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2 posts from February 2008

February 13, 2008

Follow-On Financings: Act Like a Pro, Raise the Dough

With the capital market turmoil raging, many argue that 2008 is going to be a tough year for start-ups to raise money, particularly follow-on capital in the form of a Series B financing (not surprisingly to any veteran viewers of Sesame Street, Series "B" follows Series "A" rounds of financing).

Series B financing processes are all about credibility.  Does this management team have its act together to build a great, valuable company?  As such, behaving like a pro during the fundraising process is critical.  If the management team demonstrates they can run a great fundraising process, they can run a great company.  If they look like this is their first time through the process and they are scrambling to react to questions and requests for materials, their ability to successfully execute on the business plan will be heavily discounted.

For VCs, the Series A is a “hopes and dreams” investment thesis.  Do I believe the vision and this management team's ability to bring the vision to life from nothing?  The Series B investment thesis is all about “metrics and momentum”.  The management team needs to provide a compelling case that their company and their category has tremendous momentum, in fact accelerating momentum, and that the Series B money is going to be used to cement their leadership position in a valuable market.  It is not a speculative bet.

In a first meeting with a management team, typically lasting 60-90 minutes, a VC firm’s job is to decide whether to have a second meeting.  If so, the VC firm will typically articulate to the management team the key issues or concerns there have with respect to the business that they'd like to understand better and see addressed.

If a VC firm is interested in continuing the process after the first meeting, they’ll typically invite the team back for a second meeting with a broader group of the partnership and try to understand the business at a deeper level in the context of the key issues.  If there is interest in doing “real work”, the due diligence process begins and it is "game on".  Note to entrepreneurs:  if a VC keeps meeting with you and isn't doing "real work", it's a yellow flag that you are on the back-burner of their "top new projects" list, of which there are typically no more than one or two.  Typical materials that are asked for to assist in due diligence in a Series B process include:

  • Capitalization table
  • Management team bios
  • 3-5 year Financial plan and model – the CFO should be prepared to walk through; which should include a 10-15 page PowerPoint presentation on the business model, key metrics and assumptions and how those metrics and assumptions impact the financial model
  • Historical financials, audited and unaudited
  • Note that the financial model should be packaged in an Excel file in such a way that can be send to VC firm associate/principal to tear through and tweak assumptions and run sensitivity analyses
  • Sales pipeline – VP Sales should be prepared to walk through
  • Management team references
  • Customer references
  • Partner references
  • Technology review – VP Eng should be prepared to walk through, ideally with PowerPoint presentation as guide and architecture document as back-up
  • Major contracts
  • Product roadmap – VP Marketing should be prepared to walk through; ideally with PowerPoint presentation as guide
  • Exit valuation comparables and scenarios – CFO should have matrix of public company and private exit comparables that show typical revenue and EBITDA multiples

A thorough but efficient diligence process typically takes 4-8 weeks from first meeting if everyone is focused on it.  A few pieces of good news should be sprinkled in during the process to underscore the momentum story (e.g., “By the way, we signed X” or “By the way, we were 50% ahead of plan last month”).

At the end of the day, the fundamental VC math a firm will need to be sold on for the Series B goes as follows:

  • What is the post money valuation on this round?
  • How much additional capital will be required, if any, and what’s my blended post money going to be across the two rounds
  • Multiply that number by 5-10x. 
  • Can I convince myself and my partners that I can generate that exit valuation based on the industry comparables during a rational market period over the next 3-5 years?

If the answer is "yes", you get the term sheet.  If no, rinse and repeat with next the VC firm!

February 06, 2008

Is the Exit Window Closed?

Microsoft's unsolicited $44.6 billion bid for Yahoo is an exciting, bold move for the Redmond, WA software giant who is desparately trying to compete with Google for the $800 billion in global advertising dollars, of which only $24 billion will be spent online in 2008 (a rate that is growing at over 20% per year).

But if VCs needed yet another signal that the exit environment is getting tougher, here is another one.
First, the IPO window is closed thanks to choppy stock markets and recession worries.  Then, some of the most popular technology company acquirers, like HP, IBM and Cisco, get battered in the stock market along with eveyrone else.  And now two of the most popular media and Internet acquirers, Microsoft and Yahoo, get frozen in their tracks as they try to figure out whether to combine.

What happens to VC-backed portfolios when the exit windows close?  We saw it occur in 2001-2003 and it's not pretty.  The companies who had the investment thesis, "if you build it, they will come", find that no one is coming to their party.  And the companies that had the investment thesis, "get a few leading customers and then let's sell to Yahoo/Microsoft/Google" are seeing two of the three candidates go into hunker down mode for the forseeable future.

Bottom line:  if you are raising capital and have the option, raise a bit more.  And if you have set your 2008 budget, reset it...a bit lower.