Tag Archives | Venture Capital

How to Choose a Venture Capital Investor

As we prepare for our second round of venture capital financing at SalesCrunch, I thought it might be interesting to talk a little about the process we are going through to select the people and firms we want to work with.

I have raised a few rounds of venture financing in my career dating back to the first coming of the Internet in 1999, but there has never been a better time to be a technology company raising venture capital. There is more money available from more venture firms than ever before, even compared to the “web 1.0″ days. Back then there were only a few proven business models like ecommerce (Amazon | eBay) and online advertising (Yahoo).  It wasn’t clear then, nor is it clear now, if online advertising would be big enough to support more than a handful of select companies.  A disproportionate amount of ad revenue still goes to a few large players like Google, Facebook and Yahoo. Remember, advertising is all about reach and frequency, so if your audience is small….  Anyway, now there are several additional proven business models, including social commerce (Groupon | Gilt), social selling (Chloe & Isabel), virtual goods (Zynga), consumer apps (iPhone store), consumer subscriptions (Birchbox), marketplaces (TaskRabbit | WorkMarket) and software as a service (Salesforce | SalesCrunch:), to name a few.  There is also more liquidity from acquisitions and IPOs then there have been in a long time.

More proven business models and liquidity means there are more options than ever for entrepreneurs to raise capital.  So how do you pick your ideal firm? Here are a few of the more important things to consider:

  1. Vertical focus – first and foremost, focus only on partners and firms that have experience investing in your space. Make a list of the companies in your space that you most admire and research their investors, but avoid your competitors’ investors if the company is still active in their portfolio, as it will be a conflict of interest. When I left Trulia, most of my personal venture connections focused on consumer internet companies. Most didn’t have experience or interest in the consumerization of enterprise software. They took meetings with me because they knew me, but I ended up wasting a lot of time before I finally focused on people and firms that really understood and appreciated what we were doing.
  2. Stage – what you don’t want to do is waste your time pitching firms that are too early or too late stage. If you are raising $10M, an early stage firm with a $30M fund likely won’t be able lead the deal or write you a $5M to $10M check. Conversely, if you are raising $1M and you are pitching an $800M fund that has no track record of doing seed stage deals you are probably wasting your time. The other thing to be conscious of is how much of the fund has already invested and how much is allocated for future rounds in existing portfolio companies. If a firm has invested or allocated a large percentage of their fund you could be wasting your time. A good salt test is to see when they raised their last fund via press or filings and how many investments they made in the last year compared to each of the previous three years. If they raised a while ago and have slowed down considerably, you have a pretty good indication.
  3. Reputation - Now you have your initial list of ideal partners and firms, start doing your homework on which have the best reputations. You can search the web to quickly figure out which are the top tier firms in your space. You can also get a sense of the partners by Googling them and reading their blogs, but you will need to work a little harder to get the real skinny on people. Go on LinkedIn and figure out who you know in common and start asking anyone that has worked with them about their experience. You want to talk to entrepreneurs who worked with them in successful startups and ones that have failed so you know what to expect in both situations. I’ll do a dedicated post about the most important terms in a venture deal, but at this stage you just want to find out if the firms on your list have a reputation for fairness and for being entrepreneur friendly.
  4. Chemistry - you are going to have to live with your investors for a long time, so you better like them.  Chances are they will join your board and you will spend a great amount of time in good times and bad solving big problems and overcoming interesting challenges. Spend as much time dating them as you can with them before you get married.
  5. Geography – this is much less of an issue than it use to be.  When Trulia got started back in 2005, you needed to be in Silicon Valley to get funded as an internet company. Now, there are more hubs like New York, Austin and Denver and VC’s get on planes more than ever.  SalesCrunch has investors from New York, Silicon Valley and Boston. Groupon and 37Signals are in Chicago.  All that said, if you are a starving and/or unproven entrepreneur, you will have to move closer to one of the hubs to afford to take meetings and have VCs willing to invest in you.

We are very fortunate to have some amazing, top-tier investors already at SalesCrunch. We are just looking for one or two new investors who can help us take the company to the next level, so we only need a short list of four or five that match the above criteria to find the one or two we need. If you are starting from scratch, your list might need to be a bit longer and include lots of angel investors as well. This isn’t as comprehensive as it could be, but at least its a good start.

26 more posts to go in my 30 posts in 30 days challenge.  Its getting harder now.

Credits:

Image of Steve Jobs and Mike Markula provided by Ink Magazine

Image of iFund provided by The Christian Science Monitor

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Is Super Pro Rata Super Bad?

I was talking to one of our investors the other day about our upcoming fundraising when told me his firm wants to participate in this new round “super pro rata”.   It reminded me of all the funny MBA-speak we have in the Internet startup world. So what does he mean by super pro rata and is that a good thing?

There are two answers to this question, but let’s define pro-rata before we talk about super pro rata.  It is extremely common for investors to have “pro-rata rights”, or the right to maintain their percentage ownership in a company in later stages of financing. So, if Accel invests $1M in your first round in exchange for 20% of your company they have the right to keep that 20% ownership in subsequent rounds of financing by investing more money. Incidentally, your company is now worth $5M ($1M is 20% of $5M) after the financing or “post-money.”   Let’s say you raise $10M in your second round of financing. Accel needs to invest $2M in that round just to keep their 20% ownership stake, which leaves 80% of the financing to new investors. So let’s say these new investors are also buying 20% of the company for this new $8M. This means your company is now worth $40M ($8M is 20% of $40M) post-money.  That means Accel owns 20% and the new investors own 20%, for a total of 40%, and both investors have the right to keep their 20% stake going forward. While Accel had to pay up to own exactly the same percentage of the company, their 20% is now worth 8x their original $1M investment or a whopping $8M. Not a bad return, but it’s only on paper right now so don’t get too excited.

Now, let’s look at where super pro rata comes into play. There are two different ways super pro rata is used. One is super good and one is super bad:

  1. Super Pro Rata – If Accel wanted to own more than 20% of the company in the second round of financing then they would want to participate “super pro rata”.  Simply put, they want to own their pro rata percentage of 20% and they want a piece of the other 20% the new investors are going to own with additional $8M investment.  Presumably, they want to own more because the company is doing well and it’s smarter to invest more money into something you know is getting traction rather than to invest in a new, unproven company or concept.  It is ultimately up to the founders to let investors own more than their pro rata in subsequent rounds. When an existing investor wants to participate super pro rata, it is a good sign and it sends a positive signal to other investors that things are going well since existing investors have the most information about a company.
  2. Super Pro Rata Rights – This is when an existing investor adds the contractual right to buy more than their pro rata share in subsequent rounds into the term sheet of the first found of financing.  It might seem like a subtle difference, but wanting to own more and having the right to own more are very different.  Plenty has been written about why super pro rata rights are bad by Mark Suster, Brad Feld and David Beisel. Net-net, this is bad because it significantly reduces your options for new investors in subsequent rounds, which drives the valuation of your company lower and reduces your chances of getting funding at all.  As Mark points out, if the investor that has super pro rata rights exercises them, then there might not be enough room in the round for new investors, so they get to name their price. If they have super pro rata rights and don’t exercise them, it sends a red flag to new investors. Basically, you’re damned if they do and you’re damned if you don’t, so don’t do it!

So, to sum it up, super pro rata is super good, super pro rata rights are super bad.

28 more posts to go in my 30 posts in 30 days challenge, so stay tuned.

Photo complements of Break.com and EntertainmentWallpaper

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