present your case to a venture capitalist. What are some of the dos and don’ts for entrepreneurs when they are about to pitch to a VC?
Sammut: There are lots of don’ts – and many dos. But let’s start with the don’ts. All right. The process often does start with a business plan. The format for business plans is available in a variety of textbooks, and I believe others in this series have addressed that. So I won’t dwell on that. But I will give you a couple of perspectives that venture capitalists have.
First off, through their experiences over many years, the venture capitalists by and large expect that six months to a year after their investment – no matter how well done the business plan is –the company is going to look very different. Market conditions change, the technologies change, and there are some positive surprises and some negative surprises. Unfortunately they seem most often to be negative surprises. As a result, the way many venture capitalists look at business plans is that they are evidence of a very good consensus that has been built among the management team, that they [the team has] thought through the issues, that they have debated them internally and, in doing so, have demonstrated that they can work together as a team. [Also, the venture capitalists see that the team’s] thought process is flexible given certain circumstances. The cleverest of venture capitalists will probe for the degree of consensus building and real insight into what is behind the business plan.
Entrepreneurs recognize that the process requires a lot of thought. This is not a weekend endeavor. And even when entrepreneurs go away for a retreat, they should be taking careful notes and understanding the various viewpoints.
One “don’t” is do not send out a business plan that has internal inconsistencies. And by that I mean the product development plan – in terms of costs and projections – the market plan, the sales forecasts, the overall project management picture should all line up with one another and especially with the cash needs and cash flow forecasts. Oftentimes, VCs will get a business plan and it is so obvious that no one responsible for each of those chapters has spoken with one another. So, the entrepreneur needs to go through that with a fine-tooth comb.
The other big “don’t” is do not send your business plan indiscriminately to every venture capital fund that you can find. Do a very careful selection based on what kinds of things the venture funds – that venture fund or a particular venture fund – have made investments in. Look at the stage of investments that they usually do. Look at the way they have gone about forming companies and adding value – and, ultimately, finding exits. So that is a “don’t” that translates to a “do.” It’s a common error that entrepreneurs make.
Overall, [the guiding principle] is reasonable expectations. I generally recommend – and this is a big “don’t” – not to simply deposit your business plan in the online mailbox of the venture fund. Look very, very carefully – and this is a “do” – at the backgrounds of each of the partners. Fortunately, websites tend to be very rich in this information as well as the portfolio company information. Look at the partners’ backgrounds and see what personal connections you might have. There may be one, two or three degrees of separation, as the popular nomenclature goes. What you might do is find that either you know someone or there is a school connection or a club connection or a friend-of-a-friend connection. You should utilize that. You can also identify which of the partners may have the most particular interest in what you are doing based on the investments they have made or boards that they are on. More often than not, they will actually take a well-placed phone call or a very brief email that will probably result in a phone call. So you should try to personalize it as quickly as possible.
Arabic Knowledge@Wharton: Now let’s say you have started the process of meeting with VCs based on the dos and don’ts that you just recommended. How many VCs should you see? And how can you tell when you have found one that is the right fit? If you find more than one that seems appealing are there any pros and cons of working with just a single VC as opposed to more than one?
Sammut: Well, to give you a flippant answer, I would say you see as many as it takes to finally do your deal, but definitely in the prioritization order that you might build based on what I have just said looking for the most relevance. My personal recommendation – unless time if of the essence, and this may well be if you are looking for a second round of financing and you are running out of capital – is to be patient. It is probably best to hunt with a rifle as opposed to a shotgun and go through sequentially or two or three at a time rather than 10 or 20. VCs will pick up very quickly how widely distributed your plan is.
On the other hand, there is an expression that the deal is “shop worn,” that is to say, it [a business plan] has been through too many hands. So before sending a business plan out, this preliminary approach might be a good one.
Now, generally speaking, it is a good thing, and extraordinarily positive, when there is more than one VC interested, because one of two things can happen, and I actually prefer the first. In any venture financing it is often better to have a syndication of venture capitalists where two or three are coming forward in the same round of financing. There are a couple of reasons for that. One is they can rely on one another for due diligence. They bring perhaps a broader perspective to the needs of the company. One other benefit is that with more people around the table, there are more pockets and deeper pockets because it is inevitable that a company is going to need more financing. If there is already a base of venture capitalists, that capital is more likely to be there, and while in the next round of financing there may be a new venture fund that comes in to lead the deal and set the price, at least there is a base of capital.
So entrepreneurs should be very cautious when only one fund has come forward. And if that one fund wants to fund the whole round, you have to have a very specific conversation about how much capital they are going to keep in reserve for your company and what their criteria would be for doing a second round of financing. One of the worst things that can happen to an entrepreneur, and an entrepreneurial team, is for the investor in one round to not participate in the second round. Now this caveat applies to taking money from formal venture capital funds. In an initial round of financing, or a seed or start up round that has been funded by angels or by state programs, it is not really expected [to have more than one source of funds]. And it won’t disqualify a company from a venture round of financing if those investors opt not to invest because there is an understanding that personal wealth is finite.
Arabic Knowledge@Wharton: Once the conversations with VCs begin, a debatable, if not contentious, issue is sometimes about valuation. What advice would you offer entrepreneurship about discussing this with VCs?
Sammut: Well valuation, as you point out, is a difficult issue and it does have contentious elements to it. Entrepreneurs who have been through the process of working with venture funds can have more insight into how this works. The first thing that you must appreciate, though, is despite all the important models for valuation that are taught in business schools and what you might even find in the manuals, the approach that venture capitalists take to valuing a company is not necessarily on the future performance of the company as a commercial entity. So things like discounted cash flows – while it is important to know these and they may contribute to the valuation proposition – are not the real driver.
The venture fund ultimately has to think about what the company is going to be worth at the time of liquidation, which might be either a public offering or more than likely a trade sale – that is to say, an acquisition by another company. And once they have a sense of that, they have to look at not only the amount of money they are putting in now, but what the cash needs are likely to be over the coming years.
So the result is – or the big question is – what percentage of the company must I own now allowing for future cash needs and dilutional events and the most likely range of terminal values for me to determine the valuation? And in that process, I have to also be thinking about the majority of companies in my portfolio that are not going to be successful.
So as a result, the entrepreneurs on the initial offer by the venture capitalists feel that they are being treated grossly unfairly. That is not necessarily inappropriate to feel. Unfortunately, it is one of the realities of dealing with venture capital funds.
Arabic Knowledge@Wharton: Once VCs invest in a company, what kind of positive role can they play? Can you give any examples of companies that have benefited?
Sammut: In selecting [a venture capital fund], if they have a number of offers from different venture funds, entrepreneurs should take a very close look at what the track record of that venture fund is in a variety of ways. Of course, entrepreneurs are always interested in what role the venture capitalist has played and the timing that they have played in helping promote the exit. But in my view, that is not the most important issue. It has to do with helping to reformulate strategy, recruit people to fill holes in the management team, active participation – not only at board meetings but between board meetings – contacts and assistance with forming strategic alliances. They should do all of these things.
And it is totally within reason for an entrepreneur, when they have an offer from a venture firm, to call entrepreneurs for which the venture capital fund has provided capital and ask your entrepreneurial colleagues straight out how that venture fund has served? Was it as advertised? Did they do what they said they were going to do? And then did they follow up? So you have a burden of due diligence of your own. [There are] many examples [of how venture capitalists can help] – and it depends on different industries – if you are dealing with software information technology [you may want to look at] the pace at which you develop, the markets at which you want to direct, how you are going to segment your market. An experienced VC probably has more insight into that than you do. Why? They are probably looking at about 1,000 deals a year in order to do 10 to 20, if that. As a result, they generally have a much better context and it is worth listening to.
The life sciences, which are of growing interest in the Middle East, are is a very complex field that requires a great deal of technical insight and market insight. Look for venture funds that have gone down that path and have a realistic appraisal, but at the same time have enough flexibility to see how in your region a pharma company or a biotech company is going to evolve as opposed to the way it would evolve in the US. I’m not saying the regulatory path is easier. Quite the contrary in many cases. But certainly the way a company in Abu Dhabi might develop itself and bring a product to market is very different [from other markets].
Arabic Knowledge@Wharton: Any risks of working with VCs that you would ask entrepreneurs to look out for?
Sammut: Yes, I think there are many risks. I’ll just point out a couple of the most critical. First of all, venture capitalists might decide even before an investment that they would prefer that the founder or CEO not remain in an active role in managing the company. In many cases, it is not fair. They should give the founder or the CEO the opportunity to make it work. But VCs, because they have met so many different managers and know what is going to look good with other venture firms or in an acquisition or an alliance negotiation, may have other views. This can be shattering to a founder or CEO. They have to make a realistic appraisal of themselves and put that issue on the table very early in the process, because if it comes up later it can derail a negotiation.
The other risk is term sheets. This varies from region to region because there are contractual provisions that are acceptable in some legal jurisdictions that are not in others. I am referring to what is known as preferred stock. In those instances, even when an entrepreneur thinks he or she still has control of the company by virtue of a majority of ownership of the shares, the preferred shares often have features with respect to voting rights and other issues that surreptitiously give the venture fund or funds control of the company, especially acting as a group, which they will do. So having competent counsel if you don’t have experience in making sure you understand exactly what the impact of every provision is going to be is critical with respect to control, because you can lose your company if you are not careful.
Moreover, these same provisions actually change the valuation equation, and what looks like straightforward ownership or participation in the ultimate economics is often skewed by so-called liquidation preferences, dividends and some other features. So the entrepreneurs should make sure they understand what those are and very carefully model out the economics so that they perhaps can do a better job of negotiation.