Should I take Venture Capital money?

Over the past few months I have had discussions with several software start-ups about the pros and cons of taking VC money. The questions and decision process might be helpful, or at least interesting, to many of you. As part of my job with Microsoft’s Emerging Business Team I work with VCs and start-ups, many times helping to match start-ups with the appropriate VCs.

Back in the ‘90s and early 2000’s if you had a high technology start-up it was automatic that you would take several rounds of VC money to build your company. The dot com bust changed the environment significantly. Today entrepreneurs are considering all the options from boot-strapping with personal funds, taking consulting projects to simultaneously build a custom product and a generic one, raising funds from angel investors, and traditional VC investments.

Who should not consider taking VC money?

• Established family run businesses

• Companies transitioning from consulting business to a product business

• Low or steady growth businesses

• Non technical product companies

• Service businesses

There are lots of very nice profitable businesses that are not good candidates for VC investment. These are typically low technology and/or low steady growth businesses. The growth can typically be financed out of profits or through traditional asset based lending. These companies are typically closely held with few stock options for employees. If your company can reasonably grow to $10M in revenues over 5 years, and be worth $10M to $30M in a sale transaction, VC investment is not for you. It would be better to consider angel investors, friends and family, or trade partner investors.

In a previous post I discussed the role of Angel Investors like Keiretsu Forum, eCoast Angels, Launchpad, and Common Angels in the Boston area.

What types of companies are good candidates for VC money?

• High growth potential companies that can go from $1M to $50M or more, in 5 years or less

• Big market opportunity companies competing with well financed incumbents

• Capital intensive start-ups

• Highly technical products that few other financiers could understand

• Companies that need to hire experienced mangers, and build strategic partnerships

These companies have great growth potential and need to grow quickly to grab market share before competitors enter the market. They need to hire great people and invest heavily in R&D in the early years. They sometimes need to build exclusive strategic partnerships with key industry players to gain market penetration. These types of ventures require lots of capital and rely on a trusted network of people to build the business.

What does a typical VC investment look like and what kind of return is expected?

• Total investment of $2m to $10M over several rounds, typically $2M in the first round

• Take 20% to 30% equity stakes

• Expect 5X to 10X returns over 5 years

• Post money valuations should range from $25M to $50M

• IPO or M&A liquidity events of $100M to $500M

VCs make very risky investments that banks or other lenders would never make. They expect very high returns to compensate for the risks. Out of ten investments they hope to have two that return 10X their investment, three that return an average of 5X their money, and the remaining five lose money or break even. Of course every single investment is made with the expectation that it will be a winner. But, the odds are that about half of them will just break even.

What do VCs bring to the table other than money?

• Experience – they have typically built 10 to 15 companies to successful outcomes

• People – they can recruit experienced managers and leaders

• Connections – they know potential acquirers and investment bankers

• Money – they can bring in follow on investors in later rounds

• Credibility – Customers and potential new hires feel more comfortable when VCs are invested

What are the risks in taking VC money?

• Expectations and growth curves are raised dramatically

• Management changes may be required in order to meet the growth

• Earlier liquidity exits may be ignored in hopes of bigger long term payouts

• VCs expect a liquidity event within 5 to 7 years

VC investment is not for everyone, but for high tech, high growth businesses it is a good option. You give up some equity and some control but your odds of success are increased. When VCs have a vested interest in your success good things can happen.

Comments

[Markus]

Interesting points. Why are you saying companies transitioning from services to products should not consider VC?

[DonDodge]

Making the transition from a services based company to a product based company is very difficult and often unsuccessful. VCs typically stay away from deals like this because of the transition issues, and because the growth potential usually doesn't meet their expectations.

Services businesses are also more capable of self funding the transition based on their existing revenue stream.