Every year hundreds of entrepreneurs and investors congregate at the base of the mountains at the Fairmont Banff Springs Hotel in Alberta. Over the course of two days, approximately 50 IT, life science, and cleantech companies make their pitch to an audience of venture capitalists and angel investors. (This year’s event is combining virtual and in-person events.)
Panels, speakers and networking round out the event. Invariably, an entrepreneur will immediately begin pitching the venture capitalist (VC) as he seated himself next to him, while another entrepreneur will corner a VC at the coffee bar. Everyone is well-dressed and holding fast to proper decorum, but it’s hardcore angling for cash.
Once, after listening to an entrepreneur harshly criticizing the VCs that had passed on his deal, it became apparent that he understood virtually nothing about venture capital. While there is much more to discuss, here are five simple tenets to consider.
1. Be Okay with No.
Insiders call it the elegant turndown. When a VC can decline a deal and end the meeting with the entrepreneur still feeling good, the elegant turndown has been achieved. The VC will rarely want to go through the lengthy process of educating the entrepreneur on why the deal doesn’t work for them. As a result, they often say things like ‘Our allocation for your sector is complete’, ‘Call me when you reach $X level of sales’ or ‘Call me when you find a lead investor’. The real reason is rarely revealed because it will only lead to an argument and simply wastes time. Just move on.
2. Understand their focus and that they can help you.
Most VCs have a specific target investee for a particular sector or stage of growth. Don’t pitch them if you don’t fit their investment criteria which are usually detailed on their website. Also, don’t think that you can convince them to invest outside of their criteria. The VCs invest money entrusted to them by institutions and pension funds based on a funding model that restricts their investment activity. So if they fund IT, don’t bother pitching your medical device. The right VC for you is well experienced and connected in your sector. The right VC will work on your business with you. Don’t target just the cash; target cash that comes from hands that can help move the company forward.
3. Understand their fund cycle.
The age of their fund is also critically important. Take a look through their news releases. When did they launch their fund? If it was more than six years ago, that fund is irrelevant to you. Venture funds typically operate on a 10-year term. VCs generally target exits of four to seven years post-investment. A fund that is now more than six years old is no longer doing new deals. At most, they will do follow-on rounds in their current portfolio companies. At this time, however, the VC will likely be trying to raise the next fund. If this is the case, they will start forming a watch-list of companies for the next fund, which could open as early as year seven or eight of the previous fund.
4. Understand their workload.
The VC three to five years into their fund is spending considerably more time working on their investments than seeking new deals, but that does not mean that they can afford to miss any deals. As their time and availability shift to portfolio work from deal origination, they have to compress time spent with the same number of prospective companies. Meetings become shorter and their ability to explain why they won’t consider your deal evaporates. In this part of the fund cycle, they become masters at the elegant turndown.
5. Understand their return requirements.
It’s a generally accepted principle that VCs will invest in one of 100 deals. In an example where a fund makes 20 picks, they will have had to consider 2,000 deals to choose their 20. You might think that these 20 are then sure winners. No. Not even close. There are hundreds of ways a promising company can lose its way, and more often than not, today’s star is tomorrow’s dud. As a result, four of the 20 are complete losses and 12 limp along, never failing altogether and never really succeeding. This leaves only four to succeed, and for the entire fund to provide a reasonable return on investment these four have to be home runs to make up for the four complete losses and the 12 walking dead.
The VC is paid a salary but his real goal is called carried interest. Typically the general partner of a fund will fetch 20 percent of the gain after the fund has completed exiting all of its investments at the end of the 10-year cycle.
Sounds great, but it’s tough. Not only is it tough because the investments have to work, but the fund first pays a return to the institutions and pension funds that put up the cash. Often this return, called a hurdle, will equal the amount of the size of the fund that must be paid out before the VC sees a dime. Many VCs do not achieve the elusive carried interest. With these kinds of pressures and odds stacked against the VC, you can begin to understand why the due diligence is so thorough or why the terms of the deal seem unfair.
It has recently come into vogue to grab the microphone at entrepreneur events and brashly declare that the venture capital model is broken. This always is a crowd favourite. However, venture capital cannot be generalized into declarations of shiny good or evil bad, but it does need to be understood before it can be utilized intelligently.
Warren Bergen is President of Alberta-based AVAC Ltd.
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