Small Business

Before You Accept VC Funding...


A veteran entrepreneur tells you what you need to look for in a venture-capital firm before before you agree to a deal

Venture capital can be the best thing that ever happened to your company or your worst nightmare. Make sure you know what you are getting into before you sign on the dotted line.

In my last column I discussed the extensive due diligence that venture capitalists conduct to evaluate an investment and what you should have in place to get an offer (see BusinessWeek.com, 8/1/06, "15 Things You Need to Score VC Funding").

DO YOUR HOMEWORK.

A VC offer comes in the form of a term sheet—a document that details the amount the VCs want to invest, their conditions and requirements, legal rights, financial terms, and the controls they are seeking. If all goes well, you will get term sheets from more than one VC firm.

When that happens, it's time to do your homework. All VCs aren't created equal. They have the potential to bring a lot to the table, but there are always a few strings and onerous conditions. The more you know about your partners and the more careful you are about negotiating terms, the better your chances of a productive relationship (see BusinessWeek.com, 7/17/06, "Venture Capital: The Good, Bad, and Ugly").

Here are the important questions to cover while doing your VC homework:

1. Besides capital, what does the VC firm bring to the table? Sales leads: What potential customers can they provide introductions to? Partner introductions: Who do they know within the companies you may want to partner with? Recruiting: How extensive are their contacts, and will they make their Rolodexes available? Will they help you interview prospective employees? Strategic advice: Do they understand your market? Will they be able to help you with business strategy? Mentoring: Can they help you develop your skills? Networking: Do they bring the companies in their portfolios together and facilitate networking?

2. Track record. Check the performance of other companies in which they have invested. What types of returns did the founders of those companies receive?

3. Deep pockets. Do they have enough in reserve for follow-up rounds of financing? Can they get other VCs to co-invest with them? No matter how sure you are that you're asking for enough, make sure more money is available if you need it. The odds are you will.

4. Founder relations. How did they treat the founders of their other companies? Were founders shunted after the financing was complete?

5. Friends in need. Did they stand by their companies when times got rough? Did they provide follow-up financing when things went poorly, and were the terms reasonable? Did they roll their sleeves up and help management?

6. Personality/compatibility. Do you get along? Are they a group of people you would want to deal with on a frequent basis for the next three to five years?

7. Integrity/ethics. How honest have the VCs been in past deals? Do they maintain a code of ethics and stick to it?

8. Reputation. What do other venture firms think about this one? Remember that you are going to be branded by the VC you choose. Their reputation is going to rub off on you.

9. Commitment. How many other boards is your VC on? Will they spend the necessary time to support you? Is this a significant transaction or just a distraction?

Ask the VCs these tough questions and check their answers with others. You should call several executives and founders of companies they have invested in—both the successes and the failures. Dig down to find out how valuable the firm's assistance was. Ask about the disagreements and whether they would consider an investment from the same VC firm again. Try to get an idea of what your future may hold.

You should also ask the VCs what they think about each other. By the time you are done, you'll know about their battles and motivations and find that the VCs have as many warts as you do. You will also develop a realistic set of expectations.

OTHER KEY POINTS.

Here is some additional advice on what you need to do before you accept any deal:

1. Look very carefully at the terms you're being offered. Get a good lawyer to help you understand each of the terms and negotiate hard before you sign anything. Some of the conditions may not seem significant now, but could come back to haunt you later.

2. Don't accept an "exploding term sheet." Some venture capitalists will employ used-car dealer tactics and pressure you with a short deadline. If the deal is good enough for them now, it will be equally good after you have completed your due diligence and looked into other options.

3. Negotiate the valuation, but don't necessarily go with the highest valuation. The higher the stock price, the less ownership you have to give up for the same amount of investment. But there are many additional terms and conditions, and the highest valuation may not be the best deal. What's equally important: the quality and reputation of the firm you're dealing with and what other benefits it brings to the table.

4. Keep your options open and have backup plans. Just because you have a term sheet doesn't mean that you will complete the deal.

5. Remember, there is no urgency for the VCs to make an investment. You may be in a hurry, but the longer the VCs wait, the more willing you become to accept their onerous terms. The best way to accelerate timetables is to create competition with other firms or via other funding options.

6. Don't buy the line: "We'll invest if you can find another firm to take the lead on the term sheet." This is VC-speak for: "I'm too risk-averse to invest, but if a bigger firm jumps on the deal, I want a seat at the table." Most VCs will bring their partner firms into the deal if there is a need.

If you pick the right partners and negotiate wisely, there is no reason that everyone can't win in this partnership. The key is to know what you're getting into and have reasonable expectations.

Vivek Wadhwa, a former tech entrepreneur, is the Wertheim Fellow at the Harvard Law School and an executive-in-residence at Duke University. He writes a column on policy issues affecting entrepreneurs every month.

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