I'm currently raising venture capital for Lijit and being immersed in it reminds me of a blog post I have been meaning to write for some time. Over the years being around companies trying to obtain venture financing, being on the evaluation side of deals for venture guys, and being involved in raising money myself, I have made some mental notes of when deals "went off the rails" for entrepreneurs. Like my Angel Financing post from a month ago, I'm trying to take a demonstrative path as there is plenty on information out there about "how to build a business plan" that isn't really that useful I have found.
The following are just a couple of the general derailments I have witnessed over and over. It's important to note these items are not a guarantee that things are going south, but are often indicators. When you hear yourself saying them make sure you understand what the guy on the other side of the table "may" be hearing. The thing that makes some of these examples particularly insidious is that the entrepreneur didn't even see the ditch coming, and may today still not know what went wrong.
What you said #1: We are seeking an investment of about $1.5 Million dollars and that's about all the capital we will ever need.
What may have been heard: You can't fault anyone for building something they can get profitable within the scope of $1.5M. But, there is a secret derailment within this statement. First this is often an indication that the investment or the idea isn't big enough for an institutional investor. Typical venture funds are in the $50M to $500M range and have 5 to 10 partners. Each partner can only invest in a handful of companies so that dictates they have to put between $5M and $10M into a company over its lifetime making a $1.5M investment look too small (one guy can't do 50 of these). The statement can also indicate that the opportunity is just too small, VC's want to fish in the "10x back on their money pond", if the company can be self-sustaining on that little money there is probably not much barrier to others doing it also or it can mean the entrepreneur isn't focused on the right thing (for a venture deal), making a BIG valuable thing using cash as the rocket fuel. Finally, this can just mean the entrepreneur is just a green bean and doesn't know how much money it takes to make something big, fast. Again, nothing wrong here but keep in mind you are trying to attract an investor that wants to put $5M in and get $30M to $50M out.
What you said #2: Our technology is very unique; we intend to provide solutions in healthcare, engineering and education.
What may have been heard: Very often technology based founders are very excited about the generic applicability of their invention, idea, etc. This is a normal thought process to engineering types; make something cool that can be used over and over again. However, to a VC this sounds like an excited nerd with no idea how to productize, sell, or market their idea. While your widget can do 100 things, VC's are looking for the ONE thing you are actually going to do. Personally, as a recovering nerd this one is painful for me to watch unfold live. The VC says what's your market and your strategy to get to that market, and the entrepreneur says, "it's very generic it works for everyone". They go back and forth and before you know it the train is off the tracks running down the meadow without an engineer. Good VC's - that like the idea (in spite of the entrepreneur) - will often suggest that the entrepreneur partner with a "business person" at this juncture, smart nerds will do it. Here again, nothing wrong with a unique idea that can o multiple ways, but you better lead with solid single direction or you will never get to all the others.
What you said #3: Our customers love our stuff, they embed it deeply in their products. We help them adapt the products look, feel and functionality to exactly solve their problem!
What may have been heard: I see this one most often with scrappy entrepreneurs or consulting companies that have recently productized something and now want to sell their widget. There are two kinds of revenue to a VC, product revenue and professional services revenue. Product companies can grow revenue by selling their product into different distribution channels that scale independently of head count. Professional services associated with a product, such as customization only scales as you add people. If your business has to have lots of people to make lots of money that's a concern as the cost of sale is also very high and the profit margin is lower. Remember at the end of the day as a startup entrepreneur your product is your company and someday you will sell the company. It's very typical to sell a company on a multiple of your revenue either forward or backward looking. What happens is acquirers will apply one multiple to product revenue (say 10x) and another to service revenue (say 0 .1x). So, the same company with $50M in revenue can be worth $500M or significantly less than the amount of money you invested depending on the mix of revenue. Moral of the story, make sure your revenue mix isn't out of whack and you don't need to add another dude to make another dollar. From what I have seen, keep professional services less than 30% of revenue.
What you said #4: We provide a very attractive platform capability for our customers. It's so good we build a host of other applications on top of it!
What may have been heard: This is another form of the focus problem and is another engineering centric thought process. Engineers think I can make this generic platform and sell that, plus I can build these cool apps on top of it that other less intelligent people "just can't see yet". The problem here is the VC hears "I have 3 businesses here, and I'm going to run them all!". Standard answer, you may have great ideas how to build vertical applications on your platform and if that's true then give some thought to *just* building the vertical application.
As with my Angel Financing post a lot of this stuff seems like common sense after you have been around for a while. It all comes back to motivations. It's important to know that Venture Capitalists have motivations and generally it's to build a high value company fast and get a high value return in 5 to 10 years. They have seen a lot of companies come and go and have the advantage over the entrepreneur that at best builds a company a handful of times in their carrier. My advice is that if starting venture backed startups is your path of choice, start making notes of what you see works and what doesn't. It's the best way to learn.