VENTURE CAPITAL - HOW THE PROCESS WORKS
(February, 2000 )

• Introduction
• The Rounds Begin - Fools, Friends and Family
• Seed Financing - The Angel
• First ("Real") Round
• The Second Round
• The Third Round
• Mezzanine Round - Before the IPO
• The Team

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Introduction

The stereotype of a venture capitalist as a wealthy person funding start-ups does not mimic reality. Generally, pools of capital are looking for a high rate of return (at least 25% compounded) within five years or less.

In the VC world, money generally does not come as one big lump followed by an IPO. Typically money arrives in small (clearly a relative term) rounds, and a successful startup will generally have multiple rounds.

As a principal in a startup, you should expect to look for your second round of funding before the ink dries on the paperwork for the first round. Some successful startups will have one founder who does nothing but focus on fundraising. Fundraising is very time consuming.

The Rounds Begin - Fools, Friends and Family

Many startups get their initial survival money from the triumvirate of friends, fools and family. At this stage, you may not even need a formal business plan. It's when you have tapped out the friends, fools and family that you look to your first "professional" round. At this point, you probably wont go any farther without a business plan.

Seed Financing - The Angel

This next round, considered the earliest stage of investment, is often called the "seed round," and generally is provided by an "angel investor". This money is earmarked for things like market research, developing a prototype, completing the management team, improving the business plan and generally getting to the point where the company can qualify for "first round financing."

An "angel" is a private wealthy individual who invests in startups. An "angel round" is typically smaller than a true "first round" investment by a VC.

The hardest part about the seed round is getting and keeping a potential investor's attention long enough to convince him or her that your startup is worthy of his investment. Once you have an investor's attention, you must then negotiate for enough to make it to the next round.

The special risks associated with seed financing has led to the emergence of specialists who focus on seed round investing. These specialists may find it easier to stomach an incomplete management team or business plan that is rough around the edges.

First ("Real") Round

After the seed round and the company's start-up phase, comes the "first ("Real") round" of financing. This should be the company's first involvement with an institutional VC fund. This round usually involves a step-up in valuation and total size ($4,000,000 and up is common). Typically, at this stage, your company has something that is either commercially available or far along in development.

Moving from the seed round to the first round can be a challenge. At this juncture, many companies face the problem of developing their product and / or service (i.e. ""It""). Why? Because, the optimistic time and cost projections used in the seed round business plan falters and if the development of the products and / or services are incomplete or late, you have missed your first key milestone.

My advice is to let your seed round investors know, let potential first round investors know, and then modify the business plan based on the new reality. When you are short of money, you don't want to be short on credibility too. This kind of problem can be prevented by working with pessimistic time assessments for "It" development. Just accept the reality that "It" always takes longer than you anticipate.

The Second Round

After the first round, comes the second round, which generally provides the company with the much needed "working capital for the initial expansion of a company, which at this point should be producing and shipping its products and be increasing the size of its accounts receivable.

The Third Round

Next comes the third round. This round is typically provided for the major growth expansion of a company with increasing sales volume and either breaking even or profitable. The funds provided by the third round of financing, are generally utilized for further expansion, marketing, and working capital or development of an improved product."

Mezzanine Round - Before the IPO

Often, this round is an unplanned round, while the company waits for that "right" moment to do its IPO.

The Team

Almost every venture capitalist makes the same comment. There is nothing more important to a VC than the TEAM. You may have the best idea in the world, but without a powerful team, finding funding with will be extremely difficult. It is an absolute clichéthat a VC given a choice between an "A" team and "B" idea, or a "B" team and "A" idea will always choose the "A" team. No matter how good your idea, a great team is essential So, start amassing early.

Key players in your team should include your CEO, COO, and your key VPs (VP of marketing, Chief Technology Officer, etc.) Use your network of contacts to build an impressive Board of Directors that should include experienced business people, visionaries, and leaders VCs will recognize. The Board might even include some of your key professionals like your attorney.

If you can get recognizable and successful leaders, business people and professionals on your Board, with names you can use that may help garner the attention you need. You also now have a network of interested people sitting on your Board who can help open the doors, you will later need opened.

Popular legend notwithstanding, without an appropriate introduction from a respected intermediary, the best business plans almost never get funded. You will find the Lotto to be a better bet than a cold mailing to VCs.

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