Wednesday, March 28, 2007

The truth about Venture Capital and Angel Investing is …

Last week, I was on a panel with other investors discussing the “do’s” and “don’ts” of angel and venture capital investing some one from the audience fired a series of intriguing compounded questions ” why are the VC’s so illusive?, why don’t they have all their information available? Why don’t they disclose how they come up with their valuations? Why are the selection criteria’s so undefined????”

All valid questions and valid statements – the event made me think that entrepreneurs view of the equity investment community is entirely different than that of the inner circle and this mismatch of perceptions is not disruptive and unhealthy.

So let’s talk about the truth about the Angles and the Venture Capital firms; here is a few points to start with:

1- Looking for Money Vs. looking for a partner: investors look for a partner that they can invest in and help grow a business. Entrepreneurs look for money and often feel (although they may claim otherwise) that if they had the money they could do it by themselves. This difference of view causes so many deals to stall and never get funded. Investors don’t want to be running companies, period. They are, however, investing to make money and if the team is not doing it, they have the responsibility to their investors (limited partners of their funds) to act and to get a wining team in place.

2- Saying NO: it is very difficult for the VC’s and investors to say no to hundreds of deals before saying yes to one. People don’t like to hear it; it is their baby, their dream and they have worked hard – the no becomes very personal to the entrepreneur. If the investors wanted to make an investment in every deal they see, they would run out of money very quickly, lose focus on the type of investments they are making and end up being bad partners for the entrepreneurs. The truth is that there are a lot of good ideas out there, but chemistry is also very important.

3- A days work: Being a professional investor is a lot of work – I have found that the entrepreneurs often feel VC’s are on the golf courses a lot and are being aloof and unavailable and not really busy – on the contrary, between talking to hundreds of entrepreneurs to identify the right deal that fits their portfolio and performing due diligence to fulfill their fiduciary responsibility to the fund, meeting with lots of service provider to ensure that they have solid relationships that secure deal referrals, spending time with portfolio companies to ensure things are going smooth and surprises are minimized (ooppps we are running out of money or well the customers just did not move fast enough, or we have more bugs that we anticipated and delays are unavoidable, etc. etc.). So … often, they are not unresponsive, but just simply overwhelmed – and yes they do get paid for it well; particularly when things work out.

4- The valuation Myth:
entrepreneurs are puzzled about how VC’s and angles come up with valuations – the truth is that investors are puzzled about that as well. There is no “absolute” formula! It is more a question of what other deals are being looked at, what other investors are willing to pay for similar deals, how over crowded a space has become, and how confident the investors are with the team pulling it off. The other dimension is purely mathematical, investors have to invest in a lot of deals for one to payoff so that “one” has to payoff big. Which means large markets and big revenues are a must. The investor should take somewhere between 25% to 40% of equity and target a 10x (ten times what they invest) in a 5 to 7 year time frame – so you can back into the valuation number. Again, it is more of an art than a science – now this is different where companies have trailing revenues and already show a profit; and that is a an all together a new blog entry.

5- Acknowledge the Differences: angels are investing their own money, get involved earlier, make a lot more emotionally charged investment decisions and like to be involved. VC’s on the other hand are investing someone else’s money and get paid a management fee (usually around 2.5% of the total fund) and also get a carry (or a piece normally around 20% of the upside). VC’s performance is measured by the investors and if they don’t perform, they can not get to close the next fund and are out of a job! – the fact is that these days a lot of VC’s are having a hard time closing a new fund and are thinking of other careers. At the end of the day, the truth is both VC’s and Angels are looking for very high returns because they are making very risky investments; and that for VC’s this is a job and for Angels, it is an opportunity to be involved with a success story and entrepreneurs should realize and acknowledge it.

And so what are your thoughts ?????

6 comments:

Adam Steen said...

Very interesting post. I think you bring up some very valid points and explain them very well.

In my opinion, (speaking from the Midwest) too many entrepreneurs are uneducated about the realities of their business models. We try to shift their mentality to chase resources, not money, and then grow the business to a point that capital will chase them.

Anonymous said...

I really like the straight talk here - I like to learn more about the truth about things -- how do we get to a point that we are on the same page with the VC's and Angels? how do I get more edcuated and more prepared? How do i get passed the point of chasing money?

Adam Steen said...

Anonymous,

On our end, for a business owner to get on the same page with us, they need to demonstrate a knowledge of their industry, customers, competitors, market trends, tech changes, etc. If they can do that, then they have a shot at growing their operating income (provided there is a market for their product). If you can demonstrate growth in operating income, the greater the chance that money will chase you.

golf inventor said...
This comment has been removed by a blog administrator.
brian said...

Great post. I hear too many entrepreneurs complain about the differences and offer suggestions as to how investors could make it easier on them. What they don't seem to realize is that many of these "differences" are necessary and they would be better off trying to understand why instead of trying to force them to fit something that works better for them. In the long run, most of their suggestions for improving the process won't work better for them anyway.

Steve Brown said...

Sid,
It seems you present in an educational format. Entrepreneurs need to be taught how to go about raising money and then what to expect from thier investors. This is something I believe would be valuable.

Steve Brown