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March 03, 2005

When and why get VC money?

OK, this post has the risk of sounding self-serving, but with all caveat emptors up-front, I thought it worth making the case for why it makes sense to take VC money in certain situations, if available.  Naturally, this is the other side of my previous post, "Top 5 Reasons Entrepreneurs Dislike VCs"!

I highlight the phrase "in certain situations" because, not surprisingly, VC investment makes no sense in the majority of small businesses.  Many businesses are low-tech, by nature likely to be slow-growth or modest in market potential - these are not appropriate to take VC money.  If a business is high-tech, has fast-growth potential and large market potential, it can be a good fit for VC cash.

To help put some dimensions around this, recognize that VCs look to make 5-10x their money in any investment in 4-6 years.  If they can't see a reasonable path to this, they won't find the investment appealing.  VCs also typically like to invest a minimum of $5-10M per company (some less, some more, but let's focus on the bulk of the bell curve).  If that $5-10M investment buys 20-30% of the company over time (typical), it means VCs typically invest in a post-money valuation at the end of the day that ranges from $15-50M.  Seeking a 5-10x multiple on this investment means VCs look to invest in businesses that will be worth $75M-500M in 4-6 years.

Bottom line:  if you have a business that you can see growing over 4-6 years to $10M in revenue and worth, say, $20M in a trade sale, you don't have a VC investment candidate.  Seek angels or friends and family if you need capital, don't bother with VCs.  That isn't a bad thing.  Many friends of mine have what I would call a "lifestyle business" - small, profitable and they own it all!

Now back to a high-tech, fast-growth, large market potential business...that is, the VC candidate business.  Why get a VC?  An entrpereneur who has enough money to fund a new business himself said it well the other day:  "Credibility, Connections, Counsel and, yes, Capital".  Prospective employees, customers, partners and service providers all recognize and appreciate the that start-ups with VC investments are more likely to survive and succeed.  A good VC firm and partner should bring a wealth of connections that help in team-building, business development and strategic partnerships.  And a good VC has seen the start-up movie over and over and over again.  A good, serial entpreneur may have run a start-up every 5 years, but a good VC has invested in and worked closely with 10 start-ups in 5 years, thus they should be in a position to see patterns, look around corners and generally help guide and advise the entrepreneurial team in the science of company-building.  And finally, VCs bring capital - not just in the round they invest in, but in theory in their commitment to continue to invest in the company over many years, through good times and bad (albeit at varying valuation rates and thus varying levels of dilution!).

Whether the case for working with a VC is compelling enough is in the eyes of the beholder - the entrepreneur - but in the end, a high-tech, fast-growth, large market potential business is more likely to be successful if the founding team are willing to give up a share of the pie to bring on VC partners who can help them meaningfully grow the pie.

Comments

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Your comment was great for us at this juncture. We are a small software company seeking VC at this time. I would like to hear more about how to raise money quickly and effectively. Here are some background info about our company:

C-Wiki Inc. is an Internet Collaboration Software Company. The company was founded in 2003 in Beijing and has received no outside investment. C-Wiki produces and markets collaboration Wiki software called “C-Wiki” to enable people or organization working efficiently. The product was started as a University project (University of Science and Technology of China), and quickly expanded into various sectors in China. The majority users are academics and education institutions. We are interested in taking the company to the next level by expanding business into US market and continuing growth in China.

The real reasons why entrepreners seek VC is because either (a) they have dreams that require huge cash up-front; or (b) they somehow think VC will be the answer to whatever ails them. VCs arrogantly dismiss all businesses that aren't candidates for their largess as "lifestyle businesses:, yet the VC success rate is extremely low (classic 2-6-2 rule). The reality is that VCs are technology speculators, not real investors, and they like to put large cash to work over short time-frames on highly speculative bets on proprietary technology and big-story deals. They bet hoping for a bail-out (aka liquidity) event. In that sense it is a million light years away from the issues involved in building profitable stable long-term companies.

There is no question in my mind that my company would not have seen its successful IPO without the non-financial assistance I received from our two silicon valley VC. Hiring great people, connecting with great partners, you name it.

Great Article. Nice Work.

Thank you very much for the information I really appreciate it!!

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